RAMEAU A. AND PHYLLIS A. JOHNSON, ET AL.,1 Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 16038-93, 16039-93, 17007-93, 14430-94.
UNITED STATES TAX COURT
Filed June 16, 1997.
108 T.C. No. 22
Held:
- (a) At the time Ds sold a VSC they acquired a fixed right to receive, and must currently include in gross income, the portion of the contract price deposited in escrow. The reasoning of Commissioner v. Hansen, 360 U.S. 446 (1959), controls.
- (b) This amount did not constitute a purchaser deposit. Commissioner v. Indianapolis Power & Light Co., 493 U.S. 203 (1990), distinguished.
- (c) Nor did this amount constitute a trust fund for the benefit of the purchaser. Angelus Funeral Home v. Commissioner, 47 T.C. 391 (1967), affd. on other grounds 407 F.2d 210 (9th Cir. 1969), and Miele v. Commissioner, 72 T.C. 284 (1979), distinguished.
Pursuant to secs. 671 and677, I.R.C. , Ds are treated as owners of the escrow accounts and must currently include investment income of the accounts in gross income. Effect ofsec. 468B(g), I.R.C. , explained.- Premiums are capital expenditures that must be recovered through amortization. Fees are deductible in accordance with a formula that reasonably measures A‘s performance of services over the life of the VSC‘s. Ds may not either currently deduct these payments to offset income they are required to recognize with respect to the corresponding portions of the contract price or defer recognition of income until the offsetting deductions are allowable.
- An adjustment under
sec. 481, I.R.C. , is sustained.
Kenneth G. Kolmin, Francis J. Emmons, and Aaron E. Hoffman, for petitioners.
Karen J. Goheen and Elsie Hall, for respondent.
Rameau A. Johnson and Phyllis A. Johnson (the Johnsons), docket No. 16038-93.
| Year | Deficiency | Penalty |
|---|---|---|
| 1991 | $4,097 | $819 |
Thomas R. Herring and Karon S. Herring (the Herrings), docket No. 16039-93.
| Year | Deficiency | Penalty |
|---|---|---|
| 1991 | $2,093 | $419 |
DFM Investment Co., d.b.a. St. Louis Honda, docket No. 17007-93.
| Year Ended | Deficiency | Addition to Tax | Penalty |
|---|---|---|---|
| Mar. 31, 1989 | $2,285 | $114 | - 0 - |
| Mar. 31, 1990 | 110,378 | - 0 - | $22,076 |
| Mar. 31, 1992 | 34,686 | - 0 - | 6,937 |
David F. Mungenast and Barbara J. Mungenast (the Mungenasts) docket No. 14430-94.
| Year | Deficiency | Addition to Tax | Penalty |
|---|---|---|---|
| 1990 | $355,623 | $27,492 | $71,125 |
| 1991 | 84,431 | 5,316 | 16,886 |
- Whether accrual basis motor vehicle dealerships may exclude from gross income for the year of the sale of a VSC that portion of the contract price that they were required to deposit in escrow to secure their obligations under the contract;
- whether the dealerships may exclude from gross income the investment income earned by the funds held in escrow; and
- whether the dealerships may exclude or deduct from gross income for the year of the sale of a VSC those portions of
the contract price that they remitted to third parties as prepayments of service fees for administration of the VSC program and an insurance premium for indemnification of their losses under the program. If respondent prevails on these issues, we must further decide whether the income of one of the dealerships is subject to an additional adjustment pursuant to section 481 .
We hold that the dealerships’ method of accounting for VSC‘s was not a proper application of the accrual method, and, except in regard to the treatment of the dealerships’ administrative fee expenses, we sustain respondent‘s revised adjustments in full.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulations of fact and attached exhibits are incorporated by this reference. At the times they filed their petitions, the Johnsons, the Herrings, and the Mungenasts were residents of, and DFM Investment Co. maintained its principal place of business in, the State of Missouri. The relationships between petitioners and the dealerships whose method of accounting for VSC‘s is the subject of controversy in these cases (collectively, the Dealerships) are set forth below:
| Corporate Name | Doing Business As | Tax Status During Taxable Yr.(s) At Issue | Petitioners Owning Shares |
|---|---|---|---|
| DFM Investment Co. | St. Louis Honda | Subchapter C corp. | David Mungenast (at least 82%) |
| DRK Investment Co. | St. Louis Acura | Subchapter S corp. | David Mungenast (100%) |
| Capco Sales, Inc. | St. Louis Lexus | Subchapter S corp. | David Mungenast (100%) |
| MAD Investment Co. | Alton Toyota/Dodge (prior to 1991) | (not in evidence) | David Mungenast (not in evidence) |
| DAR, Inc. | Alton Toyota/Dodge (beginning 1991) | Subchapter S corp. | David Mungenast (50%), Rameau Johnson (33%), Thomas Herring (17%) |
During the years at issue, the four Dealerships offered VSC‘s under a common program in conjunction with the sale of new and used motor vehicles. Before October 1991 the program was administered by Mechanical Breakdown, Inc. (MBP), a corporation unrelated to petitioners. From October 1991 through March 1992, the program was administered by Automotive Professionals, Inc. (API), also unrelated to petitioners, but the structure and operation of the program remained, in all material respects, substantially unchanged.3 A standard form of VSC recites that it is a contract between the issuing dealer and the motor vehicle purchaser (referred to in some contracts as the “contract holder“). Under the terms of the VSC, the dealer agrees, for a fixed price, to
make repairs or replace any of the below listed parts or components of the Contract Holder‘s Vehicle covered hereunder or cause such repairs or replacement to be made by an authorized repair facility at no cost for parts or labor to the Contract Holder (but subject to applicable deductible, if any) whenever covered components or parts in the Contract Holder‘s said Vehicle experience a Mechanical Breakdown.
The VSC purchaser can select the term of coverage he desires from a range of options, each defined by reference to a specified time or mileage limitation, whichever is reached first. Approximately three-quarters of the contracts sold by the Dealerships during the years at issue provided coverage for at least 5 years or 60,000 miles. However, the aggregate limit of a dealer‘s liability is fixed in some of the contracts as the value of the vehicle at the time of purchase and in the rest of the contracts as the lesser of the value of the vehicle at the time of purchase or $10,000.
The VSC provides that
A specific amount of the Contract purchase price shall be held in escrow in accordance with and as specified in Automotive Professionals, Inc.‘s Administrator Agreement, a copy of which is available from the Dealer. Said amount shall be paid directly to the
escrow account established by the Administrator and Brokerage Professionals, Inc., the Escrow Trustees. * * * All amounts placed in escrow, together with accrued investment income, shall constitute a Primary Loss Reserve Fund (the “Reserves“) for payment of claims covered by the Contract. Dealer further agrees to provide an insurance policy with the Travelers Indemnity Company to cover claims in excess of the Reserves and continue to maintain said policy in force during the term of this Contract.
