23 T.C. 1026">*1026 These consolidated proceedings involve deficiencies in taxes determined against Curtis R. Andrews and Carol W. Andrews as follows: 23 T.C. 1026">*1027

The issues to be decided are: (1) Whether advance tuition fees, received by a partnership of which petitioner Curtis R. Andrews was a member, constituted income in the year of receipt; and (2) whether petitioner Curtis R. Andrews realized a long-term capital gain in the amount of $ 81,813.19 upon the sale of his interest in the partnership.

Some of the facts were stipulated.

FINDINGS OF FACT.

The stipulated facts are so found and are incorporated herein by this reference.

Curtis R. Andrews (hereinafter referred to as petitioner) and Carol W. Andrews are husband and wife, now residing in Ann Arbor, Michigan. Petitioner filed individual income tax returns for the taxable years 1942 through 1946, and he and his wife filed a joint return, on the cash basis, for the taxable year 1948 with the collector of internal 1955 U.S. Tax Ct. LEXIS 225">*228 revenue for the district of Michigan.

In May 1938, petitioner and one Doris Eaton entered into an oral agreement (subsequently formalized by a written agreement) for the formation of a copartnership to engage in the business of furnishing dancing instruction under the name of Arthur Murray Studios of Michigan. Thereafter, the partnership operated dance studios in Detroit, Birmingham, and Flint, Michigan, and in Toledo, Ohio. The partnership furnished dancing instruction principally on a private-lesson basis to individual students, although there was some class instruction. The students contracted for a specified number of lessons and paid the tuition fees in advance, either by lump-sum payments of cash or by the execution of promissory notes. If payment was made by note, the note was immediately negotiated by sale to a bank, with full recourse, at a discount of 6 per cent. The discounted proceeds of such notes were deposited in the partnership's general bank accounts without segregation from other partnership funds and without restriction as to their use.

Under the direction of a certified public accounting firm employed by the partnership, its books were set up on the accrual system, 1955 U.S. Tax Ct. LEXIS 225">*229 and 23 T.C. 1026">*1028 advance tuition payments (including the proceeds of discounted notes) were treated as deferred income. By means of individual records maintained for each student, an inventory was prepared at the end of each year showing the total number of prepaid lessons still to be taught. The receipts, with respect to the lessons which had been taught during the year, were reflected in income for that year on the books of the partnership and on its returns. The balance of the prepaid receipts was designated as Unearned Tuition and credited to income in subsequent years as the lessons were taught. In the opinion of the accountant who set up this system, it represented proper accounting practice.

Occasionally, students would fail to pay balances due on notes which had been discounted. The partnership redeemed such notes and charged the unpaid balances due on them to the Unearned Tuition account. The partnership discouraged the cancellation of students' contracts and tuition fees were refunded only as a matter of maintaining good public relations. The receipts given to students were marked "No Cash Refunds"; and, beginning in 1947, the notes executed by the students were, by their terms, "Non-Cancellable." 1955 U.S. Tax Ct. LEXIS 225">*230 Refunds were made in hardship cases where students became incapacitated through illness, where students entered military service before completing their course of instruction, and when the contracts of minors were disavowed. The record does not disclose the extent to which the partnership was obliged to redeem students' notes which had been discounted or to refund advance tuition payments.

When a student discontinued the course before taking all the lessons for which he had paid, if no question of a refund was involved, the balance of prepaid receipts on his record would be credited to income for that year. Also taken into income each year were all prepayments of $ 20 or less credited to the accounts of inactive students. Upon inventorying the students' cards at the end of the year, it would occasionally be discovered that a student had received more lessons than he had paid for. The amount due on such additional lessons would be taken into income for that year.

In 1955 U.S. Tax Ct. LEXIS 225">*231 keeping its books, the partnership treated prepaid deductible items such as taxes, rent, and insurance as an asset account and deducted such expenses pro rata over the balance of the period for which they had been prepaid.

