Blum's, Inc. v. Commissioner

7 B.T.A. 737, 1927 BTA LEXIS 3111

• Court: United States Board of Tax Appeals
• Decided: July 26, 1927
• Docket: Docket No. 2523.
• Status: Published

Opinion

OPINION.

Littleton:

Petitioner moved to dismiss the Commissioner’s amended answer on the grounds that it was not really an answer in the case as originally made by the appeal, and had no relation to the deficiencies originally asserted and appealed from; that the amended answer did not meet any issue raised in the petition but amounted in substance to the institution of an entirely new case; that its effect was to assess new deficiencies without giving the petitioner the 60-day notice authorized by the statute and affording it an opportunity to appeal in the regular way; that the Commissioner having determined, in the deficiency notice, an overassessment for 1918, and the five-year period of limitations, in respect of the assessment of a tax for that year, having expired, the Commissioner was without authority on October 16, 1925, to assert a deficiency for that year.

It is unnecessary to enter into a discussion of the question whether the Commissioner, after having determined an over assessment for certain years and deficiencies for certain other years in the 60-day notice mailed to the petitioner, may, thereafter, when the petitioner has filed a petition with the Board for the redetern ¡nation of the deficiencies, by affirmative allegations reverse his determination as set forth in the notice mailed to the petitioner showing an over-assessment and have the Board instead determine a deficiency, since it appears from the record that the assessment and collection of any tax for the calendar year 1918 was barred by the statute of limitation prior to the date on which he mailed the notice of his determination, to wit, January 15, 1925. The Board will therefore consider the facts relating to the calendar year 1918 only insofar as may be necessary correctly to redetermine the deficiencies for the calendar years 1919 and 1920.

The Commissioner was within his rights in asking that the Board determine greater deficiencies for the calendar years 1919 and 1920 than he had determined in his original deficiency notice. Hotel de France Co., 1 B. T. A. 28; Rub-No-More Co., 1 B. T. A. 228; Bank of Hartsville, 1 B. T. A. 920; Insley Manufacturing Co., 1 B. T. A. 1029; section 274 (e) of the Revenue Act of 1926.

Each of the first five assignments of error pertain to some feature of the general proposition of accounting, for income-tax purposes, for income and deductions by the use of the installment sales method. They, with such other related questions as arise from the pleadings, will be considered and disposed of together.

At the outset it should be stated that the Commissioner has not, and does not now, contest the right of this petitioner to return its income from installment sales by the use of the installment sales method as prescribed by article 42 of his Regulations 45. The issues presented are confined solely to a determination of the proper amount of income returnable, and the proper deductions to be made, under the installment sales method. Before undertaking to dispose of the issues here raised, we think it well briefly to review the history of the installment sales method of returning income from the time of its conception in departmental regulations until it finally received legislative sanction by explicit enactment of the Revenue Act of 1926.

The installment sales method of reporting income was first recognized by article 117 of Regulations 33, Revised. These Regulations were promulgated January 2, 1918. On April 17, 1919, the first edition of Regulations 45, containing article 42, was promulgated by the Commissioner with the approval of the Secretary, which, so far as pertinent here, provided as follows:

Aut. 42. Sale of personal property on installment plan. — Dealers in personal property ordinarily sell either for cash, or on the personal credit of the buyer, or on the installment plan. * * * The rule prescribed is that in the sale or contract for sale of personal property on the installment plan, whether or not title remains in the vendor until the property is fully paid for, the income to be returned by the vendor will be that proportion of each installment payment which the gross profit to be realized when the property is paid for bears to the gross contract price. Such income may be ascertained by taking that proportion of the total payments received in the taxable year from installment sales (always including payments received, in the taxable year on account of sales effected in earlier years as well as those effected in the taxable year) which the gross profit to be realized on the total installment sales made during the taxable year bears to the gross contract price of all such sales made during the taxable year. * * * If for any reason the vendee defaults in any of his installment payments and the vendor repossesses the property, the entire amount received on installment payments, less the profit already returned, will be income of the vendor for the year in which the property was repossessed, and the property repossessed must be included in the inventory at its original cost to, himself, less proper allowance for damage and use, if any. (Italics ours.)

Identically the same language was incorporated in article 42 of the second edition of Regulations 45, promulgated December 29, 1919. On January 28, 1921, Regulations 45 (1920 edition) were promulgated and these contained a material change in the rule laid down in the earlier editions, particularly with respect to including in income a proper proportion of the “payments received in the taxable year on account of sales effected in earlier years.” The 1920 edition of Regulations 45 was still in effect when this appeal came on for hearing; and article 42 thereof, with the new matter in italics, provides as follows:

Art. 42. Sale of personal property on installment plan. — Dealers in personal property ordinarily sell either for cash or on the personal credit of the buyer or on the installment plan. * * * The rule prescribed is that in the sale or contract for sale of personal property on the installment plan, * * * the income to be returned by the vendor will be that proportion of each installment payment which the gross profit to be realized when the property is paid for bears to the gross contract price. Such income may be ascertained by taking as p?-ofit that proportion of the total cash collections received in the taxable year from installment sales (such collections being allocates, to the year against the sales of which they apply), which the annual gross profit to be realized on the installment sales made during each year bears to the gross contract price of all such sales made during that respective year. In any case where the gross profit to be realized on a sale or contract for sale of personal property has been reported as income for the year m which the transaction occurred, and a change is made to the installment plan of computing net income, no part of any installment payment received subsequent to the change, representing income previously reported on accoimt of such transaction, should be reported as income for the year in which the installment payment is received; the intent am&. purpose of this provision is that where the entire profit from installment sales has been included in gross income for the year in which the sale was made, no part of the installment payments received subsequently on account of such previous sales shall again be subject to the tax for the year or years in which received. * * * If for any reason the vendee defaults in any of his installment payments and the vendor repossesses the property, the entire amount "eceived on installment payments, less the profits already returned, will be income of the vendor for the year in which the property was repossessed, and the property repossessed must be included in the inventory at its original cost to himself, less proper allowance for damage and use, if any. (Italics ours.)

