Timing of Income and Deductions: Annual Accounting and Accounting Principles
I. Annual Accounting
After Glenshaw Glass (chapter 2, supra), we know that one element of “gross income” that taxpayer must recognize is that the taxpayer must have dominion and control of it. After Cottage Savings & Loan (chapter 2, supra), we are aware that a realization requirement applies to deductions as well as to income. It is not always obvious just exactly when taxpayer has dominion and control. Consider some possible problematic scenarios:
The Tax Formula:
→ (gross income)
MINUS § 62 deductions
EQUALS (adjusted gross income (AGI))
→ MINUS (standard deduction or itemized deductions)
MINUS (personal exemptions)
EQUALS (taxable income)
Compute income tax liability from tables in § 1 (indexed for inflation)
MINUS (credits against tax)
• Taxpayer has “dominion and control” over money that clearly would count as “gross income” but in a subsequent year learns that s/he must give the money back.
• Taxpayer has “dominion and control” over money but knows that s/he might have to return it if certain contingencies occur. For example, taxpayer has been paid money but the judgment on which his/her receipt of money was based has been appealed. Taxpayer might lose the appeal and have to return the money. In the meantime, taxpayer may spend the money anyway s/he chooses.
• Taxpayer has entered into a contract that calls for various acts of performance to occur over more than one year, perhaps many years. The taxpayer pays expenses in some years and receives payments in some years. However, in any given year, there is no matching of expenditures and receipts by transaction. In some years, expenses are very high; in other years receipts are very high. When taxpayer does receive money, s/he may spend it any way s/he chooses.
Claim of Right doctrine: Taxpayer must include in his/her gross income an item when s/he has a “claim of right” to it. In North American Oil Consolidated v. Burnet, 286 U.S. 417, 424 (1932), the Supreme Court stated the doctrine thus:
If a taxpayer receives earnings under a claim of right and without restriction as to its disposition, he has received income which he is required to return, even though it may still be claimed that he is not entitled to retain the money, and even though he may still be adjudged liable to restore its equivalent.
The Internal Revenue Code requires taxpayers to compute their taxable income annually. See § 441. This can prove to be quite inconvenient for a taxpayer – and even a bit misleading if we apply this principle to the third scenario above, i.e., where taxpayer enters into a contract calling for performance over a long period of time. Should there be any principle by which we can mitigate the failure to match the expenses and income derived from a particular transaction?
Burnet v. Sanford & Brooks, 282 U.S. 359 (1931)
MR. JUSTICE STONE delivered the opinion of the Court.
In this case, certiorari was granted, 281 U.S. 707, to review a judgment of the court of appeals for the Fourth Circuit, reversing an order of the Board of Tax Appeals, which had sustained the action of the Commissioner of Internal Revenue in making a deficiency assessment against respondent for income and profits taxes for the year 1920.
From 1913 to 1915, inclusive, respondent, a Delaware corporation engaged in business for profit, was acting for the Atlantic Dredging Company in carrying out a contract for dredging the Delaware River, entered into by that company with the United States. In making its income tax returns for the years 1913 to 1916, respondent added to gross income for each year the payments made under the contract that year, and deducted its expenses paid that year in performing the contract. The total expenses exceeded the payments received by $176,271.88. The tax returns for 1913, 1915, and 1916 showed net losses. That for 1914 showed net income.
In 1915, work under the contract was abandoned, and in 1916 suit was brought in the Court of Claims to recover for a breach of warranty of the character of the material to be dredged. Judgment for the claimant was affirmed by this Court in 1920. United States v. Atlantic Dredging Co., 253 U.S. 1. It held that the recovery was upon the contract, and was “compensatory of the cost of the work, of which the government got the benefit.” From the total recovery, petitioner received in that year the sum of $192,577.59, which included the $176,271.88 by which its expenses under the contract had exceeded receipts from it, and accrued interest amounting to $16,305.71. Respondent having failed to include these amounts as gross income in its tax returns for 1920, the Commissioner made the deficiency assessment here involved, based on the addition of both items to gross income for that year.
The court of appeals ruled that only the item of interest was properly included, holding, erroneously, as the government contends, that the item of $176,271.88 was a return of losses suffered by respondent in earlier years, and hence was wrongly assessed as income. Notwithstanding this conclusion, its judgment of reversal and the consequent elimination of this item from gross income for 1920 were made contingent upon the filing by respondent of amended returns for the years 1913 to 1916, from which were to be omitted the deductions of the related items of expenses paid in those years. Respondent insists that, as the Sixteenth Amendment and the Revenue Act of 1918, which was in force in 1920, plainly contemplate a tax only on net income or profits, any application of the statute which operates to impose a tax with respect to the present transaction, from which respondent received no profit, cannot be upheld.
If respondent’s contention that only gain or profit may be taxed under the Sixteenth Amendment be accepted without qualification, see Eisner v. Macomber, 252 U.S. 189; Doyle v. Mitchell Brothers Co., 247 U.S. 179, the question remains whether the gain or profit which is the subject of the tax may be ascertained, as here, on the basis of fixed accounting periods, or whether, as is pressed upon us, it can only be net profit ascertained on the basis of particular transactions of the taxpayer when they are brought to a conclusion.
All the revenue acts which have been enacted since the adoption of the Sixteenth Amendment have uniformly assessed the tax on the basis of annual returns showing the net result of all the taxpayer’s transactions during a fixed accounting period, either the calendar year or, at the option of the taxpayer, the particular fiscal year which he may adopt. Under … the Revenue Act of 1918, 40 Stat. 1057, respondent was subject to tax upon its annual net income, arrived at by deducting from gross income for each taxable year all the ordinary and necessary expenses paid during that year in carrying on any trade or business, interest and taxes paid, and losses sustained, during the year. … [G]ross income “includes … income derived from … business … or the transaction of any business carried on for gain or profit, or gains or profits and income derived from any source whatever.” The amount of all such items is required to be included in the gross income for the taxable year in which received by the taxpayer, unless they may be properly accounted for on the accrual basis under § 212(b). See United States v. Anderson, 269 U.S. 422; Aluminum Castings Co. v. Rotzahn, 282 U.S. 92.
That the recovery made by respondent in 1920 was gross income for that year within the meaning of these sections cannot, we think, be doubted. The money received was derived from a contract entered into in the course of respondent’s business operations for profit. While it equalled, and in a loose sense was a return of, expenditures made in performing the contract, still, as the Board of Tax Appeals found, the expenditures were made in defraying the expenses incurred in the prosecution of the work under the contract, for the purpose of earning profits. They were not capital investments, the cost of which, if converted, must first be restored from the proceeds before there is a capital gain taxable as income. See Doyle v. Mitchell Brothers Co., supra, 247 U.S. at 185.
That such receipts from the conduct of a business enterprise are to be included in the taxpayer’s return as a part of gross income, regardless of whether the particular transaction results in net profit, sufficiently appears from the quoted words of § 213(a) and from the character of the deductions allowed. Only by including these items of gross income in the 1920 return would it have been possible to ascertain respondent’s net income for the period covered by the return, which is what the statute taxes. The excess of gross income over deductions did not any the less constitute net income for the taxable period because respondent, in an earlier period, suffered net losses in the conduct of its business which were in some measure attributable to expenditures made to produce the net income of the later period.
But respondent insists that, if the sum which it recovered is the income defined by the statute, still it is not income, taxation of which without apportionment is permitted by the Sixteenth Amendment, since the particular transaction from which it was derived did not result in any net gain or profit. But we do not think the amendment is to be so narrowly construed. A taxpayer may be in receipt of net income in one year and not in another. The net result of the two years, if combined in a single taxable period, might still be a loss, but it has never been supposed that that fact would relieve him from a tax on the first, or that it affords any reason for postponing the assessment of the tax until the end of a lifetime, or for some other indefinite period, to ascertain more precisely whether the final outcome of the period, or of a given transaction, will be a gain or a loss.
