115 T.C. No. 42
UNITED STATES TAX COURT
JAMES W. AND LAURA L. KEITH, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 11426-98. Filed December 28, 2000.
Prior to and during the years in issue, GIA, a proprietorship owned by P wife, sold residential real property by means of contracts for deed. Under these agreements, the buyers obtained possession; assumed responsibility for taxes, insurance, and maintenance; and became obligated to make monthly payments, with interest, of the purchase price. A warranty deed would be delivered to the buyers by GIA only upon full payment, and any default by the buyers prior thereto would render the contracts null and void, with GIA retaining all amounts paid as liquidated damages.
In accounting for these transactions, Ps reported the gain attributable to the contracts for deed in the year in which full payment was received and title transferred. Only interest payments were included in income for tax purposes until such time. GIA also depreciated the subject properties during the term of each contract. - 2 -
Held: Each contract for deed effected a completed sale for tax purposes in the year of execution, and income attributable to such disposition must be recognized and reported for that taxable year.
Held, further, the net operating loss carryovers claimed by Ps must be adjusted to take into account income which should have been reported in years preceding those at issue, for contracts entered during such prior periods.
Held, further, Baertschi v. Commissioner, 49 T.C. 289 (1967), revd. 412 F.2d 494 (6th Cir. 1969), will no longer be followed.
William J. White, for petitioners.
Nancy E. Hooten and Mark S. Mesler, for respondent.
OPINION
NIMS, Judge: Respondent determined the following
deficiencies and penalties with respect to petitioners’ Federal
income taxes for the taxable years 1993, 1994, and 1995:
Taxable Income Tax Penalty Year Deficiency Sec. 6662(a) 1993 $74,925.00 $14,985 1994 127,304.00 25,461 1995 106,261.54 21,252
After concessions, the issues remaining for decision are:
(1) The proper method of accounting for, and timing of
recognition of gain attributable to, sales of property by means
of contracts for deed; and - 3 -
(2) the reduction of net operating loss carryovers from
years preceding the years in issue to reflect income attributable
to contracts for deed executed in those prior years.
Additionally, the parties have agreed that a third issue,
the availability of depreciation deductions for properties
subject to such contracts for deed, is dependent upon and will be
resolved by our decision regarding petitioners’ accounting
method. The parties have stipulated the amounts to be allowed as
depreciation deductions in the event of a ruling either for
petitioners or for respondent.
Unless otherwise indicated, all section references are to
sections of the Internal Revenue Code in effect for the years in
issue, and all Rule references are to the Tax Court Rules of
Practice and Procedure.
Background
This case was submitted fully stipulated pursuant to Rule
122, and the facts are so found. The stipulations of the
parties, with accompanying exhibits, are incorporated herein by
this reference. Petitioners resided in Moultrie, Georgia, during
each of the years in issue and at the time their petition was
filed in this case.
Formation of Greenville Insurance Agency (GIA)
Petitioner James W. Keith is a radiologist, and petitioner
Laura L. Keith is a dentist. Mrs. Keith is also the owner of a - 4 -
proprietorship known as Greenville Insurance Agency (GIA). Mrs.
Keith established the business in 1983 on the advice of her
father, J.D. Latzak, as a vehicle to create potential tax
savings. GIA was formed primarily to sell insurance, to purchase
real estate for resale or rent, and to broker mortgages. Since
its genesis, GIA has been run by Mr. Latzak who, because of large
judgment creditors, could not conduct business or hold assets in
his name. Although neither of the Keiths possesses an insurance
license or has experience in real estate transactions, Mr. Latzak
is a licensed insurance agent and an experienced broker. We
previously addressed the treatment of insurance commissions and
mortgage placement fees earned incident to GIA’s operations for
years 1984 through 1988 in Latzak v. Commissioner, T.C. Memo.
1994-416. We now focus on the reporting of income attributable
to the company’s sales of real property.
GIA’s Real Estate Transactions
During the years at issue, GIA was in the business of
selling, financing, and renting residential real property. The
sales were effected by means of contracts for deed. The record
reflects 18 such contracts entered into between 1989 and 1995, 12
of which were executed in the 1993 to 1995 period presently
before the Court. The following is representative of these
agreements: - 5 -
CONTRACT FOR DEED
GEORGIA, MERIWETHER COUNTY
This agreement entered into by the seller and the buyer(s). The seller hereby agrees to convey to the buyer(s) fee simple title to a certain property described on Exhibit “A” to this contract, at which time all of the conditions of the sale described below are met by the buyer.
SELLER: Greenville Insurance Agency, a proprietorship, which is registered and domiciled in Meriwether County, Ga., maintaining an office open to the public at 109 Court Square, Greenville, Georgia 30222.
BUYER(S): _____________________________________________ _____________________________________________ _____________________________________________
SELLING PRICE: ____________ DOWN PAYMENT _____________
BALANCE of $__________ to be evidenced by a promissory note plus interest at ____% interest payable in ___ monthly installments of $______ per month, starting _________ and ending ________.
SPECIAL STIPULATIONS TO THE CONDITIONAL SALE:
(1) The buyer(s) shall pay the prorated [year of execution] property taxes, and all future property taxes promptly when due.
(2) The buyer(s) shall not permit the general condition of the property to deteriorate in value any futher [sic] than its delivered condition.
(3) The buyer(s) shall perform any and all required maintenance on the property.
(4) The buyer(s) shall assