Lincoln Storage Warehouses v. Commissioner , 13 T.C. 33 ( 1949 )

Lincoln Storage Warehouses, Petitioner, v. Commissioner of Internal Revenue, Respondent

Lincoln Storage Warehouses v. Commissioner

Docket No. 18665

United States Tax Court

13 T.C. 33; 1949 U.S. Tax Ct. LEXIS 132;

July 13, 1949, Promulgated

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Decision will be entered for the respondent.

Petitioner corporation, on the accrual basis, credited the account of its sole stockholder, who was on the cash basis, with certain amounts for rents, salary, and interest over a period of years up to and including 1943 and part of 1944 and, after the stockholder's death in 1944, credited the account of the stockholder's estate, which respondent determined to be on the cash basis, with further items. Petitioner made cash payments in 1943 to the stockholder and in 1944 to the stockholder and to his estate. There was no application either by petitioner or by the recipients of any of these payments in satisfaction of any particular credit or credits. In its return for 1943 petitioner deducted from gross income the amounts which it had credited to the account of the stockholder in 1943, and in its return for 1944 the amounts which it had credited to the accounts of the stockholder and of his estate in 1944. Held that, under the law of New Jersey, the cash payments to the stockholder in 1943 should be applied first to the amounts credited prior to 1943 and then to the amounts credited in 1943, and the cash payments to the stockholder and to his estate in 1944 should be applied first to the amounts credited prior to 1944 and then to the amounts credited in 1944. Accordingly, a portion of the amounts credited to the stockholder in 1943 was not paid by petitioner in 1943 or within 2 1/2 months after the close thereof, and a portion of the amounts credited to the stockholder and to his estate in 1944 was not paid by petitioner in 1944 or within 2 1/2 months after the close thereof. Therefore, respondent did not err in disallowing, under section 24 (c) of the Internal Revenue Code, the deduction of these portions from petitioner's gross income in 1943 and 1944.

Andrew B. Crummy, Esq., for the petitioner.

Stanley W. Herzfeld, Esq., for the respondent.

Harlan, Judge. Murdock, J., dissenting. Arundell, Opper, and Johnson, JJ., agree with this dissent.

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HARLAN

Respondent determined deficiencies for the taxable years 1943 and 1944 as follows:

		Declared
		value	Excess profits
Year	Income tax	excess profits	tax
		tax
1943	$ 77.51	$ 3,437.36	$ 19,449.14
1944	None	441.36	2,481.42

The questions presented are: (1) Do the provisions of section 24 (c) of the Internal Revenue Code require the disallowance by respondent of the deduction by petitioner of $ 20,330.95 in its income tax return for the taxable year 1943? (2) Do the provisions of section 24 (c) of the Internal Revenue Code require the disallowance by respondent of the deduction by petitioner of $ 1,816.85 in its income tax return for the taxable year 1944?

The case was submitted upon the pleadings, a stipulation of facts, and a supplemental stipulation of facts, including attached exhibits. The stipulation and supplemental stipulation are adopted by reference and the facts therein set forth are found by us.

It was stipulated that petitioner concedes that, of the amount of $ 27,132.66 disallowed as a deduction for interest, rents, and salary by respondent for the taxable year 1943, the amount of $ 6,801.71 claimed as a deduction for interest was not a deductible item and was therefore properly disallowed without regard to section 24 (c) of the Internal Revenue Code.

FINDINGS OF FACT.

Petitioner is a corporation, organized in 1917 under the laws of the State of New Jersey. Its income and excess profits tax returns for 1943 and 1944 were filed with the collector of internal revenue at Newark, New Jersey.

From December 31, 1917, to June 26, 1944, Reginald T. Blauvelt, Sr., owned all of petitioner's outstanding stock. He died on June 26, 1944. On that date the estate of Reginald T. Blauvelt, Sr., deceased, became the owner of all of petitioner's outstanding stock and continued to own all of the stock at all times material to this proceeding. Also on that date, all legal claims which Reginald T. Blauvelt, Sr., had against petitioner became assets of his estate.