The following table sets forth, for each of the years 1942 through 1947 and for the period January 1 through January 31, 1948, the total amounts of prepaid income received by the partnership, the amounts reported as gross income, the balance in the Unearned Tuition account at the end of each of such periods, and the increase or decrease in the Unearned Tuition account during each of such periods: 23 T.C. 1026">*1029

Partnership returns of income 1955 U.S. Tax Ct. LEXIS 225">*232 for the taxable years 1942 through 1947, treating prepaid income as hereinabove described, reported the following amounts as net income for such years, and the amounts credited to the partners' investment accounts as follows:

According to the records of the partnership for the period January 1 to January 31, 1948, a net income of $ 12,187.45 was earned for such period. One-half of this amount was credited to the investment account of each partner.

The partners' drawings from the partnership during the years 1942 through 1947 and the period January 1 to January 31, 1948, were in the following amounts:

There were deficits in the partners' capital accounts at the close of each of the years 1942 through 1955 U.S. Tax Ct. LEXIS 225">*233 1947 and the period ended January 31, 1948, in the following amounts:

23 T.C. 1026">*1030 The partnership had balances aggregating $ 47,495.82 in its various bank accounts at the close of business on January 31, 1948.

On March 22, 1948, the partners executed a written agreement terminating their partnership, effective as of the close of business on the preceding January 31, 1948. The terms of the dissolution agreement provided that petitioner assign the Michigan studios and the Arthur Murray franchise for that State to Eaton and that she, in turn, assign the Toledo studio and its franchise to petitioner. Petitioner and Eaton each acquired all the assets and assumed the liabilities of the studios assigned to them pursuant to the dissolution agreement. In addition, the agreement provided that Eaton pay petitioner the sum of $ 126,914.42, of which $ 26,914.42 was paid contemporaneously with the execution of the agreement. The $ 100,000 balance was to be paid in monthly installments 1955 U.S. Tax Ct. LEXIS 225">*234 of not less than $ 1,000, beginning April 1, 1948. No note or security for the payment of the $ 100,000 was given by Eaton, but one Paul H. Travis, a local businessman who subsequently married Miss Eaton, guaranteed that he would pay to petitioner the installments due on the $ 100,000 in the event of Eaton's default. Petitioner received 9 monthly installments of $ 1,000 each on this obligation during 1948. He tried to sell the obligation but was unsuccessful in these efforts. In 1952, when a balance of approximately $ 50,000 remained on the contractual obligation of Eaton, he accepted approximately $ 30,000 from her in full payment of such obligation.

The books of the partnership disclose that the Toledo studio, including all its assets and liabilities, was distributed to petitioner and its net book value charged to his capital account. A subsequent entry closed the balance of petitioner's capital account in the partnership and is accompanied by the following explanation: "To record payment to C. R. Andrews for balance of partnership assets and purchase per agreement."

The following table sets forth the assets received by petitioner upon the distribution to him of the Toledo studio1955 U.S. Tax Ct. LEXIS 225">*235 and the sale of the remainder of his partnership interest:

Petitioner commenced the operation of the Toledo studio as a sole proprietor on February 1, 1948. The closing balance of the partnership's 23 T.C. 1026">*1031 Unearned Tuition account on January 31, 1948, was $ 272,958.80, and $ 14,308.66 of this amount was attributable to the Toledo studio. Petitioner assumed the obligation of furnishing the dancing lessons represented by this $ 14,308.66 in prepaid tuition, together with the other liabilities of the Toledo studio, which he had assumed from the partnership. Petitioner kept the books of the Toledo studio, from February 1 to December 31, 1948, according to the same system of accounting which the partnership had previously used. His books disclosed a balance of $ 10,965.12 in the Unearned Tuition account on December 31, 1948, and a loss of $ 29,044.86 for the period February 1 to December 1955 U.S. Tax Ct. LEXIS 225">*236 31, 1948.

