John M. Cameron and Caroline D. Cameron, and John P. and Teena G. Broadaway v. Commissioner , 105 T.C. No. 25 ( 1995 )

105 T.C. No. 25UNITED STATES TAX COURT
JOHN M. CAMERON AND CAROLINE D. CAMERON,
AND JOHN P. AND TEENA G. BROADAWAY, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 2137-94. Filed November 29, 1995.
Ps were shareholders of X, which computed its
earnings and profits under the percentage of completion
method of accounting. X elected to be taxed as an S
corporation and, in a subsequent taxable year,
distributed a dividend to Ps.
Held, for purposes of measuring the amount of the
dividend, X's earnings and profits for its last taxable
year as a C corporation must be computed on the basis
of year-end estimates of the total costs of its long-
term contracts. The estimates may not be revised
retroactively to reflect actual costs, and earnings and
profits may not be adjusted for subsequent taxable
years to which the subchapter S election applied.
Edgar J. Tyler, for petitioners.
Michael F. O'Donnell, for respondent.
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OPINION
LARO, Judge: The Camerons and Broadaways (petitioners)
jointly petitioned for redetermination of Federal income tax
deficiencies determined by respondent as follows:
Year Deficiency
Broadaways 1989 $18,705.89
Year Deficiency
Camerons 1989 $45,102.35
1990 6,289.11
After concessions by the parties, we must decide two remaining
questions that will determine the extent to which petitioners
recognized dividend income from a distribution by Cameron
Construction Co. (Company) in 1989:
(1) Whether Company's contemporaneous estimates of the cost
of completing its long-term contracts may be revised
retroactively in computing earnings and profits under the
percentage of completion method. We hold that they may not.
(2) Whether Company's earnings and profits may be adjusted
for taxable years to which its subchapter S election applied. We
hold that they may not.
Stipulations
This case was submitted on the basis of a fully stipulated
record. The stipulations of fact and attached exhibits are
incorporated herein by this reference.
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At the time they filed their joint petition, the Broadaways
resided in Bono, Arkansas, and the Camerons resided in Jonesboro,
Arkansas. Petitioners were shareholders in Company during the
taxable years at issue. Company is engaged in the road and
highway construction business. Company calculated its income
from construction contracts under the completed contract method
of accounting. Accordingly, it was required by section
312(n)(6)1 to compute its earnings and profits as if it used the
percentage of completion method of accounting. Company elected
to be taxed as an S corporation, pursuant to section 1362(a),
effective following the close of its taxable year ended
October 31, 1988. As an S corporation, Company's first tax year
was a short year ending December 31, 1988, and Company thereafter
reported on a calendar year basis.
At some time during its 1989 taxable year, Company made a
distribution to petitioners. The distribution is taxable to
petitioners as a dividend to the extent of the accumulated
earnings and profits of the Company existing on December 31,
1989. The parties have specified four alternatives:
(1) If Company's earnings and profits must be computed as
of the end of each taxable year on the basis of reasonable
contemporaneous estimates of the costs to complete its
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the taxable years at
issue, and all Rule references are to the Tax Court Rules of
Practice and Procedure.
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construction contracts, and may not be adjusted for taxable years
ended after October 31, 1988, then the accumulated earnings and
profits and resulting deficiencies for the 1989 taxable year are:
E&P Broadaways Camerons
$251,650.13 $19,126.69 $46,014.36
(2) If Company's earnings and profits may be computed as of
the end of each taxable year on the basis of the actual contract
costs determined thereafter, but may not be adjusted for taxable
years ended after October 31, 1988, then the accumulated earnings
and profits and resulting deficiencies for the 1989 taxable year
are:
E&P Broadaways Camerons
$163,580 $12,860.57 $30,901.69
(3) If Company's earnings and profits must be computed as
of the end of each taxable year on the basis of reasonable
contemporaneous estimates of the costs to complete its
construction contracts, and may be adjusted for taxable years
ended after October 31, 1988, then the accumulated earnings and
profits and resulting deficiencies for the 1989 taxable year are:
E&P Broadaways Camerons
$141,738.76 $11,392.81 $27,153.55
(4) If Company's earnings and profits may be computed as of
the end of each taxable year on the basis of the actual contract
costs determined thereafter, and may be adjusted for taxable
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years ended after October 31, 1988, then the accumulated earnings
and profits and resulting deficiencies for the 1989 taxable year
are:
E&P Broadaways Camerons
($21,851.09) $2,323 $3,109
Our task is to select the one alternative, if any, that is in
accordance with the governing law.