At all times material to this proceeding petitioner used the accrual method of accounting in keeping its books of account and in preparing and filing its income and excess profits tax returns. At all times material to this proceeding Reginald T. Blauvelt, Sr., used the cash receipts and disbursements method of accounting in keeping his books of account and in preparing and filing his income tax returns.

The following schedule shows a summary of the account of Reginald T. Blauvelt, Sr., on the books of petitioner for the period January 1, 1935, to June 30, 1944, and a summary of the account of the estate of Reginald T. Blauvelt, Sr., deceased, on the books of petitioner for the period July 1, 1944, to December 31, 1944, and the amounts reported in the income tax returns of Reginald T. Blauvelt, Sr., and of his estate for the years 1935 to 1944, inclusive, on account of sums accrued on the books of petitioner for rent, salary, and interest.

Credits to Account
Year	Salary	Interest	Rents	Loans and	Total credits
				advances
1935	$ 4,800		$ 38,100		$ 42,900.00
1936	4,800		38,100	$ 1,000.00	43,900.00
1937			38,100	375.00	38,475.00
1938			38,100	140.00	38,240.00
1939			38,100		38,100.00
1940			38,100		38,100.00
1941			38,100		38,100.00
1942	6,000		37,725		43,725.00
1943	6,000	$ 6,801.71	36,600	1,990.00	51,391.71
1944 3,000	1,118.88	18,250	1,024.00	23,392.88
1944	755.13	18,350	128.50	19,233.63

		Balance of account		Reported in personal
	Payments	end of year		income tax returns
Year	and other					Rents
	charges
		Debit	Credit	Salary	Interest
1935	$ 29,370.92		$ 37,138.80	$ 5,037.00		$ 24,311.00
1936	28,074.35		52,964.45	4,800.00		22,995.00
1937	33,249.31		58,190.14			32,874.31
1938	30,735.90		65,694.24			30,735.90
1939	35,280.00		68,514.24			35,275.00
1940	34,308.33		72,305.91			34,313.33
1941	47,935.00		62,470.91			47,935.00
1942	50,466.26		55,729.65	6,000.00		37,725.00
1943	64,388.75		42,732.61	6,000.00	$ 6,801.71	36,600.00
1944 1	33,147.45		32,978.04	3,000.00	1,118.88	18,250.00
1944 2	34,092.32		18,119.35		755.13	18,350.00

None of the payments by petitioner to Reginald T. Blauvelt, Sr., or to his estate referred to in the above schedule which were debited to the accounts of Reginald T. Blauvelt, Sr., and his estate was applied by either petitioner or the recipients in satisfaction of any particular credit or credits in the accounts of the recipients.

In its income and declared value excess profits tax return for 1943 petitioner deducted from gross income and showed as credits to the account of Reginald T. Blauvelt, Sr., the following items:

Salary	$ 6,000.00
Interest	6,801.71
Rents	36,600.00
Total	49,401.71

The Commissioner disallowed $ 27,132.66 of the deductions, contending that that amount should have been applied to the reduction of a credit balance owing Blauvelt growing out of transactions of prior years and that it was not a permissible deduction during the taxable year.

The Commissioner's disallowance was computed as follows:

Credit balance due Reginald T. Blauvelt, Sr., for interest,
rents, and salary as of December 31, 1943, (see
schedule)		$ 42,732.61
Payments made to Reginald T. Blauvelt, Sr., for interest,
rents, and salary during the period January 1 to
March 15, 1944, incl	$ 14,649.95
Loans and advances by Reginald T. Blauvelt, Sr., to petitioner
during the period January 1 to December 31,
1943, inclusive	950.00
		15,599.95
Amount disallowed for interest, rents, and salary allegedly
paid to Reginald T. Blauvelt, Sr., for the year
1943		27,132.66
Interest (see schedule) -- conceded by petitioner to be
properly disallowed without regard to section 24 (c)
Internal Revenue Code		6,801.71
Portion of disallowed deduction at issue		20,330.95