The Sixteenth Amendment was adopted to enable the government to raise revenue by taxation. It is the essence of any system of taxation that it should produce revenue ascertainable, and payable to the government, at regular intervals. Only by such a system is it practicable to produce a regular flow of income and apply methods of accounting, assessment, and collection capable of practical operation. It is not suggested that there has ever been any general scheme for taxing income on any other basis. … While, conceivably, a different system might be devised by which the tax could be assessed, wholly or in part, on the basis of the finally ascertained results of particular transactions, Congress is not required by the amendment to adopt such a system in preference to the more familiar method, even if it were practicable. It would not necessarily obviate the kind of inequalities of which respondent complains. If losses from particular transactions were to be set off against gains in others, there would still be the practical necessity of computing the tax on the basis of annual or other fixed taxable periods, which might result in the taxpayer’s being required to pay a tax on income in one period exceeded by net losses in another.
Under the statutes and regulations in force in 1920, two methods were provided by which, to a limited extent, the expenses of a transaction incurred in one year might be offset by the amounts actually received from it in another. One was by returns on the accrual basis …, which provides that a taxpayer keeping accounts upon any basis other than that of actual receipts and disbursements, unless such basis does not clearly reflect its income, may, subject to regulations of the Commissioner, make its return upon the basis upon which its books are kept. See United States v. Anderson, and Aluminum Castings Co. v. Routzahn, supra. The other was under Treasury Regulations (Article 121 of Reg. 33 of Jan. 2, 1918 … providing that, in reporting the income derived from certain long-term contracts, the taxpayer might either report all of the receipts and all of the expenditures made on account of a particular contract in the year in which the work was completed or report in each year the percentage of the estimated profit corresponding to the percentage of the total estimated expenditures which was made in that year.
… [R]espondent [does not] assert, that it ever filed returns in compliance either with these regulations … or otherwise attempted to avail itself of their provisions; nor, on this record, do any facts appear tending to support the burden, resting on the taxpayer, of establishing that the Commissioner erred in failing to apply them. See Niles Bement Pond Co. v. United States, 281 U.S. 357, 361.
The assessment was properly made under the statutes. Relief from their alleged burdensome operation, which may not be secured under these provisions, can be afforded only by legislation, not by the courts.
Notes and Questions:
1. Taxpayer was a dredger. It was hired by the government to do some dredging of a channel in the Delaware River. The Government represented that its probes of the river bottom had shown that the material to be removed was mainly mud and fine sand, but it did not guarantee the accuracy of its findings and indicated that bidders should perform their own tests. In fact, the Government probes had also revealed the presence of “impenetrable” materials. This is what caused taxpayer to cease work on the contract and to sue in the Court of Claims.
• In the absence of tax rules, parties would presumably enter into the most efficient contract possible insofar as matters of payments and performance are concerned.
• Do you think that the holding in this case would affect the terms of future contracts that may require more than one year to perform?
• What exactly was taxpayer’s contention?
2. The Court held out the possibility that taxpayer might keep accounts on the accrual basis or on a percentage-of-completion basis in the case of long-term contracts. What do you think these methods are? Would one or the other of these methods have been better for taxpayer? Why?
3. The Code of course now has one more mechanism by which a transaction in one year may offset a transaction in another: the net operating loss (§ 172). Taxpayers may use losses up to two years back and twenty years forward to offset income. See chapter 6, supra.
4. Interesting questions involving the impact of annual accounting on particular taxpayers arise when tax rates change. Tax rates often change because of war – they increase because of the war and decrease after the war.
United States v. Lewis, 340 U.S. 590 (1951)
MR. JUSTICE BLACK delivered the opinion of the Court.
Respondent Lewis brought this action in the Court of Claims seeking a refund of an alleged overpayment of his 1944 income tax. The facts found by the Court of Claims are: in his 1944 income tax return, respondent reported about $22,000 which he had received that year as an employee’s bonus. As a result of subsequent litigation in a state court, however, it was decided that respondent’s bonus had been improperly computed; under compulsion of the state court’s judgment, he returned approximately $11,000 to his employer. Until payment of the judgment in 1946, respondent had at all times claimed and used the full $22,000 unconditionally as his own, in the good faith though “mistaken” belief that he was entitled to the whole bonus.
On the foregoing facts, the Government’s position is that respondent’s 1944 tax should not be recomputed, but that respondent should have deducted the $11,000 as a loss in his 1946 tax return. See G.C.M. 16730, XV-1 Cum. Bull. 179 (1936). The Court of Claims, however, relying on its own case, Greenwald v. United States, 57 F. Supp. 569, held that the excess bonus received “under a mistake of fact” was not income in 1944, and ordered a refund based on a recalculation of that year’s tax. We granted certiorari because this holding conflicted with many decisions of the courts of appeals, see, e.g., Haberkorn v. United States, 173 F.2d 587, and with principles announced in North American Oil Consolidated v. Burnet, 286 U.S. 417.
In the North American Oil case, we said: “If a taxpayer receives earnings under a claim of right and without restriction as to its disposition, he has received income which he is required to return, even though it may still be claimed that he is not entitled to retain the money, and even though he may still be adjudged liable to restore its equivalent.” 286 U.S. at 424. Nothing in this language permits an exception merely because a taxpayer is “mistaken” as to the validity of his claim. …
Income taxes must be paid on income received (or accrued) during an annual accounting period. Cf. I.R.C. §§ 41, 42, and see Burnet v. Sanford & Brooks Co., 282 U.S. 359, 363. The “claim of right” interpretation of the tax laws has long been used to give finality to that period, and is now deeply rooted in the federal tax system. See cases collected in 2 Mertens, Law of Federal Income Taxation, § 12.103. We see no reason why the Court should depart from this well settled interpretation merely because it results in an advantage or disadvantage to a taxpayer.
MR. JUSTICE DOUGLAS, dissenting.
The question in this case is not whether the bonus had to be included in 1944 income for purposes of the tax. Plainly it should have been, because the taxpayer claimed it as of right. Some years later, however, it was judicially determined that he had no claim to the bonus. The question is whether he may then get back the tax which he paid on the money.
Many inequities are inherent in the income tax. We multiply them needlessly by nice distinctions which have no place in the practical administration of the law. If the refund were allowed, the integrity of the taxable year would not be violated. The tax would be paid when due, but the government would not be permitted to maintain the unconscionable position that it can keep the tax after it is shown that payment was made on money which was not income to the taxpayer.
Notes and Questions:
1. Marginal tax brackets decreased after the end of WWII. Hence, taxpayer’s deduction in 1946 did not save as much in income tax as the same amount of income in 1944 cost him.
2. Congress has enacted § 1341 to mitigate the effect of the Lewis rule. When § 1341 applies, taxpayer is required to pay a tax in the year of repayment that is the lesser of
• tax liability computed in that year with the repayment treated as a deduction, or
• tax liability computed by applying a credit equal in amount to the increase in tax liability caused by payment of income tax in the year of inclusion in gross income.
Notice that § 1341 does not reopen taxpayer’s tax return from the earlier tax year, thereby maintaining the integrity of the principle of annual accounting.
4. Read § 1341. Note carefully the conditions of its applicability, or the following two CALI lessons will be more difficult than they need to be.
5. Do the CALI Lesson, Basic Federal Income Taxation: Gross Income: Claim of Right Doctrine.
7. We might consider Lewis to be a case of “income first/deduction later.” What if we reverse that: “deduction first/income later?”
Alice Phelan Sullivan Corp. v. United States, 381 F.2d 399 (Ct. Cl. 1967)
Plaintiff … brings this action to recover an alleged overpayment in its 1957 income tax. During that year, there was returned to taxpayer two parcels of realty, each of which it had previously donated and claimed as a charitable contribution deduction. The first donation had been made in 1939; the second, in 1940. Under the then applicable corporate tax rates, the deductions claimed ($4,243.49 for 1939 and $4,463.44 for 1940) yielded plaintiff an aggregate tax benefit of $1,877.49.182
Each conveyance had been made subject to the condition that the property be used either for a religious or for an educational purpose. In 1957, the donee decided not to use the gifts; they were therefore reconveyed to plaintiff. Upon audit of taxpayer’s income tax return, it was found that the recovered property was not reflected in its 1957 gross income. The Commissioner of Internal Revenue disagreed with plaintiff’s characterization of the recovery as a nontaxable return of capital. He viewed the transaction as giving rise to taxable income and therefore adjusted plaintiff’s income by adding to it $8,706.93 – the total of the charitable contribution deductions previously claimed and allowed. This addition to income, taxed at the 1957 corporate tax rate of 52%, resulted in a deficiency assessment of $4,527.60. After payment of the deficiency, plaintiff filed a claim for the refund of $2,650.11, asserting this amount as overpayment on the theory that a correct assessment could demand no more than the return of the tax benefit originally enjoyed, i.e., $1,877.49. The claim was disallowed.
