1961 U.S. Tax Ct. LEXIS 21">*21
Petitioner corporation was organized on January 1, 1956, by receiving in a tax-free exchange the assets and liabilities of a partnership. Petitioner, as had the partnership, manufactured and sold dental cushions and had inventories of finished cushions and supplies. Most of petitioner's customers paid for products billed them in 30 days. The partnership had filed its returns of income on the cash receipts and disbursements basis and upon examination respondent had not changed the partnership's accounting basis. Petitioner filed its returns for 1956 and subsequent years on the cash receipts and disbursements basis.
1. Inventories are necessary in petitioner's business and its sales and purchases are properly reportable for income tax on an accrual basis.
2. The inventory and accounts receivable taken over by petitioner from the partnership had a zero basis.
3. Petitioner is not the same taxpayer as the partnership or the partners within the meaning of
37 T.C. 385">*386 Respondent determined deficiencies in petitioner's income tax for the years 1956 and 1957 in the amounts of $ 27,980.77 and $ 3,528.73, respectively.
The issues for decision are:
(1) Whether respondent correctly determined that petitioner's income for the years 1956 and 1957 should be reported on an accrual basis of accounting in lieu of the cash receipts and disbursements basis upon which petitioner kept its books and filed its returns.
(2) If an accrual basis is the proper method of accounting, whether respondent was correct in not deducting inventory as of January 1, 1956, acquired in a nontaxable exchange, and in adding the amounts of accounts receivable similarly received by petitioner in computing petitioner's income for the years 1956 and 1957.
(3) Whether petitioner is the same taxpayer as the partnership, the assets of which were transferred to petitioner in a nontaxable exchange as of January 1, 1956, within the meaning of
FINDINGS OF FACT.
Some of the facts have been stipulated and are found accordingly.
Petitioner is a corporation organized on or about January 1, 1956, under the laws of Pennsylvania. It filed its income tax returns for the calendar years 1956 and 1957 with the district director of internal revenue at Philadelphia, Pennsylvania.
The business of petitioner was originated by a partnership composed of two brothers, Julius Hollander and Harry Hollander. From 1944 to December 31, 1955, the business was operated as a partnership under the name of Ezo Products Company, hereinafter referred to as the partnership. Julius and Harry each had a 50 percent interest in the capital and the profits and losses of the partnership. On or about January 1, 1956, Julius and Harry transferred the assets and liabilities of the partnership to petitioner in exchange for its capital stock. The transaction constituted a tax-free transfer under the provisions of
Petitioner is engaged, as was the partnership, in the manufacture of dental cushions, consisting of cloth pads impregnated with paraffin for use by wearers of false1961 U.S. Tax Ct. LEXIS 21">*25 teeth whose gums have receded. The raw materials used in the manufacture of the cushions are primarily cloth and paraffin. The cushions are cut and molded by machine and then 37 T.C. 385">*387 counted, packaged, and placed in shipping cartons. In 1956 and 1957 petitioner maintained a stock of finished goods from which it filled its sales orders. It also maintained stocks of raw materials including cloth, cushions, cartons, and other items.
From about 1950 throughout the year 1955 the sales of products by the partnership were primarily to retail drugstores throughout the United States and to some extent in Canada. For the years 1956 and 1957 petitioner's sales were similarly primarily to retail drugstores in the same areas as the sales made by the partnership. The method of operation of the business and the manufacture of the cushions by the partnership was the same as the method employed by petitioner.
In keeping its books and reporting its income on its Federal income tax returns, petitioner used the cash receipts and disbursements method of accounting. It did not take inventories into account. It reported taxable income of $ 17,049.57 for the year 1956 and $ 11,535.04 for the year1961 U.S. Tax Ct. LEXIS 21">*26 1957.
From the time of its organization throughout the year 1955 the partnership used the cash receipts and disbursements method of accounting in keeping its books and filing its partnership Federal returns of income and did not take inventories into account in filing its returns. The partnership did not maintain any record of inventories.
In the early part of 1956, petitioner began to keep records of its inventories for insurance purposes. Thereafter, each month it would count and record each item of raw materials and finished goods on hand, price each item, extend, and total the extensions. This information was kept on inventory sheets which were not part of the books of account of petitioner. Petitioner's inventory as of December 31, 1956, amounted to $ 39,650, and as of December 31, 1957, amounted to $ 54,795. Its inventories, as of December 31, 1958, 1959, and 1960, were $ 42,206, $ 29,572, and $ 28,018, respectively.
Petitioner's inventory sheets include items in the nature of supplies and materials in addition to goods for manufacture and sale. The terms of sale stated by petitioner on its invoices were 2-percent discount if payment was made within 10 days. Most of petitioner's1961 U.S. Tax Ct. LEXIS 21">*27 customers paid the invoices rendered to them after 10 days but within 30 days. However, in some instances a customer would take the 2-percent discount when payment was not made until 40 days after the invoice date, and petitioner would accept such payment.
