Bien v. Commissioner , 20 T.C. 49 ( 1953 )

V. T. H. Bien and Bertha C. Bien, Petitioners, v. Commissioner of Internal Revenue, Respondent

Bien v. Commissioner

Docket No. 33872

United States Tax Court

20 T.C. 49; 1953 U.S. Tax Ct. LEXIS 198;

April 10, 1953, Promulgated

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Decision will be entered under Rule 50.

1. Were the petitioners computed their net income upon the basis of the "hybrid" method of accounting regularly employed in keeping their books, held, the method employed does not clearly reflect income and the determination of the respondent is sustained.

2. Where petitioners failed to produce any evidence to substantiate their claimed deduction for expenses incurred in connection with the rental of a portion of their residence, held, the petitioners have failed in their burden of proof and the determination of the respondent is sustained.

3. Where petitioners incurred expenses in connection with the maintenance of an office in their residence but failed to produce evidence from which the amount could be determined specifically, held, under Cohan v. Commissioner, 39 F. 2d 540, the petitioners are entitled to a deduction of $ 400 in each of the years 1946 and 1947.

Edward A. White, Esq., for the petitioners.

Reuben G. Clark, Jr., Esq., for the respondent.

Hill, Judge.

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HILL

The respondent determined deficiencies in the income tax of the petitioners as follows:

V. T. H. Bien and Bertha C. Bien	1946	$ 1,669.73
V. T. H. Bien	1947	735.88
V. T. H. Bien and Bertha C. Bien	1948	138.18

The questions presented for our decision are as follows:

1. Did the Commissioner err in disapproving the method of accounting used by petitioners to determine net income derived from services as an architect and in redetermining such income on the cash basis?

2. Are petitioners entitled to additional deductions for the year 1946 for expenses in connection with the rental of a portion of their residence?

3. Are petitioners for the year 1946 and petitioner V. T. H. Bien for the year 1947 entitled to an additional deduction for expenses in connection with the maintenance of an office in their residence?

The issue raised by paragraph 4 (b) of the petition relating to a claimed deductible loss on the sale of a boat was conceded by the petitioners upon brief, as well as certain minor issues relating to the disallowance of interest in the amount of $ 74.45 and an addition to certain trust income in the amount of $ 37.50. Such concessions will be taken into account in the recomputation under Rule 50.

FINDINGS OF FACT.

Petitioners, husband and wife, are residents of Bethesda, Maryland, and filed their joint income tax returns for the calendar years 1946 and 1948 and separate returns for the year 1947 with the collector of internal revenue for the district of Maryland.

Petitioner V. T. H. Bien (hereinafter referred to as petitioner) is a registered architect, practicing in Bethesda, Maryland. He has been registered as an architect in Maryland since about 1936, in the District of Columbia since about 1940, and in Virginia since about 1942.

Prior to 1927 petitioner worked as a general contractor. Subsequent to that date he was employed by the Government and private industry, returning thereafter to the private building business, which he combined for awhile with the practice of architecture. Since 1934 petitioner has been a practicing architect with the exception of the war years, 1941-1945, when he was privately employed. Since 1945 the petitioner has practiced architecture exclusively.

All costs and income unrelated to his practice of architecture have been treated by the petitioner on the cash receipts and disbursements basis and at all times the petitioner has maintained books of account relating to his practice of architecture and has consistently used the same method of accounting with relation to income derived from his profession as an architect.

Petitioner worked for himself and employed two or three draftsmen more or less continuously, who were paid on an hourly basis. In addition he employed an office secretary. Petitioner maintained an office, for the practice of his profession during the years in question, which was located in his residence.

Contractual relations between the petitioner and his clients were defined by the contract recommended by the American Institute of Architects, except in occasional instances where special contracts were employed, which were nevertheless basically the same as the American Institute of Architects' contract.

The professional services rendered by the petitioner were performed in three stages: (1) a preliminary stage, consisting of necessary conferences to determine the needs of the client and how much he expected to spend, preliminary studies and sketches; (2) a working drawings stage, consisting of the preparation of working drawings, large scale and full-sized detailed drawings, specifications, the drafting of proposals and contracts, and the letting of bids; and (3) the supervisory stage, involving supervision of the job under construction by the petitioner, who must visit the job frequently, checking plans and specifications against work and materials used, and ending in the issuance of a certificate of completion.