This court has had prior occasion to consider the question which the present suit presents. In Perry v. United States, 160 F. Supp. 270 (1958) (Judges Madden and Laramore dissenting), it was recognized that a return to the donor of a prior charitable contribution gave rise to income to the extent of the deduction previously allowed. The court’s point of division – which is likewise the division between the instant parties – was whether the “gain” attributable to the recovery was to be taxed at the rate applicable at the time the deduction was first claimed or whether the proper rate was that in effect at the time of recovery. The majority, concluding that the Government should be entitled to recoup no more than that which it lost, held that the tax liability arising upon the return of a charitable gift should equal the tax benefit experienced at time of donation. Taxpayer urges that the Perry rationale dictates that a like result be reached in this case.
The Government, of course, assumes the opposite stance. Mindful of the homage due the principle of stare decisis, it bids us first to consider the criteria under which judicial reexamination of an earlier decision is justifiable. [The court considered standards upon which it was appropriate to reexamine a rule announced in an earlier decision … and decided not to defer to its holding in Perry.] …
A transaction which returns to a taxpayer his own property cannot be considered as giving rise to “income” – at least where that term is confined to its traditional sense of “gain derived from capital, from labor, or from both combined.” Eisner v. Macomber, 252 U.S. 189, 207 (1920). Yet the principle is well engrained in our tax law that the return or recovery of property that was once the subject of an income tax deduction must be treated as income in the year of its recovery. Rothensies v. Electric Storage Battery Co., 329 U.S. 296 (1946); Estate of Block v. Commissioner, 39 B.T.A. 338 (1939), aff’d sub nom. Union Trust Co. v. Commissioner, 111 F.2d 60 (7th Cir.), cert. denied, 311 U.S. 658 (1940). The only limitation upon that principle is the so-called “tax-benefit rule.” This rule permits exclusion of the recovered item from income so long as its initial use as a deduction did not provide a tax saving. California & Hawaiian Sugar Ref. Corp. v. United States, supra; Central Loan & Inv. Co. v. Commissioner, 39 B.T.A. 981 (1939). But where full tax use of a deduction was made and a tax saving thereby obtained, then the extent of saving is considered immaterial. The recovery is viewed as income to the full extent of the deduction previously allowed.183
Formerly the exclusive province of judge-made law, the tax-benefit concept now finds expression both in statute and administrative regulations. Section 111 of the Internal Revenue Code of 1954 [prior to later amendment] accords tax-benefit treatment [only] to the recovery of bad debts, prior taxes, and delinquency amounts. Treasury regulations have “broadened” the rule of exclusion by extending similar treatment to “all other losses, expenditures, and accruals made the basis of deductions from gross income for prior taxable years ***” [except for depreciation recapture.]
Drawing our attention to the broad language of this regulation, the Government insists that the present recovery … should be taxed in a manner consistent with the treatment provided for like items of recovery, i.e., that it be taxed at the rate prevailing in the year of recovery. We are compelled to agree.
… [The tax-benefit rule] is clearly adequate to embrace a recovered charitable contribution. See California & Hawaiian Sugar Ref. Corp., supra, 311 F.2d at 239. But the regulation does not specify which tax rate is to be applied to the recouped deduction, and this consideration brings us to the matter here in issue.
Ever since Burnet v. Sanford & Brooks Co., 282 U.S. 359 (1931), the concept of accounting for items of income and expense on an annual basis has been accepted as the basic principle upon which our tax laws are structured. “It is the essence of any system of taxation that it should produce revenue ascertainable, and payable to the government, at regular intervals. Only by such a system is it practicable to produce a regular flow of income and apply methods of accounting, assessment, and collection capable of practical operation.” 282 U.S. at 365. To insure the vitality of the single-year concept, it is essential not only that annual income be ascertained without reference to losses experienced in an earlier accounting period, but also that income be taxed without reference to earlier tax rates. And absent specific statutory authority sanctioning a departure from this principle, it may only be said of Perry that it achieved a result which was more equitably just than legally correct.184
Since taxpayer in this case did obtain full tax benefit from its earlier deductions, those deductions were properly classified as income upon recoupment and must be taxed as such. This can mean nothing less than the application of that tax rate which is in effect during the year in which the recovered item is recognized as a factor of income. We therefore sustain the Government’s position and grant its motion for summary judgment. Perry v. United States, supra, is hereby overruled, and plaintiff’s petition is dismissed.
Notes and Questions:
1. Congress has not taken up Judge Collins’s invitation, stated in the last footnote of the case, to enact the principle of Perry – as it did in the reverse situation through § 1341.
2. Read § 111.
3. Consider: In year 1, taxpayer’s total itemized deductions were $12,000. A portion of the itemized deductions was for his contribution of a parcel of land to his church, fmv = $7000, “so long as used for church purposes.” Taxpayer filed single. The standard deduction in year 1 for single persons was $6000. In year 4, the church decided not to use the land for church purposes and returned it to taxpayer.
• How much income must taxpayer include in his 2013 tax return?
3a. Same as #3, but the fmv of the land in year 1 was only $4000? Her total itemized deductions were $12,000.
• How much income must taxpayer include in his year 4 tax return?
3b. Same as #3, but the fmv of the land was $3000 and taxpayer’s total itemized deductions, including his charitable contribution, were $5000.
• How much income must taxpayer include in his year 4 tax return?
II. Deferral Mechanisms
We have already observed that the realization requirement of gross income gives taxpayer some discretion to defer recognition of income – and in Cottage Savings & Loan, to accelerate the recognition of losses.
B. Installment Method and Other Pro-rating of Basis
There are occasions when taxpayer has an accession to wealth, but does not receive any cash with which to pay the income tax due on the gain. Perhaps a purchaser did not have cash to make the purchase and could not procure a bank loan. Taxpayer agrees to permit the purchaser to make installment payments over the course of several years plus interest on the declining balance (§ 163(b)). Section 453 requires taxpayer to defer recognition of “income”185 until receipt of installment payments. § 453(a). Taxpayer may elect out of the installment method of reporting income. § 453(d)(1).
• The installment method applies to an “installment sale.” An “installment sale” is one where at least one payment is to be received after the close of the taxable year of disposition of the property. § 453(b)(1).
• However, the installment method does not apply to a “dealer disposition” or to sales of “inventory.” § 453(b)(2).
• Moreover, the installment method does not apply to property dispositions where the seller will have the wherewithal to pay the income tax due on gain.
• Section 453 does not apply to a disposition of personal property under a revolving credit plan. § 453(k)(1).
• Section 453 does not apply to a disposition of stock or securities traded on an established securities market. § 453(k)(2)(A). Such property is so liquid that it is its own source of cash.
• The “installment” method is a “method under which the income recognized for any taxable year from a disposition is that proportion of the payments received in that year which the gross profits (realized or to be realized when payment is completed) bears to the total contract price.” § 453(c).
• Multiply every payment received by this ratio:
(AR − AB)/(Contract Price)
where AR is the amount taxpayer will eventually realize upon fulfillment of the contract.
• Include the product in gross income in the year of payment of the installment.
• There are some important definitions in the regulations. See Reg. § 15A.453-1(b).
• “Gross profit” is the selling price less adjusted basis. Reg. § 15A.453-1(b)(2)(v).
• “Selling price” is the gross selling price without reduction “to reflect any existing mortgage or other encumbrance on the property …” Reg. § 15A.453-1(b)(2)(ii).
• The “contract price” is the total selling price
• reduced by the debt that the buyer assumes
• which does not exceed the seller’s basis in the property. Reg. § 15A.453-1(b)(2)(iii). Hence, if the debt exceeds the seller’s basis, the contract price is reduced by the seller’s basis, not the amount of the debt. AND: the amount by which the debt exceeds basis is treated as a payment. Reg. § 15A.453-1(b)(3)(i) (11th sentence).