Respondent determined in Docket No. 46066 that petitioner's distributive shares of partnership income, for the years 1942 through 1947, should be increased and decreased in the following amounts to reflect tuition receipts which had not been included in income when received or accrued:

In Docket No. 46065, involving the year 1948, respondent determined that petitioner's distributive share of partnership income for the period January 1 to January 31, 1948, should be increased by $ 136,479.40 to reflect one-half the balance in the partnership's Unearned Tuition account on January 31, 1948. ¹

Respondent further determined that petitioner realized capital gains in the amount of $ 81,813.19 in 1948 upon the dissolution of the partnership. Such 1955 U.S. Tax Ct. LEXIS 225">*237 gains were computed by subtracting the adjusted cost basis of petitioner's investment account in the partnership ($ 82,486.95) from the sum of the assets received by petitioner upon the termination of the partnership ($ 164,300.14). Respondent determined the adjusted cost basis of petitioner's capital investment account in the partnership, in the foregoing computation, by adding to his capital account the advance tuition fees deferred by the partnership since its inception, as follows: 23 T.C. 1026">*1032

Respondent also determined that petitioner's income from the operation of the Toledo studio as a sole proprietor during 1948 was understated by reason of his failure to include $ 10,965.12 in advance tuition sales when received.

OPINION.

The first issue to be decided is the correctness of respondent's determination that the entire amount of the partnership's advance tuition fees must be included in income in the year of receipt, regardless of the number of prepaid lessons remaining to be taught at the end of such year. Petitioner argues that an accrual basis taxpayer's treatment of prepaid tuition receipts as deferred income is in accord with generally accepted accounting practice and that respondent erred in determining that, as a matter of law, such system failed to clearly reflect income.

Irrespective of the merits of the generally accepted commercial accounting treatment of prepaid income, it has been clearly established that, 1955 U.S. Tax Ct. LEXIS 225">*239 under the "claim of right" doctrine, prepaid income must be reported as income in the year of receipt. South Dade Farms v. Commissioner, 138 F.2d 818 (C. A. 5, 1943); Wallace A. Moritz, 21 T.C. 622 (1954); Your Health Club, Inc., 4 T.C. 385 (1944); South Tacoma Motor Co., 3 T.C. 411 (1944). The essential criterion of these cases is present here; namely, that there was no restriction as to the use or disposition of the prepaid receipts. See Brown v. Helvering, 291 U.S. 193">291 U.S. 193 (1934); North American Oil v. Burnet, 286 U.S. 417">286 U.S. 417 (1932). The fact that some portion of such receipts might have to be refunded 23 T.C. 1026">*1033 in the future did not affect their nature as income. 286 U.S. 417">North American Oil v. Burnet, supra.

The record before us indicates that the members of the partnership made unrestricted use of their prepaid receipts despite the tenets of their accounting system that such receipts were to be considered as deferred income, a liability account, until services were actually rendered therefor. Thus, upon dissolution of the partnership, the aggregate amount of prepaid receipts deferred as Unearned Tuition was $ 272,958.80; whereas the cash account of the partnership amounted to only $ 47,495.82. 1955 U.S. Tax Ct. LEXIS 225">*240 Although the partnership reported a total net income of $ 249,048.63 for the period from 1942 until its dissolution in 1948, the partners had withdrawn a total of $ 321,771.21 during this period and their capital accounts showed a deficit of $ 107,945.70 on January 31, 1948.

