Opinion
Docket No. 56301.
1956-06-20
ISHMAEL S. O'DELL AND MARY J. O'DELL, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Maurice E. Bishop, Esq., for the petitioners. W. Preston White, Jr., Esq., for the respondent.
Maurice E. Bishop, Esq., for the petitioners. W. Preston White, Jr., Esq., for the respondent.
During the taxable years petitioners were partners in the small loan business. When loans were made to a borrower petitioners took a note for the principal loaned him to which was added certain charges which petitioners called fees and commissions. The note was either payable in 1 monthly installment or in 6 monthly installments of equal amounts, as the case might be. Each note contained a provision which read: ‘it is hereby agreed any payments made on this note shall be applied first to the principal.’ When a borrower made payments on his note the payments were first credited to the principal until the full amount of principal was paid and then to the amount which had been added as fees and commissions. Petitioners, in their returns, have reported as income the amount of all fees and commissions collected in this manner. The Commissioner, in his determination of the deficiencies, has attributed a pro rata part of each collection made by petitioners to income regardless of whether the full amount of the principal had been collected. The books and records of the small loan business were kept on the cash basis and petitioners filed their joint return on the cash basis. Held, petitioners, being on the cash basis, correctly accounted for their income as it was received and the method used by the Commissioner in his determination of the deficiencies was unauthorized.
The Commissioner has determined deficiencies in petitioners' income taxes as follows:
+----------------+ ¦Year¦Deficiency ¦ +----+-----------¦ ¦1949¦$2,754.02 ¦ +----+-----------¦ ¦1950¦584.46 ¦ +----+-----------¦ ¦1951¦1,600.76 ¦ +----+-----------¦ ¦1952¦2,307.63 ¦ +----------------+
The deficiency for 1949 is due to the addition to the net income reported by petitioners on their joint return of ‘(a) Partnership income $6,717.24’ This adjustment is explained by the Commissioner in his deficiency notice as follows:
(a) It is determined that your distributable income from the State Finance Company for the year 1949 computed on the cash receipts and disbursements basis is $35,959.05. Inasmuch as you reported $29,241.81 your taxable income has been increased by the difference of $6,717.24, * * * The deficiency notice does not explain how the $6,717.24 which was added by the Commissioner was computed. However, the report of an internal revenue agent which was used by the Commissioner as a basis for the determination of the deficiency is in evidence. This report of the revenue agent's shows how the $6,717.24 was computed. It contains the following explanation:
Adjustments (as computed below) to correct the taxpayer's method of reporting gross fees. A pro rata portion of each collection should be applied to each principal amount and fees. The taxpayer has been reporting income from fees only when the entire principal was collected.
The deficiencies for 1950, 1951, and 1952 were determined in the same manner as described above for 1949, except the amounts added to the net income reported by petitioners on their joint returns are different. Inasmuch as these adjustments for 1950, 1951, and 1952 are of the same nature as the adjustment for 1949, it is not believed necessary to set them out in detail here.
Petitioners, by appropriate assignments of error, contest the correctness of the Commissioner's adjustments. The effect of petitioners' assignments of error is to allege that in each of the taxable years petitioners were engaged as partners in the small loan business and that the books and records of the business were kept on the cash receipts basis and petitioners' returns were filed on the same basis. Petitioners allege that for all the taxable years, in fact for every year since they began business in 1946, they have returned all loan fees and commissions in the years when collected and that the effect of the Commissioner's adjustments is to place into petitioners' income fees and commissions on loans which were not collected in the respective taxable years. Petitioners allege that this action of the Commissioner is unwarranted by the applicable law or regulations.
FINDINGS OF FACT.
The petitioners are individuals and residents of Birmingham, Alabama. They filed their joint income tax returns for the taxable years ended December 31, 1949, to December 31, 1952, inclusive, with the then collector of internal revenue for the district of Alabama.