The purchaser is directed to return the vehicle to the dealer in the event of a mechanical breakdown. Repairs performed by another repair facility are not covered by the contract unless the purchaser secures the Administrator‘s prior authorization. When the Administrator authorizes covered repairs by another repair facility, the Administrator arranges for payment of the claim from the Primary Loss Reserve Fund (PLRF) on the dealer‘s behalf.
The purchaser is entitled to cancel the VSC at any time upon payment of a nominal service charge. The purchaser‘s cancellation rights are spelled out in the contract as follows:
- This contract may be cancelled and the entire Contract purchase price will be refunded by the Dealer to the Contract Holder/lienholder if notice of cancellation is given during the first sixty (60) days provided a claim has not been filed hereunder.
- If a claim was authorized during the first sixty (60) days or if a cancellation is requested after the first sixty (60) days, the pro-rata unearned Contract purchase price will be refunded by the Dealer to the Contract Holder/lienholder based on the greater of the days in force or the miles driven related to the terms of this Contract.
The Administrator does not assume and specifically disclaims any lability to the Purchaser. The liability of the Administrator is to the issuing Dealer only in accordance with their separate agreement. If the dealer fails to pay an authorized covered claim within sixty (60) days after proof of loss has been filed or, in the event of cancellation, the dealer fails to refund the unearned portion of the consideration paid, the purchaser is entitled to make a claim directly against the Travelers Indemnity Company * * * through its managing agent.
Each Dealership also entered into an Administrator Agreement. The other parties to the agreement were MBP or API, the Travelers Indemnity Co. (Travelers), and Travelers’ managing agent during the years at issue, Brokerage Professionals, Inc. (BPI), referred to in the agreement as Administrator, Insurer, and Managing Agent, respectively. The Administrator Agreement provides for the establishment of “one or more trust funds or custodial accounts with financial institutions and/or money market funds in the name of the Administrator and Managing Agent as Escrow Trustees (the `Escrow Account(s)‘).” Under the program administered by API, a separate account was established in the name of the Trustees for each Dealership at a bank called the Massachusetts Co. Under the program administered by MBP, the Trustees, in the exercise of their discretion, maintained all reserves deposited by the Dealerships in a single account at the
All reserves in the Escrow Account(s) shall be held for the primary benefit of Contract holders to secure Dealer‘s performance under the Contracts and to pay for valid claims arising under the Contracts. Dealer shall have no beneficial or other property interest in the Reserves or investment income in the Escrow Account(s); nor can Dealer assign, pledge or transfer such Reserves.
The disposition of the purchase price collected from the contract holder was subject to detailed procedures set forth in the Administrator Agreement. The Dealership retained a portion as its profit. Of the remainder, specified amounts were payable to the PLRF as reserves, to Travelers as a premium for excess loss insurance over the full term of the contract (Premium), to MBP or API as a fee for administrative services (Fees), and to each of BPI and the company that marketed the VSC program on the Administrator‘s behalf as a commission (Commissions). The Administrator Agreement provides that “Dealer agrees to accept and hold such monies as a fiduciary in trust and shall be responsible for the proper and timely remittance of the same to the Administrator, Managing Agent or Escrow Accounts(s).” The PLRF deposits, Premiums, Fees, and Commissions payable with respect to all VSC‘s sold during a given month were required to
The Administrator Agreement provided for the refund of these payments in the event that the VSC was canceled in accordance with its terms. The “unearned” portions of: (1) Reserves attributable to the canceled contract (exclusive of any investment income), (2) the Fees, (3) the Premium, and (4) the Commissions were refunded to the dealer, who then would forward the combined amounts of these refunds, plus the “unearned” portion of its profit on the sale to the purchaser.
The Dealerships’ access to the reserves held in escrow was strictly controlled. Under the Administrator Agreement, release of reserves to a dealer required the approval of both Escrow Trustees and was limited to the following circumstances:
- When the dealer had performed repairs for a contract holder, it was entitled to compensation at standard rates for parts and labor.
- When a VSC sold by the dealer was canceled in accordance with its terms, the dealer was entitled to the return of the amount it owed to the contract holder.
When a VSC sold by the dealer expired, the dealer was entitled to the release of unconsumed reserves attributable to that contract, subject to certain limitations. First, under the program administered by MBP, corpus and investment income of the PLRF were separately accounted for, and the dealer was not entitled to release of the investment income portion of the unconsumed reserves. This limitation was relaxed under the program administered by API; corpus and income were available for release to the dealer on the same terms. Second, a dealer forfeited its right to unconsumed reserves attributable to a contract if it committed certain specified acts of default: Failure to achieve a minimum sales quota in the year the contract was sold, breach of the Administrator Agreement, bankruptcy, termination of participation in the program without achieving a minimum balance in its PLRF account, dissolution without a successor in interest, and the like. Third, no unconsumed reserves were released unless, in the judgment of the Escrow Trustees and Travelers, the dealer‘s account balance would remain at an actuarially safe level for satisfaction of the dealer‘s obligations under all unexpired contracts. It was Travelers’ policy to approve release of unconsumed reserves only to the extent that the particular dealer‘s loss to earned reserve ratio did not exceed 70 percent.
- When a claim for covered repairs was submitted by an authorized repair facility other than the dealer that sold the VSC, the Administrator withdrew funds for payment.
- Under the program administered by MBP, investment income not used to pay claims or refunds was payable to the Administrator upon expiration of the contract to which it was attributable, provided that the dealer‘s account would remain at an actuarially safe level.
- Upon expiration of all the contracts of a dealer and payment of all claims, any unconsumed reserves that the dealer had forfeited for one reason or another became the property of the Administrator.
- Travelers was entitled to reimbursement from a dealer‘s account in the event that it was required to pay a claim or refund by reason of the dealer‘s delinquency or default.
The Administrator Agreement imposed upon the Escrow Trustees a duty to report the status of the PLRF accounts to the other parties to the agreement on a monthly basis. Inasmuch as the VSC purchasers were not parties to the agreement, the Trustees were not required to report to them.
A separate Escrow Agreement was entered into between the Escrow Trustees and either Mercantile Bank of St. Louis or Massachusetts Co., acting as the escrow depository. The Escrow Agreement provides that the bank will establish Primary Loss Reserve Fund escrow accounts “for the Dealer Group“, and that “each dealer depositor will be insured pursuant to the regulations and rules adopted from time to time by F.D.I.C.”