From about 1950 throughout 1955 the partnership used the same terms of sale and method of billing as used by petitioner.
Petitioner did not keep an account on its books for accounts receivable. Its actual accounts receivable as of December 31, 1956, were $ 19,306, and as of December 31, 1957, $ 18,850.
37 T.C. 385">*388 The partnership had the following accounts receivable as of the dates indicated:
Date, Dec. 31 -- | Accounts receivable |
1951 | $ 5,325 |
1953 | 17,889 |
1954 | 9,693 |
1955 | 13,824 |
Petitioner had accounts receivable as of December 31, 1958, 1959, and 1960 in the amounts of $ 18,374, $ 21,739, and $ 23,813, respectively.
It was petitioner's practice to pay for materials it purchased upon receipt of the invoice therefor. It kept no account on its books for accounts payable. On December 31, 1956, it had actual accounts payable and accrued expenses of $ 1,783, and on December 31, 1957, it had actual accounts payable and accrued1961 U.S. Tax Ct. LEXIS 21">*28 expenses of $ 4,710.
The partnership reported, on its returns of income, sales of products and purchases of materials in the following amounts for the years indicated:
Year | Sales | Purchases |
1952 | $ 194,755 | $ 16,570 |
1953 | 263,398 | 23,051 |
1954 | 286,628 | 35,056 |
1955 | 335,944 | 51,580 |
Petitioner reported, on its income tax returns filed on the cash receipts and disbursements basis, sales of products and purchases of materials in the following amounts for the years indicated:
Year | Sales | Purchases |
1956 | $ 388,407 | $ 60,904 |
1957 | 438,780 | 71,365 |
1958 | 468,953 | 66,977 |
1959 | 520,573 | 69,668 |
For the years 1954 and 1955 the partnership, on its returns of income, showed ordinary income without deduction for salaries of the partners, of $ 41,085 and $ 57,230, respectively.
Petitioner, on its income tax returns filed on the cash receipts and disbursements basis, showed taxable income for the years 1958, 1959, and 1960 in the amounts of $ 20,848.45, a loss of $ 233.42, and $ 12,659, respectively.
As of the close of business on December 31, 1955, the partnership had no actual unpaid liabilities or accrued expenses. All of the merchandise purchased by the partnership had been1961 U.S. Tax Ct. LEXIS 21">*29 paid for prior to January 1, 1956. All of the inventory of the partnership on hand as of December 31, 1955, had been paid for and the amount so paid was included in the cost of goods sold in computing the income for 1955 shown on the partnership's return of income.
37 T.C. 385">*389 The income tax returns filed by Julius Hollander and Harry Hollander and their respective wives for the years 1952 and 1953 were the subject of a field examination by an internal revenue agent. During the course of this examination the income of the partnership was investigated. The revenue agent looked into the books of account of the partnership, asked for a number of documents, and substantiated invoices during the course of his investigation. After the investigation was completed, a report thereof was furnished to each of the partners, and certain minor adjustments were proposed relating to deduction of personal life insurance premiums and automobile expenses. Each of the partnersaccepted these adjustments and paid a deficiency in his income tax on the basis thereof for each of the years 1952 and 1953. The report did not make any change in the cash receipts and disbursements method of accounting used1961 U.S. Tax Ct. LEXIS 21">*30 by the partnership.
Julius Hollander discussed with the internal revenue agent investigating petitioner's income tax liability for 1956 and 1957 the fact that the partnership books had been kept and the returns of income filed on the cash receipts and disbursements basis from the time of the formation of the partnership and that no internal revenue agent had previously suggested that such method was not a proper method for keeping the books and filing the returns.
The revenue agent began his examination of petitioner's 1956 income tax return in December of 1957, and the examination of the returns for 1956 and 1957 was concluded in January 1959.
Under date of March 28, 1958, a letter was addressed to the representatives of Julius and Harry Hollander in regard to the Federal income tax returns of Harry and Eve Hollander and Julius and Lillian Hollander for the taxable year 1954 in which it was stated, "This is in reference to your Federal Income Tax return for the taxable year indicated above, which is under consideration by this office." The letter proceeded to request that a consent form extending the statutory period of limitation upon assessment of tax be executed. This letter 1961 U.S. Tax Ct. LEXIS 21">*31 was signed by the Chief of the Audit Division of the office of the District Director of the Internal Revenue Service. A similar letter requesting a further extension was sent under date of August 15, 1958. Julius Hollander and Lillian Hollander and Harry Hollander and Eve Hollander each signed the forms consenting to an extension of the time for assessment of income taxes for the year 1954, the final extension being to December 31, 1958. Each of these consent forms was accepted on behalf of the district director of internal revenue.