Early in 1925 the Appeal of B. B. Todd, Inc., (reported in 1 B. T. A. 762) came before this Board. In that case the taxpayer appealed from a rejection of its proposed returns upon the installment sales method, insisting that the Board should require the Commissioner to compute its deficiency in tax, if any, by the use of that method. That was the first time we were confronted with the necessity of ruling as to the validity of returning income on the basis prescribed by article 42 of Regulations 45, 1920 edition. We refused to require a redetermination of the deficiency, if any, based upon a net income computed on the installment sales method, holding that such a method was not recognized by statute and could not be adopted. In the course of our opinion we stated as follows:

In dealing with the installment sales basis as laid down by article 42, Regulations 45, we must inquire whether a taxpayer may properly report only the profits realized in cash during a year, while at the same time deducting upon an accrual basis all the cost of goods upon which such profits were realized, and may further deduct accrued expenses of the taxable period for which the reported income is made.

* * * These regulations appeared while the war taxes were at their height, one during the war and the other immediately after its cessation. They provided not only that taxpayers who had previously kept their books and made their returns upon the installment basis might continue to do so, but that taxpayers might, change, with the approval of the Commissioner, from the receipts and disbursements or the accrual basis to the installment basis, upon making application so to do.

This opened up a particularly attractive proposal to the taxpayers dealing in property sold on the installment basis. If a taxpayer had been making his returns up to 1916 upon an accrual basis, he had included in gross income subject to tax at low rates all the income received and all the payments anticipated upon sales made to the close of 1916. These anticipated payments in the ordinary course would be made during the years 1917, 1918, and possibly into the year 1919. By changing to the installment basis, such a taxpayer would report none of this income in the years following 1916, and he would report for the year 1918 as gross income only that proportion of the profits accrued in that year which the receipts of the year from contracts entered into during the year bore to the total accruals or accounts receivable set up from contracts made during the year. In other words, while he would deduct the full expenses of 1917, he would report as income only that portion of the profits of the year represented by the percentage of collections to gross sales. In the second year under such a system, the profits of the preceding year realized by collection during the second year would be returned, plus the profits of the second year actually realized by collection. In an installment business, such as pianos, where credits extend over three or four years, this obviously meant that the taxpayer who changed as of January 1, 1917, would not reach, until approximately 1920, the normal level where the profits of prior years coming in would offset the profits of the current year deferred. Even then, if the business was an expanding one, he would always continue to defer the time of reporting taxable income on the expanded basis and would thus possess a continuous advantage over the taxpayer reporting on an accrual basis. But the particularly attractive thing to the installment dealer, in the adoption of these regulations in 1938 and 1919, was the possibility held out to him of deferring the reporting of profits in the high war-tax years until the succeeding years of reduced taxation.

*******

* * * To report, however, upon a basis which considers only the profit upon the business entered into during a year which is actually reduced to possession in cash, and to exclude all business of prior years reduced to possession in cash, at the same time deducting as expenses all accrued obligations, is to destroy all relationship between the true net income and the income reported for taxation. This is the effect of the installment basis for the earlier years of its adoption, either by reason of the fact that the taxpayer is newly organized and therefore has no prior business experience or by reason of a change of basis from the accrual method.

* * * * * * *

To be sure, the period of collection of accounts [in an installment business] is probably longer, losses are perhaps slightly higher; but neither of these factors, in view of the results in net profits, appears to the Board to warrant special and favorable treatment of this class of taxpayers at the expense of all other classes of taxpayers reporting income on the cash or the accrual basis.

The gross and unwarranted distortion of income during the transition period, i. e., the period of time before the taxpayer would begin to report its normal level of profits, gave us deep concern in the Todd case and was one of the reasons which led us to reject the installment method of returning income.

Our decision in the Todd case had been promulgated and published before this proceeding came on for hearing, and there appeared to be grave concern as to the ultimate effect of this decision on installment business if affirmed by the Board in this case. Testimony was taken at great length from two recognized authorities on Federal taxation, which might be divided into two phases — that relating to the advisability of retaining the installment method of returning income, and that relating to the remedies to be applied to overcome the distortion of income during the transition period which admittedly resulted under the method prescribed by article 42 of Regulations 45 (1920 edition). Nothing need be said as to the testimony relating to the advisability of retaining the installment method for returning income; its retention is now a moot question by explicit legislative enactment. Both witnesses testified that, in their opinion, the distortion of income of the transition period, resulting from the application of the rule prescribed in article 42 of Regulations 45 (1920 edition), must be corrected by requiring a taxpayer, returning income through the employment of the installment sales method, to return as income, for any taxable year, all of the profits actually reduced to possession in that year, notwithstanding there may be included profits from installment sales of earlier years which had been returned and taxed as income of those years. It is noteworthy that this remedy appears to have been adopted by the Congress, and certainly has been incorporated in the regulations promulgated by the Commissioner with the approval of the Secretary, under the authority conferred upon him by the Revenue Act of 1926.

Section 212 of the Revenue Act of 1926 contains a new subdivision not theretofore contained in prior revenue acts, and, so far as material here, is as follows:

(d) Under regulations prescribed by tbe Commissioner with the approval of the Secretary, a person who regularly sells or otherwise disposes of personal property on the installment plan may return as income therefrom in any taxable year that proportion of the installment payments actually received in that year which the total profit realized or to be realized when the payment is completed, bears to the total contract price * * *.

The Act as it passed the House of Representatives and as originally reported to the Senate contained no provision for the retroactive application of section 212 (d). Standing alone, that section was conceivably subject to the construction that its provisions were applicable only in computing income under returns filed under the Revenue Act of 1926. But Congress, at least the Senate, was made aware of the decision of this Board in the Todd case. This is evident from the discussion which took place on the floor of the Senate during consideration of an amendment proposed by its Finance Committee and which was incorporated, as section 1208, in the Act as finally passed. In offering this amendment, Senator Smoot, speaking for the Committee, stated as follows:

Mr. President, this amendment provides that the installment provisions recommended by the Finance Committee, and found on pages 40 and 41 of the bill, shall be given retroactive application. Because of the confusion resulting from the recent installment decision of the Board of Tax Appeals, in the interest of certainty it is deemed advisable to provide that the installment: provisions of subdivision (d) of section 212 of this bill shall be applied with retroactive effect.

Under the amendment, past transactions returned in accordance with the Treasury regulations, to the extent that the regulations conform to the provisions of subdivision (d) of section 212 of this bill, can not be reopened, despite the decision of the Board of Tax Appeals. The Committee intends that the. installment provisions of Regulations Jt5, promulgated on December 29, 1919, tom be substantially follotoed in settling all cases under prior acts under this provision.

While the committee believes that the 1919 Treasury installment regulations were a proper interpretation of the existing law in determining net income, because of the confusion now existing it is deemed advisable to make che amendment proposed in the interest of certainty. (Italics ours.)

A similar explanation of section 1208 was given in the Report of the Conference Committee, in the following language:

Amendment No. 199: This amendment provides that the installment basis provided in subdivision (d) of section 212 shall be retroactively applied in computing income under the provisions of the revenue acts of 1916, 1917, 1918, 1921, and 1924. In the application of this provision it is intended that the installment provisions of Regulations 45, promulgated on December 29, 1919, will be substantially follotoed in settling all cases under prior acts and under this bill; and the House recedes. (Italics ours.)

Section 1208 of the Revenue Act of 1926 reads as follows:

The provisions of subdivision (d) of section 212 shall be retroactively applied in computing income under the provisions of the Bevenue Act of 1916, the Bevenue Act of 1917, the Bevenue Act of 1918, the Bevenue Act of 1921, or the Bevenue Act of 1924, or any of such Acts as amended. * * *

Under the authority conferred upon him by the statute, the Commissioner has promulgated his regulations for the proper enforcement of the provisions of subdivision (d) of section 212 of the Revenue Act of 1926, which are embodied in article 42 of Regulations 69, and which, so far as material here, follows:

The rule prescribed is that a person who regularly sells or otherwise disposes of personal property on the installment plan, whether or not title remains in the vendor until the property is fully paid for, may return as income therefrom in any taxable year that proportion of the installment payments actually received in that year which the total or gross profit (that is, sales less cost of goods sold) realized or to be realized when the property is paid for, bears to the total contract price. (See section 212(d).) Thus the income of a dealer in personal property on the installment plan may be ascertained by taking as income that proportion of the total payments-received in the taxable year from installment sales (such payments being allocated to the year against the sales of which they apply), which the total or gross profit realized or to be realized on the total installment sales made during each year bears to the total contract price of all such sales made during that respective year. No payments received in the taxable year shall be excluded in computing the amount of income to be returned on the ground that they were received under a sale the total profit from which was returned as income during a taxable year or years prior to the change by the taxpayer to the installment basis of returning income. Deductible items are not to be allocated to the years in which the profits from the sales of a particular year are to be returned as income, but must be deducted for the taxable year in which the items are paid or incurred or paid or accrued, as provided by section 200 (d).

From this brief review of the history of the installment sales method of returning income, it is manifestly clear that Congress has conferred upon dealers in personal property on the installment plan the privilege of returning income from installment sales upon the method prescribed in section 212 (d) of the Revenue Act of 1926; that such dealers may avail themselves of this right in computing income under the Revenue Act of 1916, and all subsequent revenue acts, and acts amendatory thereof; and that Congress, by implication, at least, has rejected the rule prescribed by article 42 of Regulations 45 (1920 edition) for returning income on the installment method, and has manifested an intent to sanction the rule laid down in article 42 of the second edition of Regulations 45, promulgated December 29, 1919, as a proper interpretation of the statute and as correctly defining the installment sales method of returning income. The rule laid down in Regulations 45, promulgated December 29, 1919, is that a taxpayer employing the installment method of computing income must include a proper proportion of the installment payments received during the taxable year on account of sales effected in earlier years. Note also that the statute does not provide for returning only a proportion of the installment payments received during the year relating to sales made after the change of method, but provides for returning a proportion of “the installment payments actually received in that 'year.” To the same effect are the provisions of article 42 of Regulations 69, promulgated by the Commissioner under the Revenue Act of 1926.

Thus, at last we have a remedy for the most glaring ills of the transition period in the requirement that a taxpayer employing the installment sales method of returning income must include a proper proportion of the entire installment payments received during the year, though some of them may relate to sales the entire profits from which were returned in years prior to the change of method.

There is one other feature of the general proposition of returning income on the installment sales method which must be considered before taking up the issues involved in this particular case. From the very outset the regulations of the Commissioner have held that the amount to be returned as income from installment sales is that proportion of the installment payments which the total or gross profit from installment sales to be realized when payment is completed bears to the total contract price of all such sales. This is also the rule adopted in section 212 (d) of the Revenue Act of 1926. This petitioner, and we have good reasons to believe that the same situation exists in a vast majority of like cases, can not, from its books of account, accurately determine the cost of goods sold for cash separate from the cost of goods sold on the installment plan. The cost of all goods sold was lumped in one account. Consequently, the petitioner is in no position to make an accurate determination of the gross profits from installment sales; and the proportion of the installment payments to be returned as income is not susceptible of accurate ascertainment. This deficiency in accounting records undoubtedly exists in a large majority of installment businesses, rendering it impracticable when they follow the installment sales method for them to make a meticulously exact return of income. This is probably the case with all installment businesses except those buying at manufacturer’s. list prices less trade discounts and- selling at such list prices, or those making all sales at uniform percentages of profit, and they must be rare indeed. A consideration of the entire Revenue Act and particularly the language of subsection (b) of section 212 of the Revenue Act of 1926 leads the Board to believe that it was the intent of Congress in permitting the installment sales method of returning income to authorize the use of a method which would as nearly as practicable clearly reflect income, and if a workable and reasonable rule for computing income by the use of the installment sales method can be found under which taxpayers employing this method will ultimately return all of the profits from installment sales — nothing more or nothing less — we believe such a rule should be followed generally, with such variations from time to time as may seem necessary in order to fulfill the underlying congressional intent.

Tn this case the petitioner and the Commissioner have resorted to methods for computing the proportion of the installment payments to be returned as income which are the same in principle. They difi’er only as to the proper figures to be used for the purpose of computation. Their methods accord the same treatment to both cash and installment sales. They involve the determination of a composite percentage rate of gross profit, for each taxable year, upon the basis of the combined cash and installment sales and the aggregate cost of all goods sold; and the gross income returnable is then determined by applying this composite percentage rate to the cash receipts from those sales. Where, as in the case of this petitioner, cash sales are made at a profit considerably less than that to be realized on the installment sales made within the year, it is true that the composite percentage rate of gross profit will be less than the actual percentage of gross profit on installment sales alone; and it might appear, at first hand, that by using this composite percentage rate of gross profit the petitioner would escape taxation on a portion of the profits from installment sales. However, while the petitioner would apply the lower composite percentage rate to the installment payments,' at the same time it would apply the same percentage rate to the receipts from cash sales, showing a much greater profit from cash sales than actually realized. The method works out so that the petitioner would return as income, in any taxable year, on account of sales made within that year, an amount in excess of the actual profit on cash sales plus the profits actually realized through collection of installment payments relating to installment sales made in the same year; and such excess will always be the difference between an amount obtained by applying the composite percentage rate to the gross contract price of all installment sales made within the year and that obtained by applying the actual percentage rate of gross profit on installment sales to the same base. The excess reported is taken care of in subsequent years, during which the remaining installment payments will be received, through the application of the same composite percentage rate to the collections made in those years on account of the sales made in the prior year. Under this method the petitioner will ultimately return all of its income-nothing more nor anything less. We believe the suggested method is a reasonable interpretation of the statute in the fulfillment of its underlying purpose, and will clearly reflect income to be returned by the use of the installment sales method. As the Board said in the Appeal of B. B. Todd, Inc., supra, “ The entire plan of income taxation recognizes the fact that income is a matter, at best, of estimate, and can never be reduced to absolutely definite terms in the case of a large modern business institution.”

Turning now to the issues of this case, the first is that the Commissioner has overstated the income returnable for each year on account of installment sales. The petitioner insists that the overstatement results from improper computations of the percentage rates of gross profit, and the application of these erroneous percentage rates to the cash collections. The Commissioner determined the percentage rate of gross profit, for each year, by dividing the gross profits by the net sales (gross sales less return sales). Petitioner contends that the proper percentage rate can only be obtained by dividing the gross profits by the gross sales without reduction on account of return sales. Taking the figures for 1919, the following illustrates the method of computing the percentage rate contended for by each party:

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Under the Commissioner’s method, 47.96 per cent of the cash payments received in any year, on account of sales made in 1919, must be returned as income, while under the petitioner’s method, only 41.93 per cent of such payments should be returned as income.

Much depends for the solution of this problem upon what the figures for return sales represent. It appears from the record that they include (1) the gross contract price of sales mutually canceled within the-year, the parties being restored to status quo, and (2) the unpaid balances of the accounts of purchasers who defaulted in their payments, the sale contracts being canceled, the purchasers forfeiting payments previously made, and the petitioner repossessing the merchandise. We shall direct our examination of the problem along two lines, by assuming, first, that the figures are made up entirely of return sales falling wdthin group (1); and, secondly, that they comprise only so-called return sales falling in group (2). Bearing in mind the fact that the income to be returned is to be determined by applying the percentage rate of gross profit to the cash payments actually received, it is readily apparent that, on the basis of the first assumption, the petitioner’s method must be wrong, because the total cash payments to be received can not exceed the net sales, and if the petitioner returns as income only 41.93 per cent of the cash payments as they are received it will only return a. total profit of 41.93 per cent of $645,975.27, or $270,857.43, whereas the actual profit, for the purpose of the illustration, is $309,852.45. On the other hand, if required to return as income 47.96 per cent (percentage rate under Commissioner’s computation) of the cash payments as they are received, the petitioner will return a total profit of 47.96 per cent of $645,975.27; or $309,852.45, the actual profit.

The second assumption presents a more complex problem, because the so-called return sales may represent sales made in the same year in which they were canceled, and sales made in prior years. We will consider the problem first from the viewpoint that the return-sales figures entirely represent sales which were made and canceled in the same year. During the year, the purchasers in default have made their initial payments and perhaps have met some of their deferred payments. The petitioner has retained, under the terms of its sales contracts, the payments made by these purchasers, and may have repossessed the merchandise. Aside from any possible loss occasioned through damage and use of merchandise while in the hands of the purchasers, there is no question that the petitioner is better off to the extent of the total forfeited payments, and that it has realized within the year, income to that extent. These sales are included in the gross sales for the year at the full contract price, but only the unpaid balance of the contract price is charged to return sales. If gross sales are reduced only by the unpaid balance of the contract price, the forfeited payments will be included in net sales and gross profit, which are the two factors for computing the percentage rate of gross profit to be applied against cash collections for determining the income returnable, and the result will be that instead of returning these forfeited payments in full for the year in which they are actually income they will be returned over the several years during which collections on the other sales of the year will continue. Assuming that the forfeited payments for 1919, relating to sales made and canceled in that year, amounted to $10,000, under the Commissioner’s method, the petitioner would return as income for that year, 47.96 per cent of that amount, or $4,796, and the balance would be accounted for as and when collections were made on all other sales of that year by applying to such collections a percentage rate greater than the actual percentage of profit on those sales. There are two reasons why gross sales should not be reduced by merely the unpaid balance due on defaulted sales contracts, in the case of sales made and canceled in the same year: (1) It results in spreading the income from the forfeited payments over the years during which collections will be made on all other sales of that year, when in reality the payments are income for the year in which they are forfeited; and (2) the losses sustained and the expenses incurred in the repossession of merchandise constitute deductions for the year of forfeiture and repossession, and should be absorbed as nearly as possible by including the forfeited payments in the income of that year. By reducing the gross sales by the total contract price of sales contracts made and defaulted in the same year, and by including the forfeited payments, in full, in income as a separate item, the net sales would represent the total contract price of all other sales made during the year, the percentage rate of gross profit would be the actual percentage of gross profit to be realized on the other sales of the year, and the income from the forfeited payments will be returned in the year in which it was actually realized.

Take the other viewpoint of the problem, i. e., that the return-sales figures entirely represent sales made in prior years and are canceled during the current year. By reducing gross sales by any amount on account of the cancellation of those sales, the gross profits from the sales of the current year are reduced below the actual profits, and there is a corresponding reduction in the percentage rate of gross profit which will be applied against the cash collections from sales of the current year, with the result that the petitioner will ultimately return a total profit from sales of the current year less than the actual profit. This is equivalent to the allowance of a deduction for bad debts, on account of the unpaid balances of defaulted sales contracts which have not been reported as income, spread over the years during which collections will be made on sales of the current year.

From the foregoing observations, we conclude that the petitioner’s method of computing the percentage rate of gross profit on the basis of gross sales is entirely wrong; and that the Commissioner’s method is wrong in the following particulars: (1) In failing to reduce gross sales by the total contract price of sales made and canceled in the same year on account of default in payments; and (2) in reducing gross sales by the unpaid balance of sales contracts of prior years. For the purpose of computing the percentage rate of gross profit in this case, we hold the proper procedure to be as follows:

In the case of sales made and canceled in the same year on account of default in payments: Gross sales should be reduced by the total contract price of the canceled sales. All payments made and forfeited by purchasers should be included, in their entirety, in gross income, though not in gross or net sales upon which the percentage of gross profit on all other sales of the year will be computed. In order that the petitioner may have advantage of the deduction, in the year of repossession, of the full amount of the loss sustained, if any, through damage and use of merchandise while in the hands of the purchaser, the difference between the value at which such merchandise was included in the opening inventory, or the cost of the merchandise, according to whether it was on hand at the beginning of the year or was purchased during the year, and its value when repossessed, should be deducted from the cost of goods sold and taken as a separate loss deduction from gross income.

In the case of sales canceled, on account of default in payments, in a year subsequent to the year or years in which made: No deduction in the gross sales of the year should be made. All payments made and forfeited by the purchaser, in the year in which the sale is canceled, should be included, in their entirety, in gross income for that year, though not in gross or net sales upon which the percentage of profit on sales for the year will be computed. Payments made in prior years should not be taken into account in computing gross income for the year in which the sale was canceled. The repossessed merchandise should be included in purchases at cost, less proper allowance for damage and use, if any, or at cost, less any part thereof previously recovered through payments made by the purchasers, in prior years, and not returned as income, whichever is lower. The difference, if any, between the cost, less allowance for damage and use, and cost, less any part thereof previously recovered, should be taken as a loss deduction from gross income of the year of repossession.

The cost of repossessed merchandise should be determined by applying to the contract price (selling price to defaulted purchaser) that percentage rate which is complementary to the percentage rate of profit for the year in which the sale was made.

The percentage of the cash collections which the Commissioner, in the deficiency notice, held -to be returnable as income, was determined by deducting the cost of goods sold from net sales and dividing the remainder by the net sales. Using the figures for 1919, the following illustrates the formula:

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By the same formula, the Commissioner determined the percentage of the cash collections, relating to sales effected in 1918, to be returned as income, as 52.54 per cent. Therefore, the income from sales, for 1919, shown in the deficiency notice, was computed as follows:

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Had the Commissioner included in income, in the deficiency notice, a proportion of the cash collections made in 1919, on account of sales effected in 1917, he would have included, according to the above formula, 49.40 per cent of such collections. The income shown in the deficiency notice for each year was computed in the same fashion. The total deductions allowed for 1919 are $208,356.52.

In his amended answer, the Commissioner determines the percentage of cash collections to be returned as income, by deducting from the net sales the cost of goods sold pins all expenses of the year, except bad debts, collection expenses, and refunds to purchasers, and dividing the remainder by net sales. Using again the figures for 1919, the following illustrates the formula used in his determination as set forth in the amended answer:

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By the same formula, the Commissioner, in the amended answer, determines the percentages of profit, relating to sales effected in 1917 and 1918, as 25.786 per cent and 29.679 per cent, respectively; and upon the basis of these percentages proposes a redetermination of income from sales for 1919, as follows:

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The total deductions which the Commissioner in the amended answer allows for 1919, amount to $67,122.97, which is the total for bad debts, collection expenses, and refunds to purchasers, for that year. The Commissioner proposes a redetermination of the income from sales, for all of the years in controversy, in accordance with the above procedure. The following shows the results obtained under the two methods:

Resui/cs of Method Used in Deficiency Notice

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Results of Method Used in Amended Answer

1918. 1919. 1920. $94,625. 51 136,915.91 212,008.96 $4,875.03 9, 527. 55 12,039.46 $99,500.54 146, 443.46 224,048.42 $47,749.71 67,122. 97 77,005.71 $51.750.83 79,320.49 147,042.71

Under the method of computing the percentage of profit and the income as set forth in the amended answer, the expenses of each taxable year are deferred and spread over the accounting periods during which collections on sales effected in that year are made. In other words, the expenses, other than bad debts, collection expenses, and refunds, of each taxable year are allocated against the income arising out of the sales of that year, to be deducted indirectly by returning as income a lower proportion of the cash collections, only as the income is reduced to possession and returned for the purposes of the tax. The result of this method of computing the percentage of profit and the income for 1919, in the instant case, is that instead of the total deductions of $208,356.42 (reduced by adjustments in amended answer not material here, to $196,312.36) allowed under the method folio wed in computing the percentage of profit and the income shown in the deficiency notice, the income from sales is reduced by $97,313.07, which with the total deductions for bad debts, collection expenses, and refunds to jmrchasers, amounting to $67,122.97, is the equivalent of allowing total deductions of $164,436.04, a difference of $31,876.32 against the petitioner. For the year 1920, instead of the total deductions of $281,657.87 (reduced by adjustments in amended answer not material here to $272,932.99) allowed under the method followed in computing the percentage of profit and the income shown in the deficiency notice, the income from sales is reduced $143,064.53, which with the total deductions for bad debts, collection expenses, and refunds to purchasers, amounting to $77,005.71, is the equivalent of allowing total deductions of $220,070.24, a difference of $52,862.75 against the petitioner. Of course, if the method used by the Commissioner in the amended answer should be consistently followed over a period of years, these differences against the petitioner would be adjusted and equalized; but, during the years under consideration, the tax rates were at the highest level, with a substantial reduction in rates for the years in which the differences will be adjusted, so that the adoption of the proposed method works a material disadvantage to the petitioner.

The Commissioner admits that the method used in his determination as set forth in the amended answer has not heretofore been permitted by his regulations; and we note that it is expressly prohibited by article 42 of Regulations 69, promulgated under the Revenue Act of 1926. It seems to us that the computation of the income from installment sales, under the circumstances, in this case, is already difficult and complex enough without injecting some new theory which can only operate to make it more so. Further than that, the statute goes no farther than to prescribe a method by the use of which a dealer in personal property on the installment plan may return income from installment sales. Nothing is contained in the statute which can possibly be construed to deny to this class of taxpayers the deductions provided for under sections 214 and 234, and the petitioner having employed the accrual method of accounting in keeping its books of account, we think it is entitled to deduct all of the expenses, allowances, and losses enumerated in those sections, which were paid or incurred, or paid or accrued within the taxable years, with the single reservation that it may not deduct as bad debts such portion of its installment accounts receivable not previously returned as income.

As heretofore pointed out, the Commissioner has determined a composite percentage rate of profit for each taxable year to be applied, for the purpose of computing the income returnable, against the cash collections on sales effected in those years, whether the collections be the proceeds of cash sales or installment payments on installment sales. The petitioner, however, contends that since cash sales were usually made at a profit of less than 20 per cent of the selling price, no greater percentage of the proceeds from such sales should be returned as income. If the percentage of profit on cash sales were definitely known, it would be but a matter of simple arithmetic to determine the cost of goods sold for cash and, incidentally, the cost of goods sold on the installment plan. In that event, the actual profit on installment sales and the income therefrom to be returned could be accurately determined, and there would be no necessity for resorting to the method adopted in this case. But where, as in this case, the percentage of profit on cash sales, which certainly was not uniform in respect of all such sales, is not known, no other course appears proper than to treat all sales, cash and installment, on the same basis and to determine a composite percentage of profit on the total sales which will represent the proportion of the cash collections to be returned as income. Further, if the percentage of profit on cash sales is fixed at a lower rate than the composite percentage rate, there must be a corresponding increase in the percentage of profit on installment sales; and any advantage which the petitioner might gain by returning as income a percentage of the proceeds from cash sales less than the composite percentage thereof would be greatly minimized, if not entirely wiped out, by having to return as income a greater proportion of the collections on installment sales. If the petitioner is required to return as income only 20 per cent of the proceeds from cash sales, then it will have to return 54.56 per cent, 49.33 per cent, and 52.78 per cent of the installment payments relating to sales effected in 1918, 1919, and 1920, respectively, as compared with 52.54 per cent, 47.96 per cent, and 51.96 per cent thereof, the composite percentage rates, as determined by the Commissioner in the deficiency notice, with the following results: For 1918, the petitioner would be required to return as income, on account of sales effected in that year, $109,857.92, as compared with $113,562.03, a difference in favor of the petitioner of $3,704.11; but the percentage of profit on installment sales for 1917 would be increased, and as the total installment payments received in 1918, relating to sales effected in 1917, amounted to $118,188.73, the difference in favor of the petitioner would be practically wiped out; for 1919, the petitioner would return as income, on account of sales effected in 1918 and 1919, $230,662,09, as compared with $229,857.39 in the deficiency notice, a difference against the taxpayer of $804.70, and this difference against the petitioner would be further increased on account of collections relating to sales effected in 1917, amounting to $16,953.34; for 1920, the petitioner would return as income, on account of sales effected in 1918, 1919, and 1920, $356,009.88, as compared with $354,027.14 in the deficiency notice, a difference in favor of the petitioner of $1,982.74, which would be reduced on account of collections relating to sales effected in 1917, amounting to $4,057.81.

Under the circumstances of this case, in which the total cash sales are negligible in comparison with the total installment sales, we are of the opinion that no material distortion of income will result by applying the composite percentage rate to cash collections from cash sales made within the year, in order to determine the income to be returned from that class of sales.

Second issue. In 1919 and 1920, petitioner refunded to purchasers on the installment plan certain payments made within those years in the total amounts of $1,942.31 and $3,273.65, respectively. The Commissioner allowed as deductions from gross income of 1919 and 1920 the sums of $930.53 and $1,744.20, which sums are 47.96 per cent and 53.28 per cent, respectively, of the payments refunded in those years. The petitioner contends that the Commissioner should have allowed the entire amounts refunded as deductions from gross income. Obviously the Commissioner’s action was proper, since he included in gross income only 47.96 per cent and 53.28 per cent, respectively, of the payments refunded in 1919 and 1920, and the petitioner is not entitled to any greater deduction, on account of the refunding of these payments, than the amounts which have been returned as income. Any difference of opinion in this respect could be readily avoided by excluding the refunded payments from the total installment payments received during these years before computing the proportion of the total payments to be returned as income.

Third issue. In 1918, 1919, and 1920, petitioner ascertained to be worthless and charged off as bad debts, installment accounts in the total amounts of $19,205.10, $25,064.71, and $14,419.65, respectively. The amounts thus charged off were the unpaid balances of installment sales contracts of purchasers who had defaulted in their payments, the petitioner failing to repossess the merchandise. The petitioner contends that “ although it is in agreement with the Commissioner as to the amount of bad debts actually charged off by it during the years 1919 and 1920, and as to the method of computing the portion of such bad debts which should be deducted in determining the taxpayer’s net income, viz., such part thereof as represents the computed cost of the goods embraced therein, the Commissioner has applied a gross profit percentage in excess of the true percentage as hereinbefore set forth, and thereby arrives at a smaller cost for such goods than-would be produced by the use of the correct gross profit percentage as herein contended for.” The revenue agent in computing net income for 1919 and 1920 allowed deductions for bad debts in the respective amounts of $12,249.24 and $9,092.72. From the net income as computed by the revenue agent, for 1919 and 1920, the Commissioner allowed further deductions for bad debts, in the amounts of $17,951.90 and $9,261.05, respectively. Thus the total bad debt deductions which the Commissioner has allowed for 1919 and 1920, are $30,201.14 and $18,353.77, respectively, both of which are in excess of the amounts actually ascertained as worthless and charged off by the petitioner in those years. The amount of the deduction which the Commissioner originally allowed for 1918 is not shown by the record.

The total amount of bad debts charged off on the books in 1918, according to the stipulation, related to installment accounts of 1917. Of the total amount charged off in 1919, $9,744.44 related to installment accounts of 1917, $10,623.22 related to installment accounts of 1918, and $4,697.05 related to installment accounts of 1919. Of the total amount charged off in 1920, $3,789.64 related to installment accounts of 1917, $2,991.43 related to installment accounts of 1918, $5,259.56 related to installment accounts of 1919, and $2,379.02 related to installment accounts of 1920. In his determination as set forth in the amended answer, the Commissioner allowed the following deductions for bad debts:

1918

74.214per cent of $10,205.10 (1917 accounts)_$14,252.87

1919

74.214per cent of $ 9,744.44 (1917 accounts)_ $7,231.73

7,0.321 per cent of $10,623.22 (1918 accounts) __ _ 7,470. 35

72.196 per cent of $ 4,697.05 (1919 accounts) -- 3, 391. 08

Total bad debt deduction for 1919___ 18, 093.16

1920

74.214per cent of $3,789.64 (1917 accounts)- $2,812.44

70.321 per cent of $2,991.43 (1918 accounts)_ 2,103.60

72.196 per cent of $5,259.56 (1919 accounts)- 3,797.19

68.608 per cent of $2,379.02 (1920 accounts)- 1,632.20

Total bad debt deduction for 1920. 10, 345.43

The petitioner raises two objections to tbe deductions allowed in the amended answer: (1) That so far as they relate to accounts created in 1918, 1919, and 1920, the deductions are predicated upon erroneous percentages; and (2) since the installment accounts created in 1917 were treated as completed transactions of that year, when it was following the strict accrual method of accounting, and returned in full and subjected to the tax for that year, it is entitled to deduct the whole amount of such accounts as were ascertained to be worthless and charged off. The percentages of 74.214, 70.321, 72.196, and 68.608, which the Commissioner applies against the worthless accounts in determining the bad debt deductions in the amended answer, are complementary to the percentages of gross profit for the years 1917, 1918, 1919, and 1920, respectively, as such percentages of gross profit have been computed in the amended answer, and if they were correct their application to the accounts charged off, as the Commissioner has applied them, would reflect the unrecovered cost of the merchandise, and the deductions would be correct. But these percentages are not correct because they are complementary to percentages of gross profit which are incorrect for reasons hereinbefore stated.

The petitioner’s contention that there should be deducted from gross income of 1918,1919, and 1920, as bad debts, the whole of such installment accounts of 1917 which were ascertained to be worthless and charged off in those years, is not well taken. While the fact that the entire profits from the sales represented by those accounts was included in gross income for 1917, in accordance with the method then employed for returning income, presents a situation with a strong appeal, we can not overlook the fact that income taxes are levied upon the gains and profits of annual periods, and that each annual period must necessarily, under the provisions of the taxing-statutes, stand by itself. Appeal of Atkins Lumber Co., 1 B. T. A. 317. Any situation which arises, in any taxable year, whether it involve the inclusion of a gain or profit in gross income, or the de-ductibility of an item of expense or loss, must be considered in relation to the method employed in returning income for that year. The fact that certain accounts receivable of a prior year have been included in the income of that year does not determine the treatment to be accorded them in a subsequent year, after a change in the method of returning income, when they are ascertained to be worthless and uncollectible. The deduction which a taxpayer is entitled to make from the income of any taxable year, on account of debts ascertained to be worthless and charged off within that year, depends entirely upon the method employed in returning income for that year. The rule is that all items of income and expenses and losses must be consistently accounted for on the same basis. Appeal of Henry Reubel, 1 B. T. A. 676; United States v. Mitchell, 271 U. S. 9; Appeal of Owen-Ames-Kimball Co., 5 B. T. A. 921. The income of this petitioner, for the years involved, is to be determined by the use of the installment sales method; hence, the deduction which may be made for bad debts must be determined on the same basis. A taxpayer employing the installment sales method returns income only as it is reduced to possession; consequently, the loss resulting from defaulted contracts, if the merchandise is not repossessed, is measured by the unrecovered cost of the merchandise included in the worthless accounts charged off. The Commissioner’s method of determining the bad debt deductions, for each of the years in controversy, as set forth in his amended answer,, is correct in principle; but the determination of the proper amount of the deductions must await the determination of the percentages of gross profit for 1917 and the years in controversy, in accordance with the procedure indicated by this opinion.

The fourth issue relates to the petitioner’s contention that the Commissioner erroneously disallowed as deductions from gross income of the years in controversy, discounts and allowances made to customers, the expense incurred for freight on inbound merchandise, and the cost of alterations to merchandise made on customers’ orders. If, during the years in controversy, the petitioner allowed any discounts or made any other allowances to customers, there is no evidence in the record to show that such was the case; nor is there any proof of the Commissioner’s alleged action as to discounts and allowances. Lacking any evidence upon which to base a finding of fact, there are no grounds for disturbing the Commissioner’s action in that respect. In computing the income shown in the deficiency notice, the Commissioner included freight on inbound merchandise and the cost of alterations to merchandise in the cost of goods sold. These items are also included in the cost of goods sold for each year as shown in the amended answer. The parties have stipulated that the basic figures contained in the amended answer are correct. Therefore, the Commissioner’s action as to freight on inbound merchandise and cost of alterations to merchandise is removed from controversy.

The fifth issue relates to the Commissioner’s action in disallowing as deductions, losses sustained through damage and use to repossessed merchandise while in possession of defaulted purchasers. In its returns for 1919 and 1920, the petitioner claimed deductions of $10,-106.21 and $15,604.65, respectively, because of losses of this character. The deductions were disallowed by the Commissioner on the ground that due allowance had been made for any losses of the nature stated, and the allowance of these deductions would result in allowing double deductions for such losses. The petitioner denies that the Commissioner has taken these losses into account in computing net income. That the petitioner made repossessions in 1918, 1919, and 1920, and that as a general proposition, the value of the repossessed merchandise, because of damage and use, was less than the original or unrecovered cost, is clear from the evidence; and, under these circumstances, the petitioner sustained losses, in the year of repossession, measured by the difference between the original or unre-covered cost of the merchandise and its value when repossessed. There does not appear to be any dispute as to the extent of the losses of this nature which the petitioner sustained in the years in question; the only matter in controversy is the proper manner of accounting for such losses in computing net income, and we have already decided that in our decision on the first issue.

The sixth issue relates to the Commissioner’s action in disallowing, for. 1920, a loss deduction of $10,215.36 claimed by the petitioner in its return, on account of shrinkage in value of the merchandise in the closing inventory of that year. This issue was abandoned by the petitioner.

The seventh issue relates to the Commissioner’s action in disallowing $20,000, of a total deduction of-$40,800 claimed for 1919, for salaries paid to petitioner’s executive officers. The Commissioner’s action is based on the ground that the additional salaries of $20,000 were not authorized in the year 1919. The facts are fully set out in the findings of fact. The total compensation was paid in equal amounts to Samuel and Philip Blum, who were, respectively, petitioner’s president and vice president. The testimony shows that in 1938 each of these officers was paid a fixed salary of $10,400; that on January 9,1919, they were each voted a bonus of $10,000 for 1918, and that at the same tune it was understood that for the year 1919. each would be paid a salary of $20,400; that during the year 1919, they drew their salaries weekly at the rate of $10,400 per annum, but. an informal agreement was reached during the year, between all of the directors, that a bonus of $10,000 would be voted to each, for 1919, at the next meeting of the board of directors; that the bonus of $10,000 was credited to the account of each before the boobs were closed for 1919; and that at a special meeting of the directors on April 6, 1920, the crediting of the bonus to the accounts of these officers and the payment thereof were formally ratified. Following the reasoning adopted in the Appeal of Reub Isaacs & Co., 1 B. T. A. 45, we are of the opinion that the additional salaries of $20,000 were authorized in 1919, and constitute proper deductions for those years. As to this issue, the Commissioner is reversed.

As to the eighth and ninth issues, a determination as to whether the petitioner had a net income or a net loss, in 1919 and 1920, must await a recomputation of the income for those years in accordance with this opinion.

In computing invested capital in the deficiency notice, the Commissioner included, as a part of the earned surplus, the entire profits of Installment sales effected in 1917. In the amended answer, the Commissioner eliminated from invested capital of 1918, 1919, and 1920, the profits included in the outstanding 1917 installment accounts receivable, at the beginning of each of those years, as unrealized and not properly includable in earned surplus. The petitioner opposes this action of the Commissioner on the ground that the entire profits on installment sales of 1917 were returned and taxed as income of that year. We think that the action of the Commissioner, as set forth in the amended answer, is correct. For the years in question, the installment sales method has been used in computing income. By the use of that method all of the profits actually reduced to possession in those years, are to be returned as income of those years. The fact that some of these profits have been returned in prior years is to be ignored, and they are, for the purposes of the tax, to be treated as a part of the earnings of the years in which they are reduced to possession. Obviously, the petitioner may not include in invested capital of any taxable year, as earned surplus, the earnings of that year and subsequent years.

Reviewed by the Board.

Judgment will he entered on 15 days' notice, in accordance with Rule 50.

AeuNdell not participating.