• You can see that the effect of the installment method is to pro-rate the recovery of basis according to the portion of the amount realized of the total selling price.
• Section 453B(a) provides that the disposition of an installment obligation is a recognition event to the one who disposed of it. That person would determine his/her basis in the obligation disposed of and subtract that amount from the amount s/he realizes to determine gain or loss.
Do the CALI Lesson, Basic Federal Income Taxation: Timing: Fundamentals of Installment Sales
• Do not worry about question 19 on wrap-around mortgages. When prevailing interest rates increase, read Reg. § 15A.453-1(b)(3)(ii).
The installment method of § 453 enables a taxpayer to defer recognition of gain until s/he has the wherewithal to pay the tax. However, when taxpayer enters into transactions with related persons with a view towards avoiding income tax, the Code denies the benefits of the installment method.
• Consider: Father (a high bracket taxpayer) sells daughter (a low bracket taxpayer) Blackacre. Father’s basis in Blackacre is $20,000. The selling price is $100,000. Daughter is to make annual payments of $10,000 plus interest on the declining balance. Daughter makes no payments and one week later, sells Blackacre to a third party for $100,000 cash.
• Notice: daughter has no gain/loss to recognize. She also has $100,000 cash in hand with which to fulfill her obligation to pay father $10,000 per year for the next nine years.
• Father has essentially sold Blackacre at a substantial gain. A person related to him holds the cash from the sale. Father may spread recognition of gain over the ensuing ten years.
Section 453(e) addresses so-called “second dispositions by related persons.”
• Section 453(e)(1) requires taxpayer to treat the amount realized in the “second disposition” (i.e., sale by daughter in the example) as received by the person making the “first disposition” (i.e., father in the example).
• Thus in our example, father would be treated as realizing $100,000 upon daughter’s sale of Blackacre.
• This rule applies only to a disposition made within two years after the first disposition. § 453(e)(2). However, the running of this two-year period is suspended in the event the risk of loss to the transferee is substantially diminished – as defined.
• A person is “related” if he or she bears a relationship to the transferor described in either § 318(a) or § 267(b). § 453(f)(1).
• Section 453(e)(3) limits the amount realized by the transferor making the first disposition to
the lesser of the amount realized in the second disposition, or the total contract price for the first disposition
the aggregate amount of payments received with respect to the first disposition, plus the aggregate amount treated as received under § 453(e).
• Installment payments received after the second disposition are not treated as payments with respect to the first disposition to the extent that such payments are less than the amount treated as received on the second disposition. Further payments are treated as payments with respect to the first disposition. § 453(e)(5).
• Example: Same facts as above. Daughter sells Blackacre in year 1 for $80,000. Father is treated as realizing $80,000. Daughter makes payments under the installment contract. The first eight payments are not treated as payments with respect to the first disposition. Father will pay no income tax for receiving these payments. The last two payments will produce taxable income for father as before.
• Do not worry about questions 8-16 on contingent payments.
C. Deferral Until Consumption
An “income tax” is a tax on income. A “consumption tax” is a tax on consumption. We have largely regarded the Code as one creating an income tax. In fact the Code creates a hybrid whereby income that a taxpayer spends on certain specific items of consumption is not subject to income tax – if at all – until taxpayer in fact spends it on those forms of consumption. Consider two examples:
Individual Retirement Accounts: Sections 219/62(a)(7) permit taxpayer to deduct above-the-line up to $5000, § 219(b)(5)(A), indexed for inflation, § 219(b)(5)(D), for payments to an individual retirement account. Income on the account is not currently subject to income tax. § 408(e)(1). The payee or distributee must include in his/her gross income payments from the account in the manner provided under § 72 (annuities). § 408(d)(1). Section 72(t)(1) generally imposes a 10% penalty tax – in addition to the income tax due – on an early distribution from an IRA. A distribution is not early if it occurs on or after taxpayer attains the age of 59½, §§ 72(t)(2)(A)(i), 72(t)(5); distributions must begin no later than April 1 of the calendar year after taxpayer turns 70½, § 408(a)(6) (incorporating rules of § 401(a)(9)(C)(i)). Thus, deducted amounts that a taxpayer saves in a “traditional”186 individual retirement account plus returns on the investment are subject to tax – but at a time when taxpayer will be spending it on consumption in retirement.
Health Savings Accounts: Sections 223/62(a)(19) permit taxpayer to deduct above-the-line amounts contributed to a “health savings account.” A condition of this deduction is that taxpayer must purchase a “high-deductible health plan, § 223(c)(1)(A), a phrase that the Code defines, § 223(c)(2). Taxpayer may deduct contributions to such accounts – subject to limitations, § 223(c)(b)(2). Taxpayer may use funds in the account exclusively to pay “qualified medical expenses,”187 § 223(d)(1). The account is exempt from income tax, so long as it remains a “health savings account.” §§ 223(e)(1), 223(f)(1). A “health savings account” acquired by a surviving spouse continues to be a “health savings account.” The health savings account provisions of the Code permit taxpayers not to pay any income tax on expenditures for consumption of certain medical services on the condition that taxpayers purchase high-deductible health plans.
Congress may use the tool of providing special income tax treatment – whether deferral or exemption – of the income that taxpayer saves for certain forms of consumption to encourage taxpayers to save current income for such future consumption.
III. Basic Accounting Rules
Taxpayer must account for his/her income annually. Here we consider how taxpayer accounts for it. Section 446(a) provides that: “Taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books.” There are some caveats to this facially permissive statement.
Section 446(b) establishes the standard that taxpayer’s method of accounting must “clearly reflect income.” Section 446(c) establishes “permissible methods” of accounting. We will consider only two of them: “cash receipts and disbursements method” and “accrual method.” The regulations define these phrases. Reg. § 1.446-1(c)(1)(i and ii) provide in part:
Rule of Thumb (and no more than that):
Cash method: follow the money. Income is not income unless taxpayer has received money, property, or services. When taxpayer has received money, property, or services, it is income – even if taxpayer may not yet have actually “earned” it. The same is true of deductions. Taxpayer is not entitled to a deduction unless he/she has actually paid the deductible expense.
Accrual method: follow the obligation. Taxpayer must recognize income when he/she is entitled to receive it – even if taxpayer has not actually received payment. Similarly, taxpayer is entitled to a deduction when he/she is obligated to pay an expense – even if taxpayer has not actually paid the expense. Section 461(h) also requires that “economic performance” occur before taxpayer may claim a deduction.
(i) Cash receipts and disbursements method. – Generally, under the cash receipts and disbursements method in the computation of taxable income, all items which constitute gross income (whether in the form of cash, property, or services) are to be included for the taxable year in which actually made. …
(ii) Accrual method. – (A) Generally, under an accrual method, income is to be included for the taxable year when all the events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy. Under such a method, a liability is incurred, and generally is taken in to account for Federal income tax purposes, in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability. …
In the next subsections of the text, we consider a few of the principles that these accounting methods incorporate.
Section 446(d) provides that a “taxpayer engaged in more than one trade or business may, in computing taxable income, use a different method of accounting for each trade or business.” However –
• A C corporation or a partnership with a C corporation partner whose average gross receipts for the last 3-taxable year period exceeds $5M may not use the cash receipts and disbursements method of accounting. §§ 448(a)(1 and 2), 448(b)(3), 448(c)(1).
• A tax shelter may not use the cash receipts and disbursements method of accounting. § 448(a)(3).
• A taxpayer who uses an inventory must use the accrual method “with regard to purchases and sales[.]” Reg. § 1.446-1(c)(2)(ii).
A. Cash Method
The virtue of the cash method is that it is easy. It does not always present an accurate picture of the taxpayer’s economic well-being. It can also be highly manipulable. If a taxpayer wants to increase his/her deductions, taxpayer simply prepays deductible expenses – perhaps years in advance.
• Section 461(g) addresses prepayment of interest.
• Don’t forget that § 263 (capitalization) covers intangibles that will help to produce income past the end of the current tax year. See Reg. § 1.263(a)-4(c)(1) (list of intangibles – includes insurance contract and lease).
If a taxpayer does not want to pay income tax on income, all taxpayer must do is defer its receipt. Various rules address these points.
1. Cash Equivalent
A check is considered to be the equivalent of cash. So is a credit card charge. Hence receipt of the check or credit card charge constitutes income to the taxpayer. On the payment side, payment by check is made when taxpayer delivers it in the manner that taxpayer normally does, e.g., by mail. Payment by credit card is made when the charge is incurred.
In an important case, the United States Court of Appeals for the Fifth Circuit considered whether a promissory note or contract right is a “cash equivalent” and said:
A promissory note, negotiable in form, is not necessarily the equivalent of cash. Such an instrument may have been issued by a maker of doubtful solvency or for other reasons such paper might be denied a ready acceptance in the market place. We think the converse of this principle ought to be applicable. We are convinced that if a promise to pay of a solvent obligor is unconditional and assignable, not subject to set-offs, and is of a kind that is frequently transferred to lenders or investors at a discount not substantially greater than the generally prevailing premium for the use of money, such promise is the equivalent of cash and taxable in like manner as cash would have been taxable had it been received by the taxpayer rather than the obligation.
Cowden v. Commissioner, 249 F.2d 20, 24 (5th Cir. 1961). A “promissory note” is treated as “property” and so its receipt is income to the extent of its fmv. What are the factors that make receipt of a promissory note “gross income?”
On the other hand, giving a promissory note is not the equivalent of payment, and so a promissory note does not entitle the maker to a deduction, even if the recipient of the note must include the fmv of the note in his/her gross income. See Don E. Williams Co. v. Commissioner, 429 U.S. 569, 579 (1977). “The promissory note, even when payable on demand and fully secured, is still, as its name implies, only a promise to pay, and does not represent the paying out or reduction of assets. A check, on the other hand, is a direction to the bank for immediate payment, is a medium of exchange, and has come to be treated for federal tax purposes as a conditional payment of cash.” Id. at 582-83.
2. Constructive Receipt
Reg. § 1.451-2(a) provides in part:
Constructive receipts of income. – (a) General rule. – Income although not actually reduced to a taxpayer’s possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions. …
Taxpayer Paul Hornung played in the NFL championship game on December 31, 1961. The game was in Green Bay, Wisconsin and ended at 4:30 p.m. The editors of Sport Magazine named him the most valuable player of the game and informed him of this fact. Taxpayer would be given a Corvette automobile, but the editors had neither title nor keys to the automobile at that time. They would present them to taxpayer at a luncheon in New York City on January 3, 1962. Sport Magazine could have presented Mr. Hornung with keys and title on December 31, 1961 – but the automobile was actually in New York.
• Did taxpayer constructively receive the automobile in 1961? See Hornung v. Commissioner, 47 T.C. 428 (1967) (acq.).
Taxpayer is a prisoner. The Champion Transportation Services Inc. Profit Sharing and 401(k) Plan mailed a cashier’s check for $25,000 to his personal residence in 1997. A “house-sitter” lived at the residence during the taxpayer’s period of incarceration. Taxpayer had access to a telephone. Taxpayer was released in 1998 and cashed the check at that time.
• Did taxpayer constructively receive $25,000 in 1997? See Roberts v. Commissioner, T.C. Memo. 2002-281, 2002 WL 31618544.
3. Economic Benefit
A cash method taxpayer must include in his/her gross income the value of an “economic benefit.”
Under the economic-benefit theory, an individual on the cash receipts and disbursements method of accounting is currently taxable on the economic and financial benefit derived from the absolute right to income in the form of a fund which has been irrevocably set aside for him in trust and is beyond the reach of the payor’s debtors.
Pulsifer v. Commissioner, 64 T.C. 245, 246 (1975) (taxpayer realized economic benefit even though winners of Irish Sweepstakes unable to claim prize held in Bank of Ireland until they reached age of 21 or legal representative applied for the funds).
Rev. Rul. 60-31
SECTION 451. – GENERAL RULE FOR TAXABLE YEAR OF INCLUSION, 26 CFR 1.451-1: General rule for taxable year of inclusion
Discussion of the application of the doctrine of constructive receipt to certain deferred compensation arrangements.
Advice has been requested regarding the taxable year of inclusion in gross income of a taxpayer, using the cash receipts and disbursements method of accounting, of compensation for services received under the circumstances described below.
(1) On January 1, 1958, the taxpayer and corporation X executed an employment contract under which the taxpayer is to be employed by the corporation in an executive capacity for a period of five years. Under the contract, the taxpayer is entitled to a stated annual salary and to additional compensation of 10x dollars for each year. The additional compensation will be credited to a bookkeeping reserve account and will be deferred, accumulated, and paid in annual installments equal to one-fifth of the amount in the reserve as of the close of the year immediately preceding the year of first payment. The payments are to begin only upon (a) termination of the taxpayer’s employment by the corporation; (b) the taxpayer’s becoming a part-time employee of the corporation; or (c) the taxpayer’s becoming partially or totally incapacitated. Under the terms of the agreement, corporation X is under a merely contractual obligation to make the payments when due, and the parties did not intend that the amounts in the reserve be held by the corporation in trust for the taxpayer.
The contract further provides that if the taxpayer should fail or refuse to perform his duties, the corporation will be relieved of any obligation to make further credits to the reserve (but not of the obligation to distribute amounts previously contributed); but, if the taxpayer should become incapacitated from performing his duties, then credits to the reserve will continue for one year from the date of the incapacity, but not beyond the expiration of the five-year term of the contract. There is no specific provision in the contract for forfeiture by the taxpayer of his right to distribution from the reserve; and, in the event he should die prior to his receipt in full of the balance in the account, the remaining balance is distributable to his personal representative at the rate of one-fifth per year for five years, beginning three months after his death.
(3) On October 1, 1957, the taxpayer, an author, and corporation Y, a publisher, executed an agreement under which the taxpayer granted to the publisher the exclusive right to print, publish and sell a book he had written. This agreement provides that the publisher will (1) pay the author specified royalties based on the actual cash received from the sale of the published work, (2) render semiannual statements of the sales, and (3) at the time of rendering each statement make settlement for the amount due. On the same day, another agreement was signed by the same parties, mutually agreeing that, in consideration of, and notwithstanding any contrary provisions contained in the first contract, the publisher shall not pay the taxpayer more than 100x dollars in any one calendar year. Under this supplemental contract, sums in excess of 100x dollars accruing in any one calendar year are to be carried over by the publisher into succeeding accounting periods; and the publisher shall not be required either to pay interest to the taxpayer on any such excess sums or to segregate any such sums in any manner.
(4) In June 1957, the taxpayer, a football player, entered into a two-year standard player’s contract with a football club in which he agreed to play football and engage in activities related to football during the two-year term only for the club. In addition to a specified salary for the two-year term, it was mutually agreed that as an inducement for signing the contract the taxpayer would be paid a bonus of 150x dollars. The taxpayer could have demanded and received payment of this bonus at the time of signing the contract, but at his suggestion there was added to the standard contract form a paragraph providing substantially as follows:
The player shall receive the sum of 150x dollars upon signing of this contract, contingent upon the payment of this 150x dollars to an escrow agent designated by him. The escrow agreement shall be subject to approval by the legal representatives of the player, the Club, and the escrow agent.
Pursuant to this added provision, an escrow agreement was executed on June 25, 1957, in which the club agreed to pay 150x dollars on that date to the Y bank, as escrow and the escrow agent agreed to pay this amount, plus interest, to the taxpayer in installments over a period of five years. The escrow agreement also provides that the account established by the escrow agent is to bear the taxpayer’s name; that payments from such account may be made only in accordance with the terms of the agreement; that the agreement is binding upon the parties thereto and their successors or assigns; and that in the event of the taxpayer’s death during the escrow period the balance due will become part of his estate.
(5) The taxpayer, a boxer, entered into an agreement with a boxing club to fight a particular opponent at a specified time and place. The place of the fight agreed to was decided upon because of the insistence of the taxpayer that it be held there. The agreement was on the standard form of contract required by the state athletic commission and provided, in part, that for his performance taxpayer was to receive 16x% of the gross receipts derived from the match. Simultaneously, the same parties executed a separate agreement providing for payment of the taxpayer’s share of the receipts from the match as follows: 25% thereof not later than two weeks after the bout, and 25% thereof during each of the three years following the year of the bout in equal semiannual installments. Such deferments are not customary in prize fighting contracts, and the supplemental agreement was executed at the demand of the taxpayer. …
As previously stated, the individual concerned in each of the situations described above, employs the cash receipts and disbursements method of accounting. Under that method, … he is required to include the compensation concerned in gross income only for the taxable year in which it is actually or constructively received. Consequently, the question for resolution is whether in each of the situations described the income in question was constructively received in a taxable year prior to the taxable year of actual receipt.
A mere promise to pay, not represented by notes or secured in any way, is not regarded as a receipt of income within the intendment of the cash receipts and disbursements method. [citations omitted]. See Zittle v. Commissioner, 12 B.T.A. 675, in which, holding a salary to be taxable when received, the Board said: ‘Taxpayers on a receipts and disbursements basis are required to report only income actually received no matter how binding any contracts they may have to receive more.’
This should not be construed to mean that under the cash receipts and disbursements method income may be taxed only when realized in cash. For, under that method a taxpayer is required to include in income that which is received in cash or cash equivalent. Henritze v. Commissioner, 41 B.T.A. 505. And, as stated in the above quoted provisions of the regulations, the ‘receipt’ contemplated by the cash method may be actual or constructive.
… [U]nder the doctrine of constructive receipt, a taxpayer may not deliberately turn his back upon income and thereby select the year for which he will report it. [citation omitted]. Nor may a taxpayer, by a private agreement, postpone receipt of income from one taxable year to another. [citation omitted].
However, the statute cannot be administered by speculating whether the payor would have been willing to agree to an earlier payment. See, for example, Amend v. Commissioner, 13 T.C. 178, acq., C.B. 1950-1, and Gullett v. Commissioner, 31 B.T.A. 1067, in which the court, citing a number of authorities for its holding, stated:
It is clear that the doctrine of constructive receipt is to be sparingly used; that amounts due from a corporation but unpaid, are not to be included in the income of an individual reporting his income on a cash receipts basis unless it appears that the money was available to him, that the corporation was able and ready to pay him, that his right to receive was not restricted, and that his failure to receive resulted from exercise of his own choice.
Consequently, it seems clear that in each case involving a deferral of compensation a determination of whether the doctrine of constructive receipt is applicable must be made upon the basis of the specific factual situation involved.
Applying the foregoing criteria to the situations described above, the following conclusions have been reached:
(1) The additional compensation to be received by the taxpayer under the employment contract concerned will be includible in his gross income only in the taxable years in which the taxpayer actually receives installment payments in cash or other property previously credited to his account. To hold otherwise would be contrary to the provisions of the regulations and the court decisions mentioned above,
In arriving at this conclusion …, consideration has been given to section 1.402(b)-1 of the Income Tax Regulations and to Revenue Ruling 57-37, C.B. 1957-1, 18, as modified by Revenue Ruling 57-528, C.B. 1957-2, 263. Section 1.402(b)-1(a)(1) provides in part, with an exception not here relevant, that any contribution made by an employer on behalf of an employee to a trust during a taxable year of the employer which ends within or with a taxable year of the trust for which the trust is not exempt under § 501(a) of the Code, shall be included in income of the employee for his taxable year during which the contribution is made if his interest in the contribution is nonforfeitable at the time the contribution is made. Revenue Ruling 57-37, as modified by Revenue Ruling 57-528, held, inter alia, that certain contributions conveying fully vested and nonforfeitable interests made by an employer into separate independently controlled trusts for the purpose of furnishing unemployment and other benefits to its eligible employees constituted additional compensation to the employees includible, under § 402(b) of the Code and § 1.402(b)-1(a)(1) of the regulations, in their income for the taxable year in which such contributions were made. These Revenue Rulings are distinguishable from case ‘(1)’ … in that, under all the facts and circumstances of these cases, no trusts for the benefit of the taxpayers were created and no contributions are to be made thereto. Consequently, § 402(b) of the Code and § 1.402(b)-1(a)(1) of the regulations are inapplicable.
(3) Here the principal agreement provided that the royalties were payable substantially as earned, and this agreement was supplemented by a further concurrent agreement which made the royalties payable over a period of years. This supplemental agreement, however, was made before the royalties were earned; in fact, in [sic] was made on the same day as the principal agreement and the two agreements were a part of the same transaction. Thus, for all practical purposes, the arrangement from the beginning is similar to that in (1) above. Therefore, it is also held that the author concerned will be required to include the royalties in his gross income only in the taxable years in which they are actually received in cash or other property.
(4) In arriving at a determination as to the includibility of the 150x dollars concerned in the gross income of the football player, under the circumstances described, in addition to the authorities cited above, consideration also has been given to … the decision in Sproull v. Commissioner, 16 T.C. 244.
In Sproull v. Commissioner, 16 T.C. 244, aff’d, 194 Fed.(2d) 541, the petitioner’s employer in 1945 transferred in trust for the petitioner the amount of $10,500. The trustee was directed to pay out of principal to the petitioner the sum of $5,250 in 1945 and the balance, including income, in 1947. In the event of the petitioner’s prior death, the amounts were to be paid to his administrator, executor, or heirs. The petitioner contended that the Commissioner erred in including the sum of $10,500 in his taxable income for 1945. In this connection, the court stated:
*** it is undoubtedly true that the amount which the Commissioner has included in petitioner’s income for 1945 was used in that year for his benefit *** in setting up the trust of which petitioner, or, in the event of his death then his estate, was the sole beneficiary ***.
The question then becomes *** was ‘any economic or financial benefit conferred on the employee as compensation’ in the taxable year. If so, it was taxable to him in that year. This question we must answer in the affirmative. The employer’s part of the transaction terminated in 1945. It was then that the amount of the compensation was fixed at $10,500 and irrevocably paid out for petitioner’s sole benefit. ***.’
Applying the principles stated in the Sproull decision to the facts here, it is concluded that the 150x-dollar bonus is includible in the gross income of the football player concerned in 1957, the year in which the club unconditionally paid such amount to the escrow agent.
(5) In this case, the taxpayer and the boxing club, as well as the opponent whom taxpayer had agreed to meet, are each acting in his or its own right, the proposed match is a joint venture by all of these participants, and the taxpayer is not an employee of the boxing club. The taxpayer’s share of the gross receipts from the match belong to him and never belonged to the boxing club. Thus, the taxpayer acquired all of the benefits of his share of the receipts except the right of immediate physical possession; and, although the club retained physical possession, it was by virtue of an arrangement with the taxpayer who, in substance and effect, authorized the boxing club to take possession and hold for him. The receipts, therefore, were income to the taxpayer at the time they were paid to and retained by the boxing club by his agreement and, in substance, at his direction, and are includible in his gross income in the taxable year in which so paid to the club. See the Sproull case, supra, and Lucas v. Earl, 281 U.S. 111.
Notes and Questions:
1. A “mere promise to pay” is not included in gross income. It should be apparent that at least some of the taxpayers did plan or could have planned their receipt of money in such a way as to reduce their tax liability.
• Taxpayers in cases 4 and 5 would have lost. How would you restructure the bargains that they entered?
• Does such a restructuring create other risks?
2. Read the excerpt from Pulsifer again carefully. Is there not considerable overlap between constructive receipt and economic benefit?
3. Recall our discussion of § 83.
B. Accrual Method
In United States v. Anderson, 269 U.S. 422, 441 (1926), the United States Supreme Court stated that a taxpayer using the accrual method of accounting must claim a deduction when “all the events [have occurred] which fix the amount of the [liability] and determine the liability of the taxpayer to pay it.”
The regulations provide an “all events test” for deductions and another “all events test” for recognition of gross income. Not surprisingly, the regulations are stingier about permitting deductions than requiring recognition of gross income.
Deductions: Reg. § 1.461-1(a)(2) provides in part:
Under an accrual method of accounting, a liability … is incurred, and generally is taken into account for Federal income tax purposes, in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.