During the taxable years the petitioners were partners in a small loan business know as the State Finance Company located in Birmingham. This partnership filed its partnership returns of income, Forms 1065, for its fiscal years ended May 31, 1949, to May 31, 1952, inclusive, with the then collector of internal revenue for the district of Alabama. In addition, the petitioner, Ishmael S. O'Dell, was a partner in the small loan business known as Ace Finance Company located as Anniston, Alabama, during its fiscal year ended May 31, 1951. This partnership filed its partnership return of income for that fiscal year with the then collector of internal revenue for the district of Alabama. Petitioner Ishmael S. O'Dell was also a partner in the small loan business known as Ace & New Finance Company, located in Anniston, Alabama, and Mercury Finance Company, located at Kansas City, Kansas, during their fiscal years ended May 31, 1952. The Ace & New Finance Company filed its partnership return of income for its fiscal year ended May 31, 1952, with the then collector of internal revenue for the district of Alabama, and the Mercury Finance Company filed its partnership return of income for that fiscal year with the then collector of internal revenue for the district of Kansas. All of these returns were prepared on the cash receipts and disbursements basis of accounting.
In general, the method used by the various loan companies in making loans during the years here involved was as follows: The company secured a loan application from a prospective borrower. After that application had been approved, the borrower would execute and deliver to the loan company a note for the amount he desired to borrow, plus the discount fee of the company, e.g., a $33.60 note for an installment loan or a $29.50 note for a single payment loan. The company, in turn, then advanced the borrower the amount he desired to borrow, e.g., $25. A typical installment payment note on which the borrower was advanced $25 reads as follows:
+-----------------------------------------------------------------+ ¦$33.60 ¦BIRMINGHAM, ALABAMA, ¦April 28, 1950 ¦No.______ ¦ +-------+--------------------------+------------------+-----------¦ ¦ ¦ ¦ ¦ ¦ +-----------------------------------------------------------------¦ ¦I (we) promise to pay to the order of STATE FINANCE COMPANY, 1928¦ +-----------------------------------------------------------------¦ ¦First Avenue, North (218-220 EMPIRE BUILDING) Birmingham, Alabama¦ +-----------------------------------------------------------------¦ ¦Thirty-Three and 60/100---------DOLLARS ¦ +-----------------------------------------------------------------+
Thirty-Three and 60/100 - - - DOLLARS
for value received, receipt of which sum is hereby acknowledged and payable in 6 Monthly installments of $5.60 beginning May 28, 1950 with 8% (Eight per cent) interest from date until paid, at their office in Birmingham, Alabama. Default in the payment of any installment of this note, or any portion of any installment, shall render the entire unpaid balance of this note due and payable at once at the option of the legal holder hereof, without demand. The makers and endorsers of this note agree to pay all costs of collection, including a reasonable attorney's fee, whether incurred by suit against one or more of said makers or endorsers, or otherwise, and each hereby expressly waives all right to claim exemption under the Constitution and Laws of the State of Alabama, or any of these United States, as to this debt, should this note not be paid as agreed. Demand, notice and protest, and all steps necessary to bind each maker and endorser hereon on the non-payment of this note, are hereby waived by each maker and endorser.
It is understood and agreed by each person whose name is signed hereunder, that he signs this note without condition, reservation or representation as to any other person or persons having signed the same, or that any other person or persons shall sign the same, as maker or endorser, and without any condition or reservation as to delivery, execution or otherwise.
It is hereby agreed any payments made on this note shall be applied first to the principal.
Witness our hands and seals at Birmingham, Alabama.