The partnership has not filed an amended return of income for the year 1954, and neither Julius nor Harry Hollander has filed an amended income tax return for that year.
37 T.C. 385">*390 Respondent in his deficiency notice adjusted petitioner's income for the year 1956 by adding thereto its inventories and accounts receivable as of December 31, 1956, and subtracting therefrom accounts payable as of the same date and adjusted its 1957 income by adding thereto inventory and accounts receivable as of December 31, 1957, and accounts payable as of January 1, 1957, and subtracting therefrom inventory and accounts receivable as of January 1, 1957, and accounts payable1961 U.S. Tax Ct. LEXIS 21">*32 as of December 31, 1957, giving the following explanation for these adjustments:
It is held that the taxpayer's income must be determined on the accrual basis of accounting in lieu of the cash receipts and disbursements basis used in its returns for the taxable years 1956 and 1957, and that inventories and accounts receivable acquired in a non-taxable exchange as of January 1, 1956, have a basis of zero, which was their basis in the hands of the transferor.
OPINION.
It is petitioner's position that it properly reported its taxable income on the cash receipts and disbursements method of accounting upon which it has regularly kept its books. Petitioner contends that such method clearly reflects its income.
Respondent contends that under the provisions of his regulations requiring the use of inventories in computing income in all cases in which purchase or sale of merchandise is an income-producing factor and his regulations requiring that purchases and sales be used where it is necessary to use an inventory, 3 the accrual method is the proper method for petitioner to use in reporting its income.
1961 U.S. Tax Ct. LEXIS 21">*34 37 T.C. 385">*391 Petitioner contends that the Income Tax Regulations under
1961 U.S. Tax Ct. LEXIS 21">*35 Respondent points out that the partners and the petitioner in this case are separate entities and different taxpayers but argues that even were they the same taxpayer, his prior action is not equivalent to authorizing the use of the cash receipts and disbursements method of accounting.
Where respondent has accepted over a long period of years or approved a method of accounting by a taxpayer, this fact will be given weight in determining whether respondent was justified in changing the method used by such taxpayer.
The provision of the regulations requiring the use of inventories in cases in which production, purchases, or sale of merchandise of any kind is an income-producing factor, has appeared in respondent's regulations over a period of many years, and has on numerous occasions received approval of the courts.
In a number of cases we have recognized as petitioner argues that where inventories are so small as to be of no consequence or consist primarily of labor, the presence of inventories is not necessarily sufficient to require a change in petitioner's method of accounting.
Petitioner argues that respondent is in error in his method of computing petitioner's income for the year 1956. 37 T.C. 385">*393 Under the provisions of the Internal Revenue Code of 1939 it has been held that inventories and accounts receivable received by a corporation in a reorganization from an individual or partnership which had reported its income on the cash receipts and disbursements basis have1961 U.S. Tax Ct. LEXIS 21">*39 a zero basis to the new corporation.
It is petitioner's contention that since it is in reality a continuation of the preceding partnership, 1961 U.S. Tax Ct. LEXIS 21">*40 there has been a change in the method of accounting from that used by the taxpayer in its preceding taxable year and, therefore, the provisions of
It is respondent's position that the petitioner herein is a corporation separate and distinct from the partnership composed of Julius and Harry Hollander, that the corporation's first taxable year was 1956, and that the corporation had no preceding taxable year to the year of change.
Where a corporation is formed for a business purpose, it is a separate entity and separate taxpayer from the stockholders who are responsible for its creation.
The partners here elected for purposes which presumably to them seemed sufficient to form a corporation as of January 1, 1956. This corporation is a separate entity and separate taxpayer from the partners.
We hold that petitioner had no preceding taxable year, and, therefore,
Petitioner offered evidence in an effort to reconstruct inventories for the years 1952 through 1955, it having no actual record of such inventories. In view of our holding with respect to
1.
2.
3.
In all cases in which the production, purchase, or sale of merchandise of any kind is an income-producing factor, merchandise on hand (including finished goods, work in process, raw materials and supplies) at the beginning and end of the year shall be taken into account in computing the taxable income of the year. * * *
In any case in which it is necessary to use an inventory the accrual method of accounting must be used with regard to purchases and sales unless otherwise authorized under subdivision (ii) of this subparagraph.↩
4.
No method of accounting will be regarded as clearly reflecting income unless all items of gross profit and deductions are treated with consistency from year to year. The Commissioner may authorize a taxpayer to adopt or change to a method of accounting permitted by this chapter although the method is not specifically described in the regulations in this part if, in the opinion of the Commissioner, income is clearly reflected by the use of such method. Further, the Commissioner may authorize a taxpayer to continue the use of a method of accounting consistently used by the taxpayer, even though not specifically authorized by the regulations in this part, if, in the opinion of the Commissioner, income is clearly reflected by the use of such method. See
5. (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 * * *↩