The petitioner's fee on individual jobs was based on a percentage of the cost of the building. The basic fee as determined is a percentage of the ultimate hypothetical cost of the building. Payments to the petitioner on account of his fee were made in accordance with paragraph 5 of the standard contract of the American Institute of Architects, which reads as follows:

5. Payments. -- Payments to the Architect on account of his fee shall be made as follows, subject to the provisions of Art. 4:

Upon completion of the preliminary studies, a sum equal to 20% of the basic rate computed upon a reasonable estimated cost.

Upon completion of specifications and general working drawings (exclusive of details) a sum sufficient to increase payments on the fee to 75% of the rate or rates of commission arising from this agreement, computed upon a reasonable cost estimated on such completed specifications and drawings, or if bids have been received, then computed upon the lowest bona fide bid or bids.

From time to time during the execution of work and in proportion to the amount of service rendered by the Architect, payments shall be made until the aggregate of all payments made on account of the fee under this Article, but not including any covered by the provisions of Article 4, shall be a sum equal to the rate or rates of commission arising from this agreement, computed upon the final cost of the work.

Payments to the Architect, other than those on his fee, fall due from time to time as his work is done or as costs are incurred.

No deductions shall be made from the Architect's fee on account of penalty, liquidated damages, or other sums withheld from payments to contractors.

It was petitioner's practice to render his first bill, 20 per cent of the basic fee, after the preliminary sketch stage and his second bill for an additional 55 per cent of the basic fee after completion of the plans and specifications, but prior to letting bids. The final statement was rendered on completion of the job, when all costs were fixed, and was adjusted to whatever the final cost of the job may have been, instead of the basic fee.

The length of the jobs varied from less than a year to as long as 5 or 10 years. Costs incurred by the petitioner in rendering his services were (1) direct costs, consisting of wages paid to draftsmen, payments for outside engineering services, and blueprinting, mimeographing, and specification costs, which were charged to the individual job accounts, and (2) indirect costs, consisting of office salaries, architectural supplies and expenses, professional dues, technical books and magazines, telephone, legal and accounting fees, payroll taxes, automobile and other miscellaneous expenses, which were not charged to the individual jobs.

The three basic books of account maintained by the petitioner were a journal, including receipts and disbursements, a "completed job cost sheets" book, and a general ledger.

Direct costs as paid were entered in check disbursements in the journal, with information showing the date, to whom paid, the check number, the amount, and a description of the job to which the amount related. From there, they were then posted to the individual job cost sheets. Monthly totals, reflecting all direct costs paid in such month, were posted to a special ledger expense account, #131, known as "jobs in progress."

Indirect costs were also posted initially to the check disbursements journal from the check book, and from there to separate individual general ledger expense accounts such as office salaries, telephone, professional dues, and technical books and magazines.

Receipts derived from services as an architect were entered in the cash receipts journal from deposit slips; they were then posted to the individual job cost sheets, from which monthly totals, reflecting all receipts for such month, were posted to a special ledger income account, #600, known as "deferred architectural fees."

At the close of each calendar year, indirect costs paid in such year, appearing in the general ledger accounts, were closed out to profit and loss in order to determine net income. However, the totals of direct costs paid in such year, as appearing in the ledger account #131, and the totals of architectural income received in such year, as appearing in the ledger account #600, were not closed out to profit and loss, or taken into account in such year in order to determine net income. Instead, petitioner advised his accountant which individual jobs should be considered to have been completed for the year in question, and the income and direct costs relating thereto were closed out to profit and loss for purposes of determining net income.

Whenever jobs were abandoned but the petitioner thought a chance of renewal existed, the account was kept open. However, when a particular job was in fact closed out in a particular year, any resumption of work on that job was treated as a new account.

Direct and indirect costs were taken into account by petitioner in 1946, 1947, and 1948 in the following amounts:

Year	Direct costs	Indirect costs
1946	$ 455.72	$ 2,652.72
1947	902.26	1,852.64
1948	1,441.85	3,031.52

The disparity between direct and indirect costs resulted primarily because the largest item of direct cost was the petitioner's own time which may not be taken into account for tax purposes. For this reason also the remaining direct costs did not form a satisfactory basis for fairly apportioning indirect costs to individual jobs and it was impossible to apportion indirect costs.