Section 461(h) defines “economic performance.” Its effect will be to defer recognition of deductions. Read it.
Income: Reg. § 1.451-1(a) provides in part:
Under an accrual method of accounting, income is includible in gross income when all the events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy. … Where an amount of income is properly accrued on the basis of a reasonable estimate and the exact amount is subsequently determined, the difference, if any, shall be taken into account for the taxable year in which such determination is made. … If a taxpayer ascertains that an item should have been included in gross income in a prior taxable year, he should, if within the period of limitation, file an amended return and pay any additional tax due. Similarly, if a taxpayer ascertains that an item was improperly included in gross income in a prior taxable year, he should, if within the period of limitation, file claim for credit or refund of any overpayment of tax arising therefrom.
An important condition that the Supreme Court permitted the Commissioner to incorporate into the accrual method of recognizing income is that taxpayer’s receipt of cash in exchange for its promise to render services to members of a club who might need them at some undetermined future time gave rise to gross income upon receipt of the cash, American Automobile Assoc. v. United States, 367 U.S. 687 (1961), irrespective of what Generally Accepted Accounting Principles (GAAP) may prescribe. Id. at 693. Taxpayer argued that it should be permitted to recognize a pro rated amount of income monthly. See also Automobile Club of Michigan v. Commissioner, 353 U.S. 180 (1957).
• How would the prepayments be taxed under § 5.02 of Rev. Proc. 2004-34, infra?
• Compare § 455 (prepaid subscription income).
The IRS has come around to the following accommodation of its position in AAA and that of taxpayers who, under the accrual method, may be expected to pay income tax on money that they received at a time that is (quite) different from when they are expected to earn it by performing services.
Rev. Proc. 2004-34
This procedure provides a method of accounting under which taxpayers using an accrual method of accounting may defer including all or part of certain advance payments in gross income until the year after the year the payment is received. …
SECTION 1. PURPOSE
This revenue procedure allows taxpayers a limited deferral beyond the taxable year of receipt for certain advance payments. Qualifying taxpayers generally may defer to the next succeeding taxable year the inclusion in gross income for federal income tax purposes of advance payments (as defined in § 4 of this revenue procedure) to the extent the advance payments are not recognized in revenues (or, in certain cases, are not earned) in the taxable year of receipt. … [T]his revenue procedure does not permit deferral to a taxable year later than the next succeeding taxable year. …
SECTION 2. BACKGROUND AND CHANGES
.01 In general, § 451 of the Internal Revenue Code provides that the amount of any item of gross income is included in gross income for the taxable year in which received by the taxpayer, unless, under the method of accounting used in computing taxable income, the amount is to be properly accounted for as of a different period. Section 1.451-1(a) provides that, under an accrual method of accounting, income is includible in gross income when all the events have occurred that fix the right to receive the income and the amount can be determined with reasonable accuracy. All the events that fix the right to receive income generally occur when (1) the payment is earned through performance, (2) payment is due to the taxpayer, or (3) payment is received by the taxpayer, whichever happens earliest. See Rev. Rul. 84-31, 1984-1 C.B. 127.
.02 Section 1.451-5 generally allows accrual method taxpayers to defer the inclusion in gross income for federal income tax purposes of advance payments for goods until the taxable year in which they are properly accruable under the taxpayer’s method of accounting for federal income tax purposes if that method results in the advance payments being included in gross income no later than when the advance payments are recognized in revenues under the taxpayer’s method of accounting for financial reporting purposes.
SECTION 3. SCOPE
This revenue procedure applies to taxpayers using or changing to an overall accrual method of accounting that receive advance payments as defined in § 4 of this revenue procedure.
SECTION 4. DEFINITIONS
The following definitions apply solely for purposes of this revenue procedure —
.01 Advance Payment. Except as provided in § 4.02 of this revenue procedure, a payment received by a taxpayer is an “advance payment” if –
(1) including the payment in gross income for the taxable year of receipt is a permissible method of accounting for federal income tax purposes (without regard to this revenue procedure);
(2) the payment is recognized by the taxpayer (in whole or in part) in revenues in its … financial statement … for a subsequent taxable year (or, for taxpayers without an applicable financial statement …, the payment is earned by the taxpayer (in whole or in part) in a subsequent taxable year); and
(3) the payment is for –
(b) the sale of goods (other than for the sale of goods for which the taxpayer uses a method of deferral provided in § 1.451-5(b)(1)(ii));
(f) guaranty or warranty contracts …;
(h) memberships in an organization (other than memberships for which an election under § 456 is in effect); …
SECTION 5. PERMISSIBLE METHODS OF ACCOUNTING FOR ADVANCE PAYMENTS
.01 Full Inclusion Method. A taxpayer within the scope of this revenue procedure that includes the full amount of advance payments in gross income for federal income tax purposes in the taxable year of receipt is using a proper method of accounting under § 1.451-1, regardless of whether the taxpayer recognizes the full amount of advance payments in revenues for that taxable year for financial reporting purposes and regardless of whether the taxpayer earns the full amount of advance payments in that taxable year.
.02 Deferral Method.
(1) In general.
(a) A taxpayer within the scope of this revenue procedure that chooses to use the Deferral Method described in this § 5.02 is using a proper method of accounting under § 1.451-1. Under the Deferral Method, for federal income tax purposes the taxpayer must –
(i) include the advance payment in gross income for the taxable year of receipt … to the extent provided in § 5.02(3) of this revenue procedure, and
(ii) … include the remaining amount of the advance payment in gross income for the next succeeding taxable year.
(3) Inclusion of advance payments in gross income.
(a) Except as provided in paragraph (b) of this § 5.02(3), a taxpayer using the Deferral Method must –
(i) include the advance payment in gross income for the taxable year of receipt … to the extent recognized in revenues in its applicable financial statement … for that taxable year, and
(ii) include the remaining amount of the advance payment in gross income in accordance with § 5.02(1)(a)(ii) of this revenue procedure.
(4) Allocable payments.
(a) General rule. A taxpayer that receives a payment that is partially attributable to an item or items described in § 4.01(3) of this revenue procedure may use the Deferral Method for the portion of the payment allocable to such item or items and, with respect to the remaining portion of the payment, may use any proper method of accounting (including the Deferral Method if the remaining portion of the advance payment is for an item or items described in § 4.01(3) of this revenue procedure with a different deferral period (based on the taxpayer’s applicable financial statement or the earning of the payment, as applicable)), provided that the taxpayer’s method for determining the portion of the payment allocable to such item or items is based on objective criteria.
.03 Examples. In each example below, the taxpayer uses an accrual method of accounting for federal income tax purposes and files its returns on a calendar year basis. …
Example 1. On November 1, 2004, A, in the business of giving dancing lessons, receives an advance payment for a 1-year contract commencing on that date and providing for up to 48 individual, 1-hour lessons. A provides eight lessons in 2004 and another 35 lessons in 2005. In its … financial statement, A recognizes 1∕6 of the payment in revenues for 2004, and 5∕6 of the payment in revenues for 2005. A uses the Deferral Method. For federal income tax purposes, A must include 1/6 of the payment in gross income for 2004, and the remaining 5∕6 of the payment in gross income for 2005.
Example 2. Assume the same facts as in Example 1, except that the advance payment is received for a 2-year contract under which up to 96 lessons are provided. A provides eight lessons in 2004, 48 lessons in 2005, and 40 lessons in 2006. In its … financial statement, A recognizes 1∕12 of the payment in revenues for 2004, 6∕12 of the payment in revenues for 2005, and 5∕12 of the payment in gross revenues for 2006. For federal income tax purposes, A must include 1∕12 of the payment in gross income for 2004, and the remaining 11∕12 of the payment in gross income for 2005.
Example 4. On July 1, 2004, C, in the business of selling and repairing television sets, receives an advance payment for a 2-year contract under which C agrees to repair or replace, or authorizes a representative to repair or replace, certain parts in the customer’s television set if those parts fail to function properly. In its … financial statement, C recognizes 1∕4 of the payment in revenues for 2004, 1∕2 of the payment in revenues for 2005, and 1∕4 of the payment in revenues for 2006. C uses the Deferral Method. For federal income tax purposes, C must include 1∕4 of the payment in gross income for 2004 and the remaining 3∕4 of the payment in gross income for 2005.