In its income and declared value excess profits tax return for 1944 petitioner deducted from gross income and showed as credits to the account of Reginald T. Blauvelt, Sr., the following items:

Salary	$ 3,000.00
Interest	1,118.88
Rents	18,250.00
Total	22,368.88

The Commissioner disallowed $ 1,816.85 of the deductions, contending that that amount should have been applied to the reduction of a credit balance owing to Blauvelt growing out of transactions of prior years and that it was not a permissible deduction during the taxable year.

The Commissioner's disallowance was computed as follows:

Credit balance due Estate of Reginald T. Blauvelt, Sr.,
deceased, for interest, rents, and salary as of December
31, 1944, (see schedule)		$ 18,119.35
Payments made to estate of Reginald T. Blauvelt, Sr., Deceased,
for interest, rents, and salary during the period
January 1 to March 15, 1945, inclusive	$ 15,150.00
Loans and advances made by Reginald T. Blauvelt, Sr.,
and by the estate of Reginald T. Blauvelt, Sr.,
deceased, to petitioner during the period January 1
to December 31, 1944, inclusive, (see schedule)	1,152.50
		16,302.50
Amount disallowed for interest, rents, and salary allegedly
paid to Reginald T. Blauvelt, Sr., and to the estate
of Reginald T. Blauvelt, Sr., deceased, for the year
1944		1,816.85

After examination of the income tax returns of Reginald T. Blauvelt, Sr., for the years 1942 and 1943 and for the period January 1 to June 26, 1944, and of the estate of Reginald T. Blauvelt, Sr., deceased, for the period June 26 to December 31, 1944, the internal revenue agent, in charge of reports of examination addressed to the estate of Reginald T. Blauvelt, Sr., deceased, proposed to adjust the reported incomes as follows:

Rent and Salary Income of Reginald T. Blauvelt, Sr., for 1942.
As Reported by Taxpayer (see
schedule)		As Adjusted
Salary	$ 6,000.00	$ 50,466.26	(Actual amount of
Rent	37,725.00		cash received --
			see schedule)
	$ 43,725.00

The difference, $ 6,741.26, was added to income because the taxpayer was on the cash basis, the report stated.

Rent and Salary Income of Reginald T. Blauvelt, Sr., for 1943.
As Reported by Taxpayer (see
schedule)		As Adjusted
Salary	$ 6,000.00	$ 62,398.75	(Actual amount of
Interest	6,801.71		cash received,
Rent	36,600.00		less loans and
			advances -- see
	$ 49,401.71		schedule)
Rent and Salary Income of Reginald T. Blauvelt, Sr., for the period January 1,
1944, to June 26, 1944.
As Reported by Taxpayer (see
schedule)		As Adjusted
Salary	$ 3,000.00	$ 32,123.45	(Actual amount of
Interest	1,118.88		cash received,
Rents	18,250.00		less loans and
			advances -- see
			schedule)
	$ 22, 368.88
Rent Income of the Estate of Reginald T. Blauvelt, Sr. Deceased, for the period
June 26, 1944, to December 31, 1944.
As Reported by Taxpayer (see
schedule)		As Adjusted
Rents	$ 18,350.00		$ 19,105.13
Interest	755.13
	$ 19,105.13		$ 52,083.17

In this report of examination an additional deduction of $ 4,573.62 not claimed by the estate on its return and not germane to the matters at issue here was proposed.

The above deficiencies in income tax of Reginald T. Blauvelt, Sr., for 1943, and for the period January 1 to June 26, 1944, and of the estate of Reginald T. Blauvelt, Sr., deceased, for the period June 26 to December 31, 1944, have been assessed by the respondent.

OPINION.

Respondent disallowed the deduction by petitioner of $ 27,132.66 in its income tax return for 1943, of which the amount of $ 20,330.95 is in controversy, and of $ 1,816.85 in its income tax return for 1944. The disallowances were computed as set forth in our findings of fact. We shall discuss these disallowances in the order named.

Respondent's position is that the amount of $ 20,330.95, which allegedly represents rents and salary paid by petitioner to Reginald T. Blauvelt, Sr., for 1943, was never paid to Blauvelt in 1943 or within two and one-half months after the close thereof. Therefore, he maintains that under the provisions of section 24 (c) of the Internal Revenue Code^{*143 at the close of 1942 was $ 55,729.65. This account was credited during 1943 with amounts totaling $ 49,401.71 (not including loans and advances). During 1943 Blauvelt received from petitioner cash payments totaling $ 64,388.75. The sole issue in the determination of deficiency for 1943 is whether these payments should be applied first to the credits accrued prior to 1943, represented by the credit balance as of the close of 1942, and then to the credits accrued in 1943, or vice versa. Respondent contends that the payments should be applied first to the antecedent credits, whereas petitioner maintains that they should be applied first to the current credits.}

If respondent is correct, disallowance of the deduction should be sustained, inasmuch as paragraphs (1), (2), and (3) of section 24 (c) would then apply. Specifically, paragraph (1) would apply, as the amount deducted would represent "expenses or interest not paid within the taxable year or within two and one half months after the close thereof." Paragraph (2) would apply, as Reginald T. Blauvelt, Sr., was on the cash basis, and, therefore, the amount deducted by petitioner, not having been paid, would not be includible in his gross income for 1943. Paragraph (3) applies, as Reginald T. Blauvelt, Sr., owned all the stock of petitioner.

The question at issue, then, is simply one of the proper application of the payments made by petitioner to Reginald T. Blauvelt, Sr., in 1943, i. e., whether first to past or to current obligations. This question is one to be settled by the law of New Jersey, where the obligations arose.

It has been stipulated that there was no application by either the debtor or the creditor or the creditor's estate of the payments in question in satisfaction of any particular credit or credits in the accounts of the creditor or his estate. In such a situation the Court of Errors and Appeals of New Jersey held, in Long v. Republic Varnish, Enamel & Lacquer Co., 169 Atl. 860; 115 N.J. Eq. 212 (1934), reversing 164 Atl. 8; 112 N.J. Eq. 321">112 N.J. Eq. 321 (1933):

* * * If neither party has exercised his right of appropriation, and a dispute subsequently arises, the court will make the appropriation, and in doing so will, as a general rule, apply the payment to the debt which is least secure. [Citing cases.]

In the case at bar, in the absence of other factors, it is plain that the earliest debt, by reason of the statute of limitations, is the least secure.

Similarly, in Naidech v. Hempfling, 24 Atl. (2d) 524; 127 N.J.L. 430">127 N.J.L. 430 (1941), the Supreme Court of New Jersey said:

* * * the rules as to application of payments are perfectly well settled. Those here applicable are as follows: 1. A debtor owing several debts to a creditor is entitled to direct application of any payment to whichever debt he wishes it applied. 2. If the debtor does not so direct, the creditor may make the application. 3. If neither party makes the application, and one debt is secured and another unsecured, a court of equity will usually direct application to the unsecured debt; and 4, as regards the items of a running account, payments not appropriated by either party will be applied to the earlier items. [Citing cases.]

These are generally the rules elsewhere as well, and they have been followed by this Court. United States v. Kirkpatrick, 9 Wheat. 720">9 Wheat. 720 (U.S. 1824); Delaware Dredging Co. v. Tucker Stevedoring Co., 25 Fed. (2d) 44 (CCA-3, 1928); Lorenz Co., 12 T.C. 263">12 T.C. 263; McConway & Torley Corporation, 2 T.C. 593">2 T.C. 593; 48 C.J., Payment, § 110 b (1); 40 Am. Jur., Payment, § 132, 137; Restatement, Contracts (1932), vol. 2, § 394.

In spite of the stipulation that there was no application of the payments to any particular credit, however, petitioner argues that the income tax returns for 1943 of both the debtor and the creditor show a recognition that the payments were to be applied first to current obligations, and that, therefore, this Court should treat such recognition as an application to current obligations. But we do not understand the returns either of petitioner or of Reginald T. Blauvelt, Sr., to show any such application. By deducting in its 1943 return the sum of $ 49,401.71 for salary, interest, and rents, petitioner, which was on the accrual basis, merely indicated that it became obligated during 1943 to pay that sum to Blauvelt. It does not follow that the payments to Blauvelt in that year were applied by petitioner first to the credits for 1943 and then to the credit balance of the prior year.

Nor does the fact that Reginald T. Blauvelt, Sr., reported $ 49,401.71 in his 1943 return imply that he believed that payments in the amount of $ 64,388.75 were first to be applied against the $ 49,401.71 accrued by the petitioner as an obligation to him in that year. As the schedule in our findings of fact shows, from 1935 through 1943 Blauvelt followed a consistent policy of reporting as income the payments from petitioner when the payments were less than the current accruals in his favor and of reporting the accruals when the accruals were the smaller of the two sums, with the single material exception of 1941, the first year in which his credit balance declined instead of continuing to increase. His reporting of the accruals during 1943 rather than the larger amount paid him therefore does not indicate a recognition by him that payments were to be applied against current accruals, but is only a reflection of his settled policy of reporting the smaller of the two amounts.

There having been no application of these payments by either the debtor or the creditor prior to the controversy herein, then, it is fundamental that it is incumbent upon this Court to make the application. We therefore hold, under the law of New Jersey, as set forth, that the payments made by petitioner to Reginald T. Blauvelt, Sr., in 1943 should be applied first to the indebtedness of petitioner to Reginald T. Blauvelt, Sr., incurred prior to 1943 and thereafter to the indebtedness incurred in 1943. Respondent's computation not being otherwise in dispute, we must hold that he did not err in disallowing the deduction of $ 27,132.66 from petitioner's gross income for 1943.

As to the disallowance of the deduction by petitioner of $ 1,816.85 from gross income for 1944, respondent's position is that it should be disallowed for the same reasons as the deduction for 1943 just discussed. To repeat, he maintains that the sum of $ 1,816.85, which allegedly represents interest, rents, and salary paid by petitioner to Reginald T. Blauvelt, Sr., and to the estate of Reginald T. Blauvelt, Sr., deceased, for 1944, was never paid to Blauvelt or to his estate in 1944 or within two and one-half months after the close thereof. Therefore, he maintains that under the provisions of section 24 (c) this amount was not deductible by petitioner.

The credit balance of the account of Reginald T. Blauvelt, Sr., at the close of 1943 was $ 42,732.61. His account and that of his estate were credited during 1944 with amounts totaling $ 42,626.51. During 1944 Blauvelt and his estate received from petitioner cash payments totaling $ 67,239.77. The issue is whether these payments should be applied first to the credits accrued prior to 1944, represented by the credit balance as of the close of 1943, and then to the credits accrued in 1944, or vice versa. As with the same question in regard to the payments for 1943, respondent contends that the payments should be applied first to antecedent credits, whereas petitioner maintains that they should be applied first to current credits. For the same reasons we gave as to our holding on the payments in 1943, we hold that respondent's contention is correct.

A further question appears as to the disallowance of the deduction of $ 1,816.85 in 1944. In its return for that year, the estate of Reginald T. Blauvelt, Sr., stated that the return was prepared on the accrual basis. If so, paragraph (2) of section 24 (c) would not apply and petitioner would be entitled to claim the deduction of all amounts accrued to the account of the estate during 1944, regardless of whether paid or not. Respondent, however, determined that the estate was on the cash basis.

As was said by the Supreme Court in Aluminum Castings Co. v. Routzahn, 282 U.S. 92 (1930) :

* * * But whether a return is made on the accrual basis, or on that of actual receipts and disbursements, is not determined by the label which the taxpayer chooses to place upon it.

Beyond the bare statement mentioned, there is nothing in the return of the estate for 1944 to show an accrual rather than a cash basis. Petitioner has not introduced the books of the estate or any other evidence to show that the estate was on the accrual basis. Under the circumstances, then, we must hold that petitioner has failed to meet its burden of proof and respondent's determination that the estate was on the cash basis must be presumed to be correct.

Respondent's computation not being otherwise in dispute, we must hold that he did not err in disallowing the deduction of $ 1,816.85 from petitioner's gross income in 1944.

In its petition petitioner also alleged error on the part of respondent in disallowing as a deduction from gross income in 1944 an expenditure of $ 985. No proof was offered by petitioner in support of this allegation of error. This issue is therefore decided in favor of respondent.

We accordingly hold that respondent did not err in his determination of deficiencies in petitioner's income tax, declared value excess profits tax, and excess profits tax for 1943 and 1944.

Decision will be entered for the respondent.

MURDOCK

Murdock, J., dissenting: The prevailing opinion denies the petitioner deductions by carrying section 24 (c) beyond its intended purpose. The petitioner is on an accrual basis. The general rule is that it is entitled to deduct items of the character involved herein when it incurs a liability to pay them and accrues them on its books. Those things all occurred in the taxable years.

Section 24 (c) is an exception to the general rule. It originally appeared as section 301 (a) of the Revenue Act of 1937, which inserted section 24 (c) of the Revenue Act of 1936. The report of the Joint Committee on Tax Evasion and Avoidance, which is dated August 5, 1937, states that the Committee had presented to it cases of artificial deductions created where the debtor kept its books and claimed deductions on an accrual basis, whereas the closely related creditor would not be required to report the items for tax purposes on the cash basis until they are actually received; the Government was delayed in getting its tax where payment in such cases was postponed for a long period of time; and the payments, if made at all, were being made in low income years, with the result that little or no tax was paid by the creditor. The Committee felt that a provision should be inserted in the law to encourage prompt payment of such obligations. The report of the Ways and Means Committee, 75th Cong., 1st sess., H. Rept. No. 1546, stated: "Under existing law, some individuals have attempted to take advantage of the difference in operation between different accounting methods of reporting income to obtain artificial deductions for interest and business expenses." This was accomplished by not making payment to the creditor until the later, more favorable year. Section 24 (c) was recommended to prevent this abuse by requiring payment within two and one-half months after the close of the taxable year of the debtor.

The petitioner in the present case paid to its creditor, within each taxable year, more than the amount of the deductions which it is claiming and the creditor reported for that year at least the amount claimed by the debtor as deductions. Thus this creditor and this debtor during these years did not do the sort of thing that Congress was trying to stop and, under such circumstances, no such technicalities as are resorted to in the majority opinion should be used to deny the petitioner the deductions which it claims.

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Footnotes

• 1. Reginald T. Blauvelt, Sr., personal account to June 30, 1944.↩

• 2. Estate of Reginald T. Blauvelt, Sr., deceased, to December 31, 1944.↩

• *. Back rent collected by taxpayer and not previously reported by the decedent.↩

• 1. SEC. 24. ITEMS NOT DEDUCTIBLE.

  * * * *

  (c) Unpaid Expenses and Interest. -- In computing net income no deduction shall be allowed under section 23 (a), relating to expenses incurred or under section 23 (b), relating to interest accrued --

  (1) If such expenses or interest are not paid within the taxable year or within two and one-half months after the close thereof; and

  (2) If, by reason of the method of accounting of the person to whom the payment is to be made, the amount thereof is not, unless paid, includible in the gross income of such person for the taxable year in which or with which the taxable year of the taxpayer ends; and

  (3) If, at the close of the taxable year of the taxpayer or at any time within two and one half months thereafter, both the taxpayer and the person to whom the payment is to be made are persons between whom losses would be disallowed under section 24 (b)↩.