Under Automobile Dealers Service Contract Excess Insurance policies issued by Travelers, each of the Dealerships was entitled to indemnification for covered losses exceeding the
In 1987, the Dealerships began offering VSC‘s under the program outlined above. Until a few years before, dealerships in which petitioner David Mungenast held an interest had sold similar vehicle service contracts under a program administered by a company called North American Dealer Services, Inc. (NADS). It appears that under that program amounts paid by the dealerships to NADS to insure their losses had been subject to NADS’ unfettered control. NADS had gone bankrupt, causing the Dealerships to sustain heavy losses honoring their contractual obligations without indemnification. The program administered by MBP and API was designed to offer dealerships greater security than the NADS program. In marketing the program to the Dealerships, salesmen for MBP stressed the security provided by the escrow arrangement and by Travelers’ reputation as a major insurance company. In his decision to adopt the MBP program for the Dealerships, David Mungenast attached considerable significance to these characteristics.
The Dealerships evidently believed that Travelers’ participation in the program would be important to their customers. Promotional literature for the program that the
All of the Dealerships maintained their books and records under the accrual method of accounting. On their Federal income tax returns for each of the years at issue, the Dealerships reported as income from the sale of VSC‘s only that portion of the contract price that they retained as profit. The PLRF accounts were not reflected on the Dealerships’ returns for these years, and the income earned by investment of these reserves was not currently included in their gross income. The Dealerships included reserves in income only when, and to the extent, paid to them from the PLRF accounts.
For calendar year 1992 and subsequent years, the Escrow Trustees have filed Forms 1041, U.S. Fiduciary Income Tax Return,
Respondent determined that the Dealerships’ method of accounting for the VSC‘s did not clearly reflect income because it resulted in omission of items of income and premature deduction of some items of expense. Respondent computed adjustments to their income for each of the years at issue in a manner designed to result in inclusion of the full purchase price of contracts sold during the year and deferral of deductions for related expenses until later years. Respondent further required the Dealerships to include in income their respective shares of the investment income of the PLRF accounts as it accrued.
Finally, respondent included in the income of certain Dealerships an additional amount pursuant to
1. Portion of Contract Price Deposited in the PLRF
a. Respondent‘s Theory
A line of cases beginning with Commissioner v. Hansen, 360 U.S. 446 (1959), expounds the conditions under which a taxpayer‘s right to receive income becomes fixed where payment to the taxpayer is withheld or deposited in a reserve account. The
The Supreme Court rejected the dealers’ first argument, stating that, under the accrual method, it was the time of acquisition of the fixed right to receive the reserves, not the
In General Gas Corp. v. Commissioner, 293 F.2d 35 (5th Cir. 1961), affg. 33 T.C. 303 (1959), the taxpayer was a natural gas distributor that sold the installment paper generated by sales of tanks and appliances to its customers to a finance company for a price equal to its face amount, which included finance charges payable ratably over the full term of the installment contract. The finance company paid the taxpayer only 90 percent of the merchandise price, withholding the remaining 10 percent plus the amount of the finance charges in a dealer reserve account to secure the taxpayer‘s guaranty of payment on the installment paper. The taxpayer did not currently include the reserves in its income. Affirming this Court, the Court of Appeals followed Hansen, reasoning that since the entire amount of the reserves
Since General Gas Corp. v. Commissioner, supra, the courts have repeatedly held that accrual basis retailers must currently include the portion of the amount realized on the sale of installment paper attributable to “participation interest“, even
The principles enunciated in the dealer reserve cases have been affirmed in other multiparty transactions in which payments to the taxpayer are withheld or deposited in reserve as security for the taxpayer‘s executory obligations. Thus, in Stendig v. United States, 843 F.2d 163 (4th Cir. 1988), an accrual basis taxpayer that constructed and operated a low-income apartment complex financed by the Virginia Housing Development Authority (VHDA) was required to secure both its loan from VHDA and its obligations to maintain and operate the complex by depositing a portion of the rents collected from tenants into reserve accounts under VHDA‘s control. The Court of Appeals held that the rule of Hansen required the taxpayer to include the rent deposits in
Respondent‘s position is that the cases at hand are controlled by the Hansen line of cases. Respondent argues that the Dealerships acquired a fixed right to receive the full purchase price of the VSC at the time of the sale, even though they were required by contract immediately to deposit a portion in an escrow account. We agree.
Petitioners take the position that amounts deposited by a Dealership in the PLRF were not includable in its gross income unless or until actually released to the Dealership as payment for covered repairs or, upon expiration of the VSC, as unconsumed reserves. Petitioners reason as follows: the VSC‘s are executory contracts. The issuing Dealership earned the amounts required to be paid under their terms through performance. At the time the VSC‘s were entered into, the issuing Dealership had not earned and was not entitled to be paid any portion of the funds required to be held in escrow. The first time the issuing Dealership had any right to this portion of the contract holder‘s
There are a number of problems with petitioners’ argument. First, it confuses the right to receive with both earning through performance and the right to present payment. Each of these rights is independently sufficient to require accrual under the all events test. Schlude v. Commissioner, 372 U.S. 128 (1963); Automobile Club of New York, Inc. v. Commissioner, 32 T.C. at 911-913. That the Dealerships could not compel the Escrow Trustees to pay reserves from the escrow accounts does not control the determination of whether the Dealerships had a fixed right to receive them. Commissioner v. Hansen, 360 U.S. at 464. Nor is it dispositive that the Dealerships had not performed any repair services under the VSC‘s at the time they collected the purchase price and deposited it in escrow. Petitioners’ confusion on this point causes them to misread the relevant case authorities. Thus, they argue that the fact that the cases at hand concern executory service contracts distinguishes them materially from the Hansen line of cases:
Hansen and Resale Mobile Homes both involve the sale of retail installment contracts. In the context of a sale of property, these cases held that the taxpayers had to currently recognize the agreed purchase price for the
installment contracts as income at the time of sale since the transfer of the property by them to their respective purchasers established their right to be paid. Here, in contrast, we are dealing with executory service contracts which can be terminated at will by the Contract Holder. At the time the VSC is entered into, the Dealerships have only a conditional right to receive a portion of agreed purchase price, and no right to receive the amount required to be held in Escrow. This fundamental difference undoes all of Respondent‘s argument based on Hansen and Resale Mobile Homes.
The distinction that petitioners draw between executory service contracts and completed sales of property misrepresents the issue in the dealer reserve cases and their holdings. If the transactions at issue in those cases had simply been closed and completed sales of property, then no portion of the purchase price would have been withheld in reserve. The dealer reserves were established precisely for the purpose of securing executory obligations of the taxpayer as guarantor of future payments on the installment paper. The cases held that the taxpayer acquired a fixed right to receive the reserves notwithstanding the possibility that, as guarantor of the consumer‘s performance, the taxpayer would forfeit some or all of the reserves to the finance company in the event that the consumer defaulted or paid off the balance of the loan prematurely, terminating the installment contract before the scheduled interest was earned.