+-------------------------------+ ¦WITNESS:¦Name: JOHN DOE ¦(SEAL)¦ +--------+---------------+------¦ ¦ ¦______________ ¦ ¦ +--------+---------------+------¦ ¦ ¦Address: ¦ ¦ +--------+---------------+------¦ ¦ ¦_____________ ¦ ¦ +--------+---------------+------¦ ¦ ¦Name: ¦(SEAL)¦ +--------+---------------+------¦ ¦________¦_____________ ¦ ¦ +--------+---------------+------¦ ¦ ¦Address: ¦ ¦ +--------+---------------+------¦ ¦_ ¦_ ¦ ¦ +-------------------------------+
A typical single payment note on which the borrower was advanced $25 reads as follows:
+-------------------------------------------------------------------+ ¦$29.50 ¦BIRMINGHAM, ALABAMA, April 28, 1950 ¦No. ¦ +--------+-----------------------------------------------------+----¦ ¦ ¦ ¦_ ¦ +-------------------------------------------------------------------¦ ¦I (we) promise to pay to the order of STATE FINANCE COMPANY, 1928 ¦ +-------------------------------------------------------------------¦ ¦First Avenue, North (218-220 EMPIRE BUILDING), Birmingham, Alabama.¦ +-------------------------------------------------------------------¦ ¦Twenty-Nine and 50/100---DOLLARS ¦ +-------------------------------------------------------------------+
for value received, receipt of which sum is hereby acknowledged and payable for in One Monthly installment of $29.50 beginning May 28,1950 with 8% (Eight per cent) interest from date until paid, at their office in Birmingham, Alabama. Default in the payment of any installment of this note, or any portion of any installment, shall render the entire unpaid balance of this note due and payable at once at the option of the legal holder hereof, without demand. The makers and endorsers of this note agree to pay all costs of collection, including a reasonable attorney's fee, whether incurred by suit against one or more of said makers or endorsers, or otherwise, and each hereby expressly waives all right to claim exemption under the Constitution and Laws of the State of Alabama, or any of these United States, as to this debt, should this note not be paid as agreed. Demand, notice and protest, and all steps necessary to bind each maker and endorser hereon on the non-payment of this note, are hereby waived by each maker and endorser.
It is understood by each person whose name is signed hereunder, that he signs this note without condition, reservation or representation as to any other person or persons shall sign the same, as maker or endorser, and without any condition or reservation as to delivery, execution or otherwise.
It is hereby agreed any payments made on this note shall be applied first to the principal.
Witness our hands and seals at Birmingham, Alabama.
+-------------------------------+ ¦WITNESS:¦Name: JOHN DOE ¦(SEAL)¦ +--------+---------------+------¦ ¦ ¦_ ¦ ¦ +--------+---------------+------¦ ¦ ¦Address: ¦ ¦ +--------+---------------+------¦ ¦ ¦_ ¦ ¦ +--------+---------------+------¦ ¦ ¦Name: ¦(SEAL)¦ +--------+---------------+------¦ ¦_ ¦_ ¦ ¦ +--------+---------------+------¦ ¦ ¦Address: ¦ ¦ +--------+---------------+------¦ ¦_ ¦_ ¦ ¦ +-------------------------------+
It will be noted that both of the foregoing notes contain a provision ‘with 8% (Eight per cent) interest from date until paid, at their office in Birmingham, Alabama.’ As a matter of fact no interest was ever collected under this provision. Approximately 40 per cent in number of loans and approximately 25 per cent in total amount of loans were made on the installment basis, the balance being for single installments.
All loans, whether covered by a single payment or installment payment note, were recorded in the same manner on the books and records of the various loan companies. When a loan was made, the loans receivable account was debited for the amount actually advanced to the borrower, and the account ‘cash’ was credited for a like amount. The discount fees of the loan company were reflected in a memorandum account entitled ‘Unearned Fees or Anticipated Fees.’
As repayments were made on the loans, the companies treated all payments as return of principal until the amount actually advanced the borrower had been recovered. Thereafter the companies treated the payments as income. When payments were received the loan companies would debit their books and records the account, cash, and credit the account ‘loans receivable’ for all amounts received until the amount actually advanced the borrower had been recovered. At that time any further payments were carried into income by a debit to the account ‘cash’ and a credit to an income account.
Petitioners returned as income from partnership, representing their distributive share of partnership income from small loan business, $29,241.81 in the calendar year 1949, $26,533.47 in the calendar year 1950, $50,505.90 in the calendar year 1951, and $35,293.65 in the calendar year 1952.
In his statutory notice of deficiency the respondent in effect determined, as a result of adopting the recommendation of his internal revenue agents, that a pro rata portion of each installment payment on the notes of these business should be considered as income at the time of their collection and thus increased the income of the State Finance Company for its fiscal years ended May 31, 1949, May 31, 1950, May 31, 1951, and May 31, 1952, in the respective amounts of $6,717.24, $1,619.23, $2,626.12, and $4,456.70. For the same reason the respondent reduced the petitioners' distributive share of the loss from the Ace Finance Company for its fiscal year ended May 31, 1951, in the amount of $41.80, and their distributive share of the loss from Ace & New Finance Company for its fiscal year ended May 31, 1952, in the amount of $1,570.79, and increased their distributive share of the income of the Mercury Finance Company for its fiscal year ended May 31, 1952, in the amount of $1,305.72.
OPINION.
BLACK, Judge:
As had been stated in our Findings of Fact, the petitioners were partners in the small loan business. That was their only business. It is not disputed that the books and records of the small loan businesses were kept on the cash receipts and disbursements basis, the partnership information returns of the small loan businesses were filed on the cash basis, and petitioners' joint income tax returns were filed on the cash basis. Also there is no dispute as to the gross amount of loans made by the small loan companies and their collections on these loans in each of the taxable years. These are correctly shown by the books and records of the small loan companies.
As had been stated in our Findings of Fact, the method used by petitioners in their small loan business was to first collect from a borrower the full amount of principal loaned him and thereafter, as the balance of the note was collected, this balance was carried into income. There is no dispute but that if this method of reporting income as used by petitioners was correct, then petitioners have correctly reported their income in each of the taxable years and there are no deficiencies. But respondent contends that this method used by petitioners was not correct.
While the deficiency notice does not disclose how the additions which were made to the income were reported by petitioners in each of the taxable years were arrived at, the internal revenue agents' reports which were used by the Commissioner as a basis for his determinations of the deficiencies show that the additions to income in each of the taxable years were arrived at by attributing a pro rata share of all collections made on small loans to earned fees, irrespective of whether or note the full principal of the loan had been collected. Petitioners concede that if respondent's method is correct, then the deficiencies are correct. Petitioners, however, vigorously deny that respondent's method is correct. Their contention is that petitioners being on the cash basis had a right under the applicable law and regulations to first collect the full amount of their principal before there was anything to return as income. They say they have fully complied with the law and regulations and have returned in each year their distributive shares of the earnings of the partnership small loan business.
The applicable sections of the Internal Revenue Code of 1939 to the issue which we have here to decide are sections 41 and 42, printed in the margin.
The following sections of Regulations 111, we think, are also applicable to the issue which we have here to decide:
SEC. 41. GENERAL RULE.The net income shall be computed upon the basis of the taxpayer's annual accounting period (fiscal year or calendar year, as the case may be) in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but if no such method of accounting has been so employed, or 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 clearly reflect the income. * * *SEC. 42. PERIOD IN WHICH ITEMS OF GROSS INCOME INCLUDED.(a) GENERAL RULE.— The amount of all items of gross income shall be included in the gross income for the taxable year in which received by the taxpayer, unless, under methods of accounting permitted under section 41, any such amounts are to be properly accounted for as of a different period. * * *
SEC. 29.41-1. COMPUTATION OF NET INCOME.— * * * The time as of which any item of gross income or any deduction is to be accounted for must be determined in the light of the fundamental rule that the computation shall be made in such a manner as clearly reflects the taxpayer's income. If the method of accounting regularly employed by him in keeping his books clearly reflects his income, it is to be followed with respect to the time as of which items of gross income and deductions are to be accounted for. (See sections 29.42-1 to 29.42-3, inclusive.) If the taxpayer does not regularly employ a method of accounting which clearly reflects his income, the computation shall be made in such manner as in the opinion of the Commissioner, clearly reflects it.
SEC. 29.42-1. WHEN INCLUDED IN GROSS INCOME.— (A) In general.— Except as otherwise provided in section 42, gains, profits, and income are to be included in the gross income for the taxable year in which they are received by the taxpayer, unless they are included as of a different period in accordance with the approved method of accounting followed by him. * * *
It should be borne in mind at the outset that we have here no case which involves the application of section 44 of the 1939 Code which deals with the installment basis of accounting and return of income, where the pro rata method of apportioning each payment between principal and profit is authorized. The Commissioner does not contend that section 44 of the Code has any application to the question which we have here.