Notwithstanding this unrestrained use of prepaid receipts, the partnership's accounting system may well have "clearly reflected income" according to generally accepted commercial accounting practice. However, accounting practice must bow to established rules of law in the determination of taxable income. The "claim of right" doctrine is firmly established and must govern the result herein. We agree with the dissenting opinion in Beacon Publishing Co. v. Commissioner, 218 F.2d 697 (C. A. 10, 1955), reversing 21 T.C. 610 (1954), that, "under the settled law in force at the time, the entire amount received for prepaid subscriptions constituted income returnable for the year in which it was received, even though the taxpayer kept its books and made its returns on the accrual basis." Respondent did not err in determining, pursuant to section 41 of the Internal Revenue Code of 1939, that the method employed by the 1955 U.S. Tax Ct. LEXIS 225">*241 partnership did not clearly reflect its income and that the entire amount of prepaid tuition fees constituted income in the years in which received. Automobile Club of Michigan, 20 T.C. 1033 (1953), on appeal (C. A. 6, Mar. 4, 1954). The divergencies which have developed between the tax and accounting methods of computing income have been recognized by the Congress^{21955 U.S. Tax Ct. LEXIS 225">*242 1955 U.S. Tax Ct. LEXIS 225">*243} and a change in the law was made in the Internal Revenue 23 T.C. 1026">*1034 Code of 1954 for the deferral of prepaid income. ³ But petitioner is governed by the Internal Revenue Code of 1939 for the years here in issue and, consequently, his distributive share of partnership income for each of such years must be increased by his proportionate share of prepaid income not reported as income by the partnership in the year of receipt. A similar adjustment must be made with respect to the prepaid receipts received by petitioner in the operation of his sole proprietorship in 1948.

The second issue herein concerns respondent's determination that petitioner realized a capital gain in the amount of $ 81,813.19 upon the sale of his interest in the partnership. Respondent computed such gain by subtracting the adjusted basis of petitioner's investment account in the partnership ($ 82,486.95) from the sum of the various assets received by petitioner upon the termination of the partnership ($ 164,300.14). ⁴ However, petitioner reported his income on the cash basis during the year in issue, 1948; and, consequently, only cash or its equivalent can be used in computing gain or loss realized by him. ^{51955 U.S. Tax Ct. LEXIS 225">*245} John B. Atkins, et al., 9 B. T. A. 140 (1927). He, therefore, contends that the $ 100,000 contractual agreement which he received as part payment for his partnership interest cannot be considered as the equivalent of cash or as having any ascertainable fair market value. He argues that only the $ 9,000 actually received on the $ 100,000 contractual agreement during 1955 U.S. Tax Ct. LEXIS 225">*244 1948 can be included in the computation of gain for that year and that no taxable gain is reportable for the year 1948 since the "amount realized" during that year was less than the basis for his partnership interest. Estate of Clarence W. Ennis, 23 T.C. 799 (1955); Nina J. Ennis, 17 T.C. 465 (1951); Harold W. Johnston, 14 T.C. 560 (1950); Dudley T. Humphrey, 32 B. T. A. 280 (1935).

Petitioner relies on Nina J. Ennis, supra, wherein we stated that "In determining what obligations are the 'equivalent of cash' the requirement 23 T.C. 1026">*1035 has always been that the obligation, like money, be freely and easily negotiable so that it readily passes from hand to hand in commerce." The promise of petitioner's partner to make deferred payments to him aggregating $ 100,000 was embodied in the agreement terminating their partnership. Although accompanied by the guaranty of another individual, this was merely a contractual obligation. It "was not embodied in a note or other evidence of indebtedness possessing the element of negotiability and freely transferable." Nina J. Ennis, supra.In computing the "amount realized from the sale" of property by a cash basis taxpayer, we do not consider that a promise such as here to make a series of deferred payments, which is embodied solely in a contract of sale of a type not commonly sold and with no readily ascertainable fair market value, constitutes "property (other than money) received."

We, therefore, conclude that petitioner realized no taxable gain on the dissolution of the 1955 U.S. Tax Ct. LEXIS 225">*246 partnership in 1948 because the sum of the $ 9,000 paid on the contract in that year plus the other property received during that year did not exceed his adjusted basis in the assets of the partnership.

Decisions will be entered under Rule 50.