Discussion
It is undisputed that Company was required to use the
percentage of completion method for purposes of computing its
earnings and profits. Sec. 312(n)(6). The first issue is how to
perform this computation. Under section 460 as enacted by the
Tax Reform Act of 1986, Pub. L. 99-514, sec. 804, 100 Stat. 2358,
gross income from a long-term contract is taken into account as
the work progresses. The amount of gross income from a long-term
contract that is accrued for each taxable year is that proportion
of the expected total contract income that the amount of costs
incurred through the end of the taxable year bears to the total
expected costs, reduced by cumulative amounts of contract income
that were reported for previous taxable years. Sec. 460(b); H.
Rept. 99-426, at 630 (1986), 1986-3 C.B. (Vol. 2) 630; see also
Kollsman Instrument Corp. v. Commissioner, T.C. Memo. 1986-66,
affd. 870 F.2d 89 (2d Cir. 1989); Berger Engg. Co. v.
Commissioner, T.C. Memo. 1961-292.
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The second issue is how the computation of Company's
earnings and profits was affected by its election under
subchapter S effective November 1, 1988. Absent the election,
Company would have continued to accrue income from its long-term
contracts for earnings and profits purposes on the basis of year-
end estimates of total contract costs. The earnings and profits
available for distribution to petitioners in 1989 would have been
determined on the basis of estimated costs to complete contracts
in progress on the last day of Company's 1989 taxable year. The
result is not the same under subchapter S.
The basic purpose of the earnings and profits account is to
keep track of the amount of corporate funds that have not yet
been taxed to shareholders. When a corporation elects
pass-through treatment under subchapter S, its net income earned
as an S corporation is taxed currently to the shareholders and
thereafter is generally distributed tax-free. Secs. 1366(a),
1368(b)(1), (c)(1). In accordance with the much more limited
role of earnings and profits in a pass-through system of
taxation, section 1371 provides, for taxable years after 1982,
that the accumulated earnings and profits that an S corporation
carries over from pre-election years when it was a C corporation,
generally are not adjusted for the taxable years during which the
election is in effect. Sec. 1371(c)(1); S. Rept 97-640, at 20
(1982), 1982-2 C.B. 718, 720 (accompanying Subchapter S Revision
Act of 1982, Pub. L. 97-354, 96 Stat. 1669). While exceptions
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apply in certain cases, none are relevant on these facts. Sec.
1371(c)(2) and (3), (d)(3). It follows that after its conversion
to an S corporation, through the end of 1989 there was no change
in the amount of Company's earnings and profits computed on the
basis of estimates made as of October 31, 1988.
Petitioners' argument starts with the proposition that
earnings and profits for a given taxable year should measure as
accurately as possible the current ability of the corporation to
make distributions to shareholders without impairing its capital.
They concede that in preparing annual tax returns using the
percentage of completion method Company would have been required
to compute earnings and profits on the basis of the limited
information that was available at the time. Yet, they contend,
where, as here, earnings and profits for the years at issue can
be recomputed when more information about the costs of Company's
long-term contracts is known, they should not be bound by the
estimates reflected on Company's original returns. In
petitioners' view, accuracy requires the use of additional
information that has subsequently become available. Although
petitioners' primary position is that the concern for accuracy in
computation of earnings and profits should override the freeze on
earnings and profits provided for by section 1371(c)(1), they
argue in the alternative that even if earnings and profits were
frozen as of the effective date of Company's subchapter S
election, "I.R.C sec. 1371(c)(1) does not disallow or forbid
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'correcting' the 'C' corporation earnings and profits if the
figures as of the date of the conversion were inaccurate."
Petitioners' contention that retroactive adjustments are
necessary if earnings and profits are to perform their intended
function would be more persuasive if no other means of correcting
inaccuracies in the accrual of long term contract revenue under
the percentage of completion method were available. That is not
the case, however. The percentage of completion method has a
built-in mechanism for correcting mistaken estimates; it differs
from the mechanism that petitioners propose. See Herwitz,
"Accounting for Long-term Construction Contracts: A Lawyer's
Approach", 70 Harv. L. Rev. 449, 465 & n.49 (1957); H. Rept. 99-
426, at 630 (1986), 1986-3 C.B. (Vol. 2) 1, 630. For each year,
the cumulative amount of contract revenue that has already been
reported in prior years is subtracted from the cumulative amount
of contract revenue that is otherwise reportable as of the close
of the current year. If in year 1 the taxpayer reports too much
revenue and overstates earnings and profits as a result of
underestimating the amount of its costs to complete contracts in
progress, there will be correspondingly less revenue that remains
to be reported for those contracts in succeeding years. The
overstatement of earnings and profits in the earlier year may
cause shareholders to report a larger amount of any distribution
in that year as a dividend. But the lower revenues and higher
costs generated in completion of the contracts will reduce
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earnings and profits available for distribution in later years,
which, in turn, may reduce dividend income for shareholders in
these years. In this way, the percentage of completion method is
self-correcting when used consistently over the life of the
taxpayer's long-term contracts.
If this self-correcting mechanism had operated to adjust
Company's earnings and profits after October 31, 1988, the
unexpectedly high costs incurred and the revision of cost
estimates in the 1989 taxable year would apparently have had the
effect of reducing accumulated earnings and profits as well as
the dividends to petitioners in that year. That petitioners
could not take advantage of this mechanism to reduce their
dividend income for 1989 was the consequence of electing the
provisions of subchapter S, one of which is the freeze on
earnings and profits. Sec. 1371(c)(1). We do not find this
result to be inequitable to petitioners, considering that they
would have had no complaint about the accuracy of earnings and
profits measurement under the percentage of completion method had
Company overestimated its total contract costs as of the time of
its subchapter S election rather than underestimating them. The
normal operation of the tax laws will not be adapted to suit the
convenience of individual taxpayers.
Petitioners' argument that in the interest of accuracy they
should be entitled to use a different adjustment mechanism from
that provided for under the percentage of completion method finds
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no support in general principles of tax accounting. On the
contrary, the general rule for the timing of income accruals as
stated in the regulations is that "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." Sec. 1.451-1(a), Income Tax Regs. To
allow a taxpayer to reopen the taxable year of the original
estimate would, moreover, be inconsistent with the annual
accounting principle upon which the Federal income tax is
predicated. The courts have long maintained:
Income tax liability must be determined for annual
periods on the basis of facts as they existed in each
period. * * * No other system would be practical in
view of the statute of limitations, the obvious
administrative difficulties involved, and the lack of
finality in income tax liability, which would result.
* * *
Estate of Block v. Commissioner, 39 B.T.A. 338, 341 (1939), affd.
sub nom. Union Trust Co. v. Commissioner, 111 F.2d 60 (7th Cir.
1940); accord Hillsboro Natl. Bank v. Commissioner, 460 U.S. 378,
377 & n.10, 378 n.11 (1983); Healy v. Commissioner, 345 U.S. 278,
284-285 (1953); Burnet v. Sanford & Brooks Co., 282 U.S. 359, 365
(1931).
It does not appear from the stipulated facts that an attempt
was made to correct the estimates reflected on Company's original
return for the taxable year ended October 31, 1988, by means of
an amended return. The implication of petitioners' argument,
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however, is that if a taxpayer in similar circumstances filed an
amended return, respondent would be obligated to accept it. The
cases hold otherwise: As a corollary to the annual accounting
principle, it is well established that where a transaction was
properly reported on the original return and the original filing
deadline has passed, the acceptance of an amended return that
alters the tax consequences of the transaction is generally
within the discretion of respondent. Goldstone v. Commissioner,
65 T.C. 113 (1975); Coons v. Commissioner, T.C. Memo. 1983-777;
see also Hillsboro Natl. Bank v. Commissioner, supra at 377 n.10.
Accordingly, Company's earnings and profits for its last
taxable year as a C corporation must be determined from Company's
reasonable estimate, as of October 31, 1988, of its costs to
complete construction contracts in progress. The parties have
stipulated that this amount is $251,650.13. The rules of
subchapter S precluded any adjustment to Company's earnings and
profits in the circumstances of this case. See sec. 1371(c)(1).
As a result, Company's earnings and profits remained $251,650.13
on December 31, 1989, and the dividend distributed to petitioners
in 1989 must be measured by reference to this amount. In
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accordance with the parties' stipulation, the deficiency in
Federal income tax for 1989 was $19,126.69 for the Broadaways and
$46,014.36 for the Camerons.
To reflect the foregoing,
Decision will be entered
under Rule 155.