Another problem with petitioners’ argument is that it assumes that the proper method of reporting income from the sale of VSC‘s is the same as the method the Dealerships are entitled
The economic consequences to the Dealership of selling a service warranty under the VSC arrangement are not the same as the economic consequences of selling repair services on a fee-for-service basis. The sale converts contingent future payments into a fixed cash deposit immediately available for satisfaction of the Dealership‘s liabilities to all its contract holders. The deposit is invested and earns income that is accumulated on the Dealership‘s behalf. If the actual cost of repairs under the Dealership‘s contracts turns out to exceed the deposits plus accumulated investment income in its account, and the Dealership has failed to insure itself or to comply with the terms of the insurance policy, the Dealership will bear the loss. On the other hand, if the actual cost of repairs turns out to be less than the reserves, some or all of the unconsumed reserves revert to the Dealership. The credit that the Dealership receives for
Like the taxpayers in the Hansen line of cases, petitioners argue that the inability of the Dealership to predict at the time it sold a VSC how much of the reserve it would ultimately recover, either through performance of repairs or upon expiration of the contract, precludes satisfaction of the necessary conditions for accrual under the all events test. They attempt to distinguish Hansen on the ground that in that case the funds
The VSC imposes an obligation upon the issuing Dealership either to perform covered repairs itself or to pay for covered repairs by another authorized facility. The use of the reserves to pay another authorized repair facility would discharge the Dealership‘s obligation and thereby constitute “receipt” within the meaning of Hansen. Commissioner v. Hansen, 360 U.S. at 465-466; cf. Old Colony Trust Co. v. Commissioner, 279 U.S. 716, 729-730 (1929). The Dealership would also “receive” the reserves in the second scenario posited by petitioners. Under the VSC, like a standard contract of insurance which it closely resembles, upon notification of the purchaser‘s election to cancel the contract, the Dealership immediately becomes personally indebted to the purchaser for the amount of the unearned portion of the contract price. See 7 Williston on Contracts, sec. 920, at 618-619, 634 (3d ed. 1963). When the Dealership secures release of reserves
This result is consistent with the case law on the taxation of dealer reserve accounts. As noted above, it is well established that a taxpayer that sells a consumer installment contract for a price that includes interest payable over the term of the contract acquires a fixed right to receive the amount of the purchase price attributable to the interest at the time it is credited to the taxpayer‘s reserve account, even though the reserve account will be charged to the extent of any interest that is abated before it is earned as a result of the consumer‘s decision to prepay the balance and terminate the contract prematurely. Resale Mobile Homes, Inc. v. Commissioner, 965 F.2d at 823; Shapiro v. Commissioner, 295 F.2d at 307; General Gas Corp. v. Commissioner, 293 F.2d at 39-41; Federated Dept. Stores, Inc. v. Commissioner, 51 T.C. at 502-503. We do not perceive any difference in substance between forfeiture under those conditions and forfeiture through the cancellation refund provisions of the VSC. In both situations the forfeiture constitutes an application of the funds to discharge the taxpayer‘s obligations, which unquestionably inures to the taxpayer‘s benefit; in neither situation does the existence of the contingent liability prevent the taxpayer from acquiring a fixed right to receive the amounts
So long as a Dealership (including any successor in interest) remains in existence until all of its VSC‘s have expired, all proceeds from the sale of those contracts that it deposits in the PLRF will, as in Hansen, either be paid to the Dealership directly or be applied in satisfaction of its various liabilities under the operative agreements. The problem of prediction suggested by petitioners does not arise.
b. Petitioners’ Deposit Theory
Petitioners advance two alternative theories under which the reserves would not be reportable as income to the Dealerships in the year they were collected from the purchaser. One theory characterizes the reserves as customer deposits. The authority on which they rely is the “complete dominion” test enunciated by the Supreme Court in Commissioner v. Indianapolis Power & Light Co., 493 U.S. 203 (1990). Although petitioners do not spell out in detail how they think Indianapolis Power & Light applies, the argument seems to run as follows: inasmuch as the Dealerships collected the amounts allocable to the PLRF subject to an obligation to refund them at the purchaser‘s option, the Dealerships did not have “some guarantee that * * * [they would] be allowed to keep the money” as long as they complied with the terms of the contract. Accordingly, the reserves were not income
In Indianapolis Power & Light the issue was whether an accrual method public utility was required to include in gross income upon receipt the amount of refundable security deposits that it required from customers with suspect credit. The amount of the deposit was twice the customer‘s estimated monthly utility bill. A customer could obtain a full refund of his deposit by demonstrating acceptable credit or by making timely payments over a specified period. The customer could choose to receive the refund in cash or have it applied against future bills. The Court held that the customer deposits were not advance payments for electricity and therefore not taxable upon receipt. “The key“, said the Court, “is whether the taxpayer has some guarantee that he will be allowed to keep the money.” Id. at 210. In the case of a nonrefundable advance payment, exemplified by the fees for dancing lessons at issue in Schlude v. Commissioner, 372 U.S. 128 (1963), and subscription fees in American Auto. Association v. United States, 367 U.S. 687 (1961),
the seller is assured that, so long as it fulfills its contractual obligation, the money is its to keep. Here, in contrast, a customer submitting a deposit made no commitment to purchase a specified quantity of electricity, or indeed to purchase any electricity at all. IPL‘s right to keep the money depends upon the customer‘s purchase of electricity, and upon his later decision to have the deposit applied to future bills,
not merely upon the utility‘s adherence to its contractual duties. Under these circumstances, IPL‘s dominion over the funds is far less complete than is ordinarily the case in an advance-payment situation.
* * * * * * *
The customer who submits a deposit to the utility * * * retains the right to insist upon repayment in cash; he may choose to apply the money to the purchase of electricity, but he assumes no obligation to do so, and the utility therefore acquires no unfettered “dominion” over the money at the time of receipt. [Commissioner v. Indianapolis Power & Light Co., supra at 210-212; fn. ref. omitted.]
In subsequent cases this Court has had occasion to apply the reasoning of Indianapolis Power & Light to analogous situations. Oak Indus., Inc. v. Commissioner, 96 T.C. 559 (1991), concerned the tax treatment of a subscription television operator that collected a security deposit from all subscribers. Upon termination of service at any time by either party, if no amounts were due from the subscriber, the television company was required to refund the entire deposit. A majority of subscribers chose to apply at least a portion of the deposit to pay monthly service charges on their final bill. In holding that the deposits were not taxable income to the television company, we reasoned that the subscribers controlled whether the deposit would be refunded or applied against amounts due for services. The subscriber made no commitment to purchase a specified amount of services from the television company, or indeed to purchase any services at all.
In Buchner v. Commissioner, T.C. Memo. 1990-417, the taxpayer operated a direct mail advertising service and required its clients to make deposits into “postage impound accounts” to cover estimated postage expenses. In the event that a client failed to reimburse the taxpayer for postage, money would be withdrawn from the client‘s account. When a client terminated its relationship, any balance in the account not so applied was refunded. We held that the deposits were not income to the taxpayer under the “complete dominion” test, because so long as clients paid their monthly bills, no portion of the deposits would be applied to payments for services and retained by the taxpayer.5
Petitioners’ attempt to apply the teaching of Indianapolis Power & Light to the cases at hand is self-contradictory and does not support their position on the issues in dispute. If the reserves were nontaxable deposits by reason of the Dealerships’ contingent liability to refund them on demand, then they would have ceased to be deposits and become taxable income at such time
It is worth noting, moreover, that the portion of the VSC purchase price that the Dealerships reported as their profit on a sale was also subject to refund on cancellation in accordance with the same declining balance formula applicable to the reserves. Yet petitioners do not suggest that the Dealerships would have been entitled to exclude their profit from gross income on the ground that it too was merely a customer deposit.
On the other hand, there are numerous precedents upholding the taxpayer‘s characterization of a refundable payment as a deposit in the absence of a binding agreement to apply the sum to the purchase of specific goods and services. Consolidated-Hammer Dry Plate & Film Co. v. Commissioner, 317 F.2d 829 (7th Cir. 1963), affg. in part and revg. in part T.C. Memo. 1962-97 (progress payments made under construction contract prior to final determination of work specifications and amount due for work); Clinton Hotel Realty Corp. v. Commissioner, 128 F.2d 968, 969, 970 (5th Cir. 1942), revg. 44 B.T.A. 1215 (1941) (lease security deposits, where “If the only agreement was that it should apply to the last year‘s rent, it would of course be rent paid in advance“, but “there were many things to which it might become applicable besides the * * * [last year‘s] rent.“); Veenstra & DeHaan Coal Co. v. Commissioner, 11 T.C. 964 (1948) (customer advances used to buy inventory prior to formation of definite sale contract).
To see why this is true, assume that a Dealership sells 500 VSC‘s, all contract holders elect to receive coverage until their contracts expire, and they file claims with the Dealership for covered repairs that fully consume the reserves in the Dealership‘s PLRF account. On these facts, all amounts deposited into the account will be recovered by the Dealership. Now assume that the facts are the same except that no claims are filed. Upon expiration of the contracts, all amounts deposited into the
The absence of any relationship between the amounts of the reserves actually applied to the provision of repairs under the VSC and the determination of how the reserves are earned for refund purposes highlights the central error in petitioners’ theory. This absence indicates that the contract price is in fact paid for a service that is measured in terms of time and
There is a straightforward explanation for the refundability of the contract holder‘s payment that does not require us to obliterate the well-settled distinction between deposits and sales income and to extend the holding of Indianapolis Power & Light beyond all recognition: the price of the VSC is subject to pro rata refund upon cancellation because it is similar to a premium paid under a standard insurance policy. Since the VSC serves the function of insuring the vehicle purchaser against loss, it is not surprising that it is sold on terms similar to other types of insurance.7
c. Petitioners’ Trust Fund Theory
According to the second theory advanced by petitioners, a Dealership did not realize income from the sale of a VSC to the
In Angelus Funeral Home the taxpayer was an accrual basis funeral home that collected payments from its customers under “pre-need funeral plan agreements” obligating it to perform, or have performed, certain funeral services for the customer upon his death. The agreements provided that the customer‘s payment be segregated in a special account, be held “in irrevocable trust for the uses and purposes herein set forth“, and be fully expended for such purposes. The funeral home reported the amounts so collected as income for the year in which the funeral
The issue in Miele was how a law firm should account for prepaid legal fees. The taxpayer, a cash basis law firm, was required under the State professional responsibility code to preserve the identity of advances received from clients by segregation of the funds in a client trust account and by separate accounting for each client. When a case was closed, the firm transferred the earned portion of the client‘s advances to its own general account and refunded the unearned portion to the client. It reported the advances as income only when transferred to its general account. In consideration of the legal restrictions on the law firm‘s use of the advances, we held that the advances were properly treated as belonging to the client until transferred to the firm‘s general account, and hence the law firm was “not in receipt of income when the payments were actually received.” Miele v. Commissioner, supra at 290.
Respondent would distinguish Angelus Funeral Home and Miele on the ground that they concerned whether the taxpayer actually
Respondent‘s contentions do not dispose of petitioners’ argument. Under the right-to-receive analysis of the Hansen line of cases, which we have applied by analogy to the cases at hand, it is clear that the amount withheld to secure the taxpayer‘s obligations is income to the taxpayer; the question is only when it must be accrued. By contrast, the question in Angelus Funeral Home and Miele was whether the taxpayer received the amounts at issue as income or as the property of another. Angelus Funeral Home v. Commissioner, supra at 395, 407 F.2d at 212; Miele v. Commissioner, supra at 289. A taxpayer cannot receive, or have the right to receive, funds as income before it acquires a beneficial interest in the funds. See Healy v. Commissioner, 345 U.S. 278, 282 (1953); Metairie Cemetery Association v. United States, 282 F.2d 225, 230 (5th Cir. 1960); Portland Cremation Association v. Commissioner, 31 F.2d 843, 845-846 (9th Cir.1929), revg. 10 B.T.A. 65 (1928); Ford Dealers Adver. Fund, Inc. v. Commissioner, 55 T.C. 761, 770-774 (1971), affd. 456 F.2d 255 (5th Cir. 1972); Artnell Co. v. Commissioner, 48 T.C. 411, 417-418 (1967), revd. on other grounds 400 F.2d 981 (7th Cir. 1968); Seven-Up Co. v. Commissioner, 14 T.C. 965, 977-978 (1950); Twin Hills Meml. Park & Mausoleum Corp. v. Commissioner, T.C. Memo. 1954-206. If and to the extent that the contract holder retains the beneficial interest in the funds collected by the Dealership, the Dealership is not required to include them in gross income.8
It is therefore necessary to address petitioners’ contention that the contract holder does not relinquish beneficial ownership of the portion of the contract price allocable to the PLRF. In other words, we must decide whether the VSC arrangement, like the preneed funeral arrangement in Angelus Funeral Home and the arrangement for prepaid legal fees in Miele, provided for collection of this money in trust for the contract holder‘s benefit.
For State law purposes, an express private trust arises where a trustee acquires legal title to specific property (the trust property or res) subject to enforceable equitable rights in a beneficiary. 1 Restatement, Trusts 2d, sec. 2 (1959); Bogert, The Law of Trusts and Trustees, sec. 1, at 1-2 (2d ed. 1984).
We begin by determining whether the PLRF constituted a trust fund. The PLRF was established for the purpose of protecting and conserving funds for the satisfaction of the Dealerships’ obligations to purchasers under the VSC‘s. The Escrow Trustees held title to the PLRF accounts in their own names as trustees. The property to which they took title was distinctly identified in the Administrator Agreement as comprising all amounts deposited by a Dealership plus the accumulated investment income. PLRF assets could inure to the benefit of a Trustee only to the extent that: (1) They were not used to pay claims or refunds prior to the expiration of the contracts to which they were attributable; (2) they were not needed to maintain the Dealership‘s account balance at an actuarially safe level; and (3) they were not otherwise payable to the Dealership or its
It does not follow that funds deposited into the PLRF accounts by the Dealerships were collected from the individual
All Reserves in the Escrow Account(s) shall be held for the primary benefit of Contract holders to secure Dealer‘s performance under the Contracts and to pay for valid claims arising under the Contracts. Dealer shall have no beneficial or other property interest in the Reserves or investment income in the Escrow Accounts(s) * * *.
The Escrow Agreement between the Escrow Trustees and the bank acting as escrow depository likewise recites that “the vehicle service contract entered into between a dealer in the Dealer Group and a consumer requires that a Primary Loss Reserve Fund escrow account be established for the benefit of the consumer.”
The language that contracting parties use to describe the effect of their agreements may accurately reflect their intentions, but it may also inadvertently or deliberately misrepresent them. In determining whether the operative agreements create rights and obligations characteristic of a trust, we do not regard the language quoted above as controlling. See Davis v. Aetna Acceptance Co., 293 U.S. 328, 333-334 (1934); In re Schnitz, supra at 955-956. Petitioners themselves do not
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The Reserves Could Not Have Been Collected From the Purchaser in Trust Under the VSC, Because the Rights of the Purchaser Under the VSC Did Not Relate to Any Specific Trust Property
A trust is a relationship in which rights are created with respect to the specific property transferred by the settlor to the trustee. Thus, under the preneed funeral arrangement in Angelus Funeral Home v. Commissioner, 47 T.C. 391 (1967), and the arrangement for prepaid legal fees in Miele v. Commissioner, 72 T.C. 284 (1979), each of the taxpayer‘s customers acquired exclusive rights in a trust fund corresponding to the amount he paid to the taxpayer. Even though, for reasons of administrative convenience, each customer‘s payment was not physically segregated, it was credited to a separate account and entitled the customer to have an equivalent amount of assets in the trust fund used exclusively for his benefit. The individual payment
By contrast, the VSC creates no rights for the purchaser that are defined by reference to the portion of the contract price deposited in the PLRF. The amount of this deposit is determined by reference to the cost that the Dealership expects to incur in satisfying its warranty obligations to the purchaser. But plainly the purchaser is not entitled to have the Dealership incur this cost in all events. Nor does the VSC or any other operative agreement require the Dealership to maintain a separate account for each contract holder to preserve a fixed portion of the reserves for his exclusive benefit. The amount of any contract holder‘s claims that may be satisfied from the reserves is at all times indefinite. The deposit attributable to each contract holder makes possible the payment not only of his own claims, but also those of other contract holders. Conversely, the amount of reserves available for use on behalf of each contract holder is as large or small as the pool, up to the specified coverage ceiling. The pooled aggregate of all deposits plus accumulated income is the only identifiable trust res, and no individual contract holder is capable of transferring title to the pool.
The refund provision under the VSC is also probative evidence that petitioners’ theory mischaracterizes the relationship among the parties. The amount of the Dealership‘s
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The Purchaser Had No Beneficial Interest in the PLRF; the PLRF Existed for the Benefit of the Individual Dealerships and for the Protection of Travelers
The operative agreements do not grant the purchaser any rights that the status of beneficiary would imply. None of the agreements expressly recognizes any right of the purchaser to enforce the terms for the establishment, funding, administration, or termination of the trust. On the contrary, the VSC expressly disclaims any liability of the Administrator to the purchaser. The obligations of the Escrow Trustees ordinarily do not run to the purchaser directly. Reserves are released to the issuing Dealership or to another authorized repair facility. Even cancellation refunds are remitted to the issuing Dealership for
Furthermore, we are unable to see any functional rationale for petitioners’ theory of beneficial ownership. The accumulation and conservation of the trust fund was clearly a matter of concern to the Dealerships. As long as they fulfilled certain minimal conditions, they were entitled to recover at least the principal portion (if not also the income portion) of any unconsumed reserves. They were personally liable for any losses in excess of the reserves and would have to pay for these losses out of their own pockets if they failed to maintain excess loss insurance or properly file claims under the insurance policies. One of the primary purposes of the PLRF arrangement was to provide the Dealership with greater security than the
The contract holder would have been largely indifferent to the status of the trust fund. Under the VSC the contract holder was entitled to have his losses covered up to the maximum amount specified in the contract from the PLRF, the Dealership‘s own funds, or Travelers. If the Dealership failed to satisfy a covered claim or refund the unearned portion of the contract price upon cancellation, the contract holder had recourse against Travelers. With “one of the six largest property and casualty insurance companies in the United States” providing ultimate assurance to the contract holder that his interests would be protected, a beneficial interest in the PLRF would have been essentially superfluous to him.
If the Dealerships had understood the VSC program to protect the contract holders by granting them a beneficial interest in the trust fund, one would expect them to have called attention to this aspect of the program when they recommended it to their customers. It generally appears that the Dealerships did not
We conclude that VSC purchasers held no beneficial interest in the PLRF. Recognition of the PLRF as a trust for Federal income tax purposes provides no basis for the exclusion of reserve deposits from the Dealerships’ gross income.
2. Investment Income of the PLRF
Investment income earned by the PLRF apparently was not reported on any tax return for taxable years prior to 1992. For 1992 and subsequent years, the Escrow Trustees filed Forms 1041 for each escrow account, ostensibly reporting this income in a manner consistent with the treatment of the accounts as complex trusts. Petitioners advance alternative arguments defending both treatments:
Code §468B(g) , which was enacted in 1986, directed Respondent to issue regulations which would specify how investment income such as that credited to the Escrow Accounts should be taxed. * * * The regulations which were finally issued do not address situations such as the one presented here. [Fn. ref. omitted.]In the absence of regulatory guidance, the Court should apply the law as it existed before enactment of
Code §468B(g) . The principles developed by the courts would defer taxation of any earnings credited to the Escrow Accounts until their owner is identified.