For the period 1946-1950, inclusive, there would be an increase or decrease, as below indicated, in gross income on the cash basis as compared to the completed contract basis:

1946 increase	$ 7,563.47
1947 increase	3,186.79
1948 increase	279.15
1949 decrease	6,454.48
1950 decrease	3,834.26

Under the method of accounting employed by petitioner, fluctuations in net income from year to year were due to the varying amounts of fees and direct costs taken into account each year, as determined by the number of jobs which in the judgment of petitioner were closed in such year.

The method of accounting employed by petitioner V. T. H. Bien is a "hybrid" method, which does not clearly reflect his income for purposes of Federal income taxation.

The petitioners are not entitled to a deduction for expenses claimed to have been incurred in connection with the rental of a portion of their residence.

The petitioners for the year 1946 and petitioner V. T. H. Bien for the year 1947 are entitled to deduct the sum of $ 400 as expenses incurred in connection with the maintenance of an office in their residence.

OPINION.

Section 41 of the Internal Revenue Code provides that net income shall be computed upon the basis of the taxpayer's annual accounting period in accordance with the method of accounting regularly employed in keeping the books of such taxpayer, but if the method regularly employed does not clearly reflect net income it shall be computed in accordance with such method as in the opinion of the Commissioner does clearly reflect net income.

Section 42 of the Code requires that all items of gross income shall be included in the gross income of the taxpayer in the year in which it is received unless an accounting method permissible under section 41 and regularly employed by the taxpayer requires that such items be accounted for as of a different period.

Similarly, section 43 of the Code provides that deductions shall be taken by the taxpayer for tax purposes in the year in which they are "paid or accrued" or "paid or incurred," dependent upon the method of accounting regularly employed in the computation of net income, unless in order to clearly reflect income the deductions or credits must be taken in a different period.

The language of these three sections of the Code is not so free of ambiguity as the simplicity of the terms used would indicate, for an examination of the language of these sections reveals almost perfect circuity of reasoning. The key language of the three sections involved is this: "clearly reflect the income." Nowhere do the revenue statutes define what does or does not clearly reflect the income. In deed, from the very nature of the business complexities involved in taxation it is seen that what will or will not clearly reflect income must vary greatly from business to business and from factual situation to factual situation. Since this is the case, the courts have given wide latitude to the respondent in his administrative determinations under sections 41, 42, and 43 of the Code. See Stern Brothers & Co., 16 T. C. 295; Hygienic Products Co., 37 B. T. A. 202, affd. 111 F.2d 330">111 F. 2d 330, certiorari denied 311 U.S. 665">311 U.S. 665.

We have found that the petitioner has computed his net income in accordance with the method of accounting regularly employed in keeping his books; therefore, our inquiry is limited to whether or not the method employed by the petitioner clearly reflects income. To prevail, the petitioner must produce evidence of sufficient weight to overturn the respondent's determination that his method does not clearly reflect the income. Thus it is pertinent to inquire into the method of accounting used by the petitioner for the purposes of computing his net income.

The petitioner refers to his method of accounting as a "completed contract" method. However, under examination, it is immediately apparent that his system is a "hybrid" system. Actually, his method is almost entirely the cash receipts and disbursements method. All items of income and expense relating to his profession of architect are entered upon his books of account when received or paid through the cash receipts and disbursements book. Fees received are entered in the cash book from deposit slips and subsequently posted to the individual job cost sheets from which monthly totals, reflecting receipts for the month, are entered in the income account, #600, known as "deferred architectural fees." The costs denominated "direct costs" in our Findings of Fact are similarly posted from check disbursements to the job sheets and from there in monthly totals to expense account, #131, known as "jobs in progress." The "indirect costs" are treated in the same fashion with the exception that they are posted to the general ledger expense account. At this point in the petitioner's method of accounting, the ledger accounts all reflect a pure cash receipts and disbursements method, as they do at the close of the accounting period but, instead of closing out to profit and loss at the end of each year all expenses and items of income pertaining to such year, petitioner's accountant closes out to profit and loss only the indirect costs and only those jobs which he is advised by the petitioner were completed in such year.