Also, it is perhaps appropriate to here point out that the Commissioner does not contend that when the small loan companies, which were being operated by the petitioners, loaned $25 and took a note for $20.50 in cases where the loan was to be paid in 1 monthly installment and a note for $33.60 where the note was to be paid in 6 monthly installments of $5.60 each, that the so-called unearned fees or commissions should be taken into income at the time the loan was made. The Commissioner recognizes that such cases as Blair v. First Trust & Savings Bank of Miami, Fla., 39 F.2d 462, affirming 11 B.T.A. 1034, would be against any such contention. In Blair v. First Trust & Savings Bank of Miami, Fla., supra, the court said:
The Commissioner of Internal Revenue determined deficiencies in income and profits taxes of respondent for 1920 and 1921, respectively, of $1,000.74 and $3,154, ruling that the commissions should be returned as income received at the time the loans were made to the borrowers. On appeal to the Board of Tax Appeals, the Commissioner was reversed.
It is plain that until the loan is paid or rediscounted the respondent has earned no profit, but has simply parted with its funds on the faith of the security. The commission is not actually received until respondent gets back what it has previously paid out plus the commission. The deduction of the commission from the face of the loan brings nothing into the coffers of the bank.
The Blair v. First Trust & Savings Bank of Miami, Fla., supra, case was followed by the Eighth Circuit in Helvering v. Martin-Stubblefield, Inc., 71 F.2d 944, affirming a Memorandum Opinion of the Board of Tax Appeals. In the Martin-Stubblefield, Inc., case the books of the taxpayer were kept on the cash basis. In its ‘unearned commissions' account at the end of the calendar years 1927 and 1928 appeared credit balances in the amounts of $3,605.40 and $25,427.53, respectively. These amounts were not reported by the taxpayer as income in its returns for those years. The Commissioner, in determining the deficiencies involved in that case, included in the taxable income of the taxpayer for the years 1927 and 1928, the amounts so credited to the ‘unearned commissions' account. The court affirmed the Board of Tax Appeals which had reversed the Commissioner and had held that the ‘unearned commissions' were not taxable as income until actually collected where the taxpayer's books were kept on the cash receipts and disbursements basis.
While the Commissioner does not contend in the instant case that the unearned fees or commissions were income at the time the loans were made, he does contend a pro rata portion of each installment payment was taxable income at the time the collection was made irrespective of whether or not the full amount of the principal had been collected. Respondent cites no case which, in our judgment, supports his position. He cites in his brief a number of cases which he urges in support of his determination. We have read these cases but we fail to see where they support respondent. We think no purpose would be served in taking up and discussing each of these cases separately.
Section 29.41-1 of Regulations 111 to which we have already referred says: If the method of accounting regularly employed by him in keeping his books clearly reflects his income, it is to be followed with respect to the time as of which items of gross income and deductions are to be accounted for. * * * We think the accounting methods used by petitioners in keeping their books and records on the cash basis clearly reflected their income from the small loan business.
As has already been noted, it was petitioners' practice to apply the payments which they received, first to the principal of the note, then to the unearned fees or commissions. This was in accordance with the provision contained in all the notes, which read: ‘It is hereby agreed any payments made on this note shall be applied first to the principal.’ Respondent does not contend that petitioners have failed to account for all commissions and fees collected in this manner. An inspection of the partnership information returns and joint returns which are in evidence convinces us that petitioners have carefully returned and paid taxes on all fees and commissions collected in the manner which they used in their books and records of their small loan business. We think there is no warrant either in the law or the regulations for the Commissioner to use the pro rata method which he has used in his determination of the deficiencies. Petitioners have been using the same method of accounting and return of income since they began the small loan business in 1946. While this fact would not stop the Commissioner from changing petitioners' method, if it is wrong, we are not convinced that it is wrong. The cases of Blair v. First Trust & Savings Bank of Miami, Fla., supra, and Helvering v. Martin-Stubblefield, Inc., supra, cited and relied upon by petitioners cannot be said to be exactly in point. We think, however, that the rationale of those cases supports the petitioners.
We sustain the method used by petitioners in reporting their income on the cash basis. The deficiencies determined by the Commissioner are not sustained.
Decision will be entered for the petitioners.