Under the “homeless income” doctrine, these amounts are not currently reportable by anyone until subsequent events determine who will ultimately receive them.
Since the funds held in the Escrow Accounts did not belong to the issuing Dealerships, the interest which accrued on the accounts is not chargeable to them either.
If the Court determines that it must develop its own rules to implement
Code §468B(g) , it should treat the Escrow Accounts as separate taxable entities (presumably trusts). Under either alternative, no investment income can be currently charged to the Dealerships.
Prior to 1986 a number of cases and rulings suggested that the earnings of a litigation settlement fund, receivership, or escrow account that did not qualify as a trust for Federal income tax purposes were not taxable until the identity of the person entitled to receive the income could be determined. See, e.g., North Am. Oil Consol. v. Burnet, 286 U.S. 417 (1932); Rev. Rul. 71-119, 1971-1 C.B. 163; Rev. Rul. 70-567, 1970-2 C.B. 133; Rev. Rul. 64-131, 1964-1 C.B. (Part 1) 485. Section 468B was enacted as part of the Tax Reform Act of 1986, Pub. L. 99-514, sec. 1807(a)(7), 100 Stat. 2814, to clarify the tax consequences of certain settlement funds established pursuant to a court order for payment of tort liabilities (“designated settlement fund“).
SEC. 468B(g). Clarification of Taxation of Certain Funds.--Nothing in any provision of law shall be construed as providing that an escrow account, settlement fund, or similar fund is not subject to current income tax. The Secretary shall prescribe regulations providing for the taxation of any such account or fund whether as a grantor trust or otherwise.
The section applies to escrow accounts, settlement funds, or similar funds established after August 16, 1986. H. Rept. 100-795, at 377 (1988); S. Rept. 100-445, at 398 (1988).
The committee reports contain the following guidance concerning the regulations authorized by the statute:
It is anticipated that these regulations will provide that if an amount is transferred to an account or fund pursuant to an arrangement that constitutes a trust, then the income earned by the amount transferred will be currently taxed under Subchapter J of the Code. Thus, for example, if the transferor retains a reversionary interest in any portion of the trust that exceeds 5 percent of the value of that portion, or the income of the trust may be paid to the transferor, or may be used to discharge a legal obligation of the transferor, then the income is currently taxable to the transferor under the grantor trust rules.
Id.
Final regulations under
The rules governing the taxation of grantor trusts are contained in subpart E of subchapter J, sections 671-679.
Under Section 677 the grantor is treated as the owner of a portion of a trust if he has retained any interest which might, without the approval or consent of an adverse party, enable him to have the income from that portion distributed to him at some time either actually or constructively * * *. [
Sec. 1.677(a)-1(c), Income Tax Regs. ; emphasis added.]
The legislative history of the Internal Revenue Code of 1954 explains that
We do not agree with petitioners that the investment income earned by the PLRF is “homeless income” whose taxation must be deferred until its ultimate disposition is determined. At the inception of the PLRF its owners were identifiable under the grantor trust rules.
In the previous section of this Opinion, we concluded that the PLRF is classified as a trust for Federal income tax purposes. The Dealerships were the grantors of the trust because it was they who supplied the trust property. As explained in the previous section, unlike the preneed funeral arrangement under which the funeral home acted as a mere conduit in transferring trust property from its customers, the money collected from VSC purchasers did not constitute identifiable trust property before it left the hands of the Dealerships. Cf. Buhl v. Kavanagh, 118 F.2d at 319; Smith v. Commissioner, 56 T.C. 263, 289-291 (1971). Pursuant to the Administrator Agreement, the PLRF was established to fund the Dealerships’ obligations under the VSC‘s. All income
The Administrator Agreement requires the authorization of both Escrow Trustees (the Managing Agent and Administrator) for release of any reserves from the PLRF. Since the Administrator is entitled to receive any investment income of the PLRF not paid to or used for the benefit of the Dealerships, the Administrator plainly holds an interest in the PLRF that is adversely affected by the release of income to or for the benefit of the Dealerships. However, the authorization contemplated by the Administrator Agreement is not the exercise of a “power” within the meaning of
In spite of having an interest adverse to the use of trust income for the Dealerships’ benefit, the Administrator is not an adverse party. Cf. In re Sonner, 53 Bankr. 859, 61 AFTR 2d 88-755, 85-2 USTC par. 9810 (Bankr. E.D. Va. 1985). Accordingly, pursuant to
3. Administrator‘s Fees and Insurance Premiums
The Dealerships’ Federal income tax returns for the years at issue do not reflect the portions of the VSC purchase price that the Dealerships promptly remitted to the Administrator in payment of the Administrator‘s Fees and excess loss insurance premiums. Petitioners’ defense of this treatment rests squarely on the matching principle: “The clear reflection of the Dealership‘s net income requires that the recognition of income and related expenses attributable to these two items occur concurrently.”
Respondent determined that the Dealerships’ method of accounting for these expenses and the corresponding receipts improperly accelerated deductions or deferred income, resulting in a distortion of the Dealerships’ income.10 We agree. However, we conclude that some of these deductions may be taken earlier than respondent has allowed.
a. Timing of Deductions
Under the accrual method of accounting, a liability is incurred and generally taken into account for the taxable year in which all events have occurred that establish the fact of the
The VSC‘s required the Dealerships to obtain excess loss insurance coverage for periods of 1 to 7 years. The Dealerships incurred the liability for this insurance in the year the Premium was paid. However, to the extent that part of any Premium was allocable to coverage for subsequent years, it must be capitalized and amortized by deductions in those years.
The Administrator‘s Fees are subject to different treatment. The VSC required the Dealerships to establish the PLRF to fund their repair obligations. Economic performance with respect to this liability occurred as the Dealerships incurred costs in connection with the establishment and administration of the PLRF.
While the rule for identifying when prepaid service expenses are incurred is clear, its application to the facts of these cases is problematic. If it were known at the inception of the contract that, for example, X percent of the services would be provided in the first year and the remaining (100-X) percent in the final year, then the rule would be applied by recognizing proportional amounts of the expense for the first and final years. If it were not known at the inception of the contract
The responsibility for developing fair and administrable standards for implementing statutory requirements lies with the Commissioner. Respondent acknowledges on brief the practical difficulty of applying the economic performance requirement under the circumstances of these cases. It appears to be respondent‘s position, at least for purposes of these cases, that where the timing and amount of services to be provided to the taxpayer cannot be determined before expiration of the service contract, but the taxpayer can demonstrate “a reasonable manner in which to estimate the amount and timing of the services that will be required“, respondent will permit the taxpayer to accrue its liability over the term of the contract in accordance with the taxpayer‘s estimates. Respondent determined that the Dealerships
We accept respondent‘s interpretation of the economic performance rule and adopt it as the evidentiary standard for these cases. However, we do not agree with respondent‘s application of this standard.