Example 5. On December 2, 2004, D, in the business of selling and repairing television sets, sells for $200 a television set with a 90-day warranty on parts and labor (for which D, rather than the manufacturer, is the obligor). D regularly sells televisions sets without the warranty for $188. In its applicable financial statement, D allocates $188 of the sales price to the television set and $12 to the 90-day warranty, recognizes 1∕3 of the amount allocable to the warranty ($4) in revenues for 2004, and recognizes the remaining 2∕3 of the amount allocable to the warranty ($8) in revenues for 2005. D uses the Deferral Method. For federal income tax purposes, D must include the $4 allocable to the warranty in gross income for 2004 and the remaining $8 allocable to the warranty in gross income for 2005.
Example 6. E, in the business of photographic processing, receives advance payments for mailers and certificates that oblige E to process photographic film, prints, or other photographic materials returned in the mailer or with the certificate. E tracks each of the mailers and certificates with unique identifying numbers. On July 20, 2004, E receives payments for 2 mailers. One of the mailers is submitted and processed on September 1, 2004, and the other is submitted and processed on February 1, 2006. In its … financial statement, E recognizes the payment for the September 1, 2004, processing in revenues for 2004 and the payment for the February 1, 2006, processing in revenues for 2006. E uses the Deferral Method. For federal income tax purposes, E must include the payment for the September 1, 2004, processing in gross income for 2004 and the payment for the February 1, 2006, processing in gross income for 2005.
Example 12. On December 1, 2004, I, in the business of operating a chain of “shopping club” retail stores, receives advance payments for membership fees. Upon payment of the fee, a member is allowed access for a 1-year period to I’s stores, which offer discounted merchandise and services. In its … financial statement, I recognizes 1∕12 of the payment in revenues for 2004 and 11∕12 of the payment in revenues for 2005. I uses the Deferral Method. For federal income tax purposes, I must include 1∕12 of the payment in gross income for 2004, and the remaining 11∕12 of the payment in gross income for 2005.
Example 13. In 2004, J, in the business of operating tours, receives payments from customers for a 10-day cruise that will take place in April 2005. Under the agreement, J charters a cruise ship, hires a crew and a tour guide, and arranges for entertainment and shore trips for the customers. In its … financial statement, J recognizes the payments in revenues for 2005. J uses the Deferral Method. For federal income tax purposes, J must include the payments in gross income for 2005.
Notes and Questions:
1. According to the revenue procedure, when must an accrual method taxpayer include income in his/her/its gross income?
2. Why was taxpayer in Example 13 able to defer recognition of income for tax purposes, but taxpayers in the other examples were not?
• In Artnell v. Commissioner, 400 F.2d 981 (7th Cir. 1968), the owner of the Chicago White Sox, an accrual method taxpayer, sold tickets in late fall of one year for games scheduled to be played the following spring and summer. [There’s never been much October baseball in Chicago.] In its financial statement, taxpayer recognizes the payments in revenue for the following spring and summer. Taxpayer sought to defer recognition of this ticket income until the following year. What result?
Do the CALI Lesson, Basic Federal Income Taxation: Timing: Cash and Accrual Methods of Accounting
Don’t worry about question 17, 18, and 19 (points on a mortgage).
A taxpayer’s accounting method must clearly reflect income. § 446(b). Reg. § 1.471-1(a) provides in part:
In order to reflect taxable income correctly, inventories at the beginning and end of each taxable year are necessary in every case in which the production, purchase, or sale of merchandise is an income-producing factor.
A taxpayer who sells from inventory who uses the cash method can too easily manipulate the cost of the goods that he/she/it sells. Hence the regulations require that such taxpayers match the cost of goods sold with the actual sale of the goods. Reg. § 1.446-1(c)(2)(i) provides:
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 …
Reg. § 1.61-3(a) provides in part:
In general: In a manufacturing, merchandising, or mining business, “gross income” means the total sales, less the cost of goods sold …
Thus, a formula for determining gross income for sales from inventory is the following:
GR MINUS COGS EQUALS GI
GR - COGS = GI
GR = gross revenue
COGS = cost of goods sold
GI = gross income.
The formula for determining COGS is the following:
OI PLUS P MINUS CI = COGS
OI + P - CI = COGS
OI = opening inventory
P = purchases of or additions to inventory
CI = closing inventory.
The Code presumes that taxpayer makes sales from the first of the items that he/she/it purchased and placed in inventory, i.e., “first-in-first-out” or FIFO. § 472. However, taxpayer may elect to treat sales as made from the last inventory items purchased, i.e., “last-in-first-out” of LIFO.
1. On December 31, 2011, taxpayer opened a retail store for business and spent $10,000 to acquire 2000 toolboxes at $5 each. During 2012, taxpayer paid $6000 to acquire 1000 more toolboxes at $6 each. Taxpayer sold 2500 toolboxes for $10 each.
• Taxpayer’s gross revenue was $25,000, i.e., 2500 x $10.
• Taxpayer’s opening inventory was $10,000. Taxpayer’s purchases were $6000.
• At the end of the year, taxpayer’s had 500 toolboxes remaining in inventory.
• If we use the FIFO method, we presume that taxpayer sold the toolboxes that he/she/it already had at the beginning the year plus the ones he/she/it purchased earliest in the year. Hence taxpayer presumptively sold the 2000 toolboxes that he/she/it had on hand at the first of the year plus 500 more that he/she/it purchased.
COGS = $10,000 + $6000 - $3,000 = $13,000
GI = $25,000 - $13,000 = $12,000.
• The value of the opening inventory of 500 toolboxes at the beginning of the next year is $3000, i.e., 500 x $6.
2. Now suppose that taxpayer has adopted the LIFO method.
• Taxpayer’s gross revenue remains $25,000.
• Taxpayer’s opening inventory remains $10,000, and taxpayer’s purchases remain $6000.
• At the end of the year, taxpayer still has 500 toolboxes on hand.
• Under the LIFO method, we presume that taxpayer sold the toolboxes that he/she/it purchased last in time. Thus, we presume that taxpayer sold (in order) the 1000 toolboxes that he/she/it purchased during the years plus 1500 that he/she/it had on hand at the first of the year.
COGS = $10,000 + $6000 - $2500 = $13,500.
GI = $25,000 - $13,500 = $11,500.
• The value of the opening inventory of 500 toolboxes at the beginning the next year is $2500.
Taxpayer’s gross income was less when the price of inventory increased during the year using the LIFO method rather than the FIFO method.
Reg. § 1.471-2(c) permits a FIFO-method taxpayer to elect to value inventory at cost or market, whichever is lower.
3. Same facts as number 1, except that the fmv of toolboxes fell to $4 by the end of the year. $4 is less than $6, so taxpayer will value the toolboxes in inventory at $4 rather than $6.
• Taxpayer’s closing inventory = 500 × $4 = $2000.
COGS = $10,000 + $6000 - $2000 = $14,000
GI = $25,000 - $13,000 = $11,000.
If taxpayer anticipates a loss on inventory before it is sold, he/she/it might elect cost or market valuation of inventory, whichever is lower.
Wrap-Up Questions for Chapter 9
1. Why do you think that Congress has never enacted a counterpart to § 1341 and imposed a tax rate on recovery of tax benefit items equal to the rate applicable at the time of the deduction?
2. Taxpayer has $5000 of before-tax income to save in an IRA. Taxpayer anticipates that his/her tax bracket will never change. Will taxpayer come out ahead with a Roth IRA or a traditional IRA? What if taxpayer anticipates that his/her tax bracket will be lower in retirement years than in working (and saving) years?
3. How should Health Savings Accounts bring down the cost of medical care in a sustainable manner?
4. Consider: Congress should permit taxpayers to save money tax-free for a variety of future needs, i.e., to implement a consumption tax model for various needs. In addition to saving for retirement and future health care, Congress permits saving for future educational expenses. Can you think of other objectives that Congress should pursue through this consumption model? What criteria should govern these decisions?
5. How would you structure a retirement plan using Revenue Ruling 60-31 to defer income tax for taxpayers, yet make the payments as secure as possible?