Petitioner argues that he employed this method in order to "get all of my costs in and all of my fees in before I attempted to figure what the profit might have been" from each job. However, it is seen at once that he does not include all of his costs in determining profit or loss on individual jobs, inasmuch as the "indirect costs" are incapable of apportionment and thus not apportioned to the individual jobs. His system permits him to determine gross profit from individual jobs. This, of course, is of interest to the petitioner; here, however, we are concerned only in determining whether or not the petitioner's system of accounting clearly reflects his net income, a statutory concept, for each taxable year. To the extent that the petitioner's method tends to distort his net income, the requisite correlation between income and the cost of producing it, required by sections 41, 42, and 43 of the Code, is destroyed. That distortion is present in the petitioner's method of accounting is borne out by the fact that under the standard contract used by the petitioner he is paid as he performs his services within a short time after incurring his direct costs.

It is also significant that the petitioner has failed to show that his books of account relating to his profession have been kept on the same basis as other architects. See Seas Shipping Co., 1 T. C. 30; Planet Line, Inc., 34 B. T. A. 253, affd. 89 F. 2d 16. Indeed, petitioner's own expert witness indicated that he kept his books of account and reported his income for tax purposes on the cash receipts and disbursements method. The vital defect in petitioner's method of accounting is this: The petitioner retains control over a time element in reporting his income for tax purposes. Yet, as he does so, he has on hand a portion or all of the fees attributable to each job. The petitioner's accountant closed out only those jobs at the end of a given year which the petitioner informed him had been completed. In addition, the petitioner on occasion kept open jobs which he thought might be abandoned but in which he felt a possibility of renewal existed. Certainly this is not the "completed contract" method of accounting, whatever else it might be, for under the completed contract method the taxpayer has no discretion over when to close out his jobs for purposes of determining net income. Jobs under that system must be closed out in the year in which substantially completed. Ehret-Day Co., 2 T. C. 25; Mesta Machine Co., 12 B. T. A. 523.

We do not mean to reflect on the good faith of the petitioner; however, undue flexibility resting in the taxpayer is fatal for the power to report income and take deductions at such indefinite future time as is indicated by a taxpayer's own judgment and selection is without the pale of the sound basis of accounting required by the Internal Revenue Code. See Brown v. Commissioner, 63 F.2d 66">63 F. 2d 66, affd. 291 U.S. 193">291 U.S. 193.

As a matter of pure bookkeeping logic, the petitioner may plausibly argue that consistency alone is sufficient to make any method of accounting clearly reflect income. However, we deal here with tax concepts and it is not in our province to weigh the relative advantages of various accounting systems known to accountants. Nor may we interfere with the respondent's determination in this regard unless the petitioner produces evidence which proves abuse of the wide discretion given to the respondent under the provisions of section 41 of the Code. Such a showing has not been made by the petitioner; therefore, on the basis of the record as a whole, the determination of the respondent upon this issue must be sustained.

The petitioners claim a deduction for the year 1946 in the amount of $ 600 alleged to have been incurred in connection with the rental of a portion of their residence. Nothing in the record tends to substantiate their claim that the expenses were in fact incurred. Therefore, they have failed to sustain their burden of proof and the respondent must be sustained on this issue.

Petitioners for the year 1946 and petitioner V. T. H. Bien for the year 1947 claim additional deductions in connection with the maintenance of an office in their residence in the amount of $ 600 for each year. There is no question but that the petitioner did maintain a business office in his residence and should be permitted to deduct an aliquot portion of the expenses incurred in maintaining the residence. The $ 600 for each year is based on what the petitioners admit to be an estimate. The record, however, is devoid of facts from which the reasonableness of the estimate may be judged. However, it can not be doubted that they did incur some deductible expense in this connection. Therefore, bearing most heavily upon the petitioners, we hold that they are entitled to deduct $ 400 in each of the years 1946 and 1947 as expenses incurred in connection with maintaining an office in their residence. Cohan v. Commissioner, 39 F.2d 540">39 F. 2d 540.

Decision will be entered under Rule 50.