One index for measuring the Administrator‘s performance may be found in the provisions of the operative agreements that govern how the Fees are earned for refund purposes. Under the refund formula, the Fees attributable to a contract are earned in proportion to the greater of time elapsed or mileage driven under the contract. This formula reflects two important aspects of the Administrator‘s performance. First, the Administrator was obligated to incur substantial costs simply in making certain resources available at all times for processing claims and cancellations, whether or not a claim or cancellation notice was actually filed. Second, the Administrator provided recordkeeping and reporting services regularly throughout the term of the VSC.
We think that the refund formula represents “a reasonable manner in which to estimate the amount and timing of the [Administrator‘s] services” for purposes of
b. Timing of Income
Petitioners argue that “proper matching of income and expense under the accrual method requires deferred recognition of the portion of the purchase price allocable to Administrator Fees
Inasmuch as the use of the accrual method serves different purposes under the Federal income tax laws and under financial accounting, the matching of income with related expenses often will not result in the clear reflection of income for Federal income tax purposes. Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 539-544 (1979); RCA Corp. v. United States, 664 F.2d 881, 885-886 (2d Cir. 1981).
In Artnell Co. v. Commissioner, supra, the Court of Appeals for the Seventh Circuit held that a baseball team owner‘s
This Court generally has limited Artnell Co. to its facts. Chesapeake Fin. Corp. v. Commissioner, 78 T.C. 869, 880-881 (1982); T.F.H. Publications, Inc. v. Commissioner, 72 T.C. 623, 644-645 (1979), affd. without published opinion 622 F.2d 579 (3d Cir. 1980); Standard Television Tube Corp. v. Commissioner, 64 T.C. 238, 242 (1975); Continental Ill. Corp. v. Commissioner, T.C. Memo. 1989-636, affd. 998 F.2d 513 (7th Cir. 1993); cf. Collegiate Cap & Gown Co. v. Commissioner, T.C. Memo. 1978-226 (following Artnell Co. in a case appealable to the Seventh Circuit, under the rule of Golsen v. Commissioner, 54 T.C. 742 (1970), affd. 445 F.2d 985 (10th Cir. 1971)). As we stated in T.F.H. Publications, Inc. v. Commissioner, supra at 644: “Since Artnell Co. this Court has indicated that it will not follow the
The cases at hand are distinguishable from Artnell Co. on their facts. First, the evidence does not establish that the Dealerships incurred costs for administration of the PLRF arrangement according to a fixed schedule. We concluded above that, in the absence of mileage information, the Dealerships could reasonably estimate their administrative costs in accordance with the passage of time. But the amount of mileage driven under a contract would be ascertainable for any year in which a mechanical breakdown or cancellation occurred, and might control the determination of costs incurred for that year. Thus, the proper schedule for accrual of these costs remained at all times contingent upon wholly unpredictable variables. Cf. T.F.H. Publications, Inc. v. Commissioner, supra; Standard Television Tube Corp. v. Commissioner, supra. Second, as petitioners themselves argued with respect to the reserve deposits issue, the Dealerships’ performance is not certain, because the purchaser retains the right to cancel. If the Dealerships were permitted to defer income until the period when they are allowed offsetting deductions for Fees and Premiums, they might never report the income. Cf. Continental Ill. Corp. v. Commissioner, supra. It was not an abuse of discretion for respondent to refuse to permit the Dealerships to match their income with their expenses.
Respondent made an additional adjustment to the income of petitioner DFM Investment Co. for its taxable year ended March 31, 1990, pursuant to
Petitioners argue that respondent‘s adjustments to the method used by the Dealerships to report income and expense under the VSC program do not trigger application of
- Payment for Premium, Commissions, or Fees;
- refund upon cancellation of the contract;
- release to another repair facility to pay for covered repairs;
- release to the Administrator upon expiration of the contract or termination of the Dealership‘s participation in the program;
- release to the Dealership to pay for covered repairs; or
- release to the Dealership upon expiration of the contract or termination of the Dealership‘s participation in the program.
The Dealership‘s practice was to report income only when and to the extent that reserves were released to the Dealership under cases (5) and (6). Amounts disposed of under each of the other cases were never recovered by the Dealership and hence would never have been reported as income. The proper application of the accrual method is to include the full contract price in income for the year the VSC was sold and, to the extent that the
Thus, the Dealership‘s practice resulted in permanent exclusion only where a deduction would have been allowable for a later period. Compared with the proper application of the accrual method, the Dealership‘s practice had the effect of either deferring income (cases (5) and (6)) or accelerating a deduction (cases (1) through (4)). Correction of this practice cannot affect the Dealership‘s lifetime taxable income under any circumstances: it can only affect the time when an increase or offsetting reduction to lifetime income is taken into account. Cf. Knight-Ridder Newspapers v. United States, 743 F.2d 781, 798-799 (10th Cir. 1984). Accordingly, the correction represents a change in method of accounting for purpose of
The second requirement for application of
The courts have repeatedly held that a change in method of accounting subject to
Petitioners correctly cite a number of our decisions for the proposition that correction of practices under which a taxpayer improperly excluded items from gross income does not necessarily constitute a change in method of accounting or may not otherwise
In Saline Sewer Co. v. Commissioner, T.C. Memo. 1992-236, the taxpayer was a utility company that excluded customer connection fees from gross income on the theory that they were contributions to capital. We found that the mischaracterization caused a permanent distortion of Saline Sewer‘s taxable income, and accordingly respondent‘s recharacterization of these receipts as taxable income did not give rise to a
In Schuster‘s Express, Inc. v. Commissioner, 66 T.C. 588 (1976), the result turned in part on the unusual procedural posture of the case. The Commissioner, who bore the burden of proof, failed to establish that under the taxpayer‘s method of reserve accounting for estimated insurance expenses “there was any procedure or intention to restore the excessive deductions to income in future years so as to properly reflect * * * [the taxpayer‘s] total lifetime income.” Id. at 596. In the absence of proof by the Commissioner that the change was solely a matter of timing, we declined to sustain a
In Security Associates Agency Ins. Corp. v. Commissioner, T.C. Memo. 1987-317, the taxpayer was required to include advance payments of insurance commissions for the year when received rather than for the following year when earned. We held that although there had been a change in the taxpayer‘s method of
None of the authorities on which petitioners rely conflicts with the
To reflect the foregoing,
Decisions will be entered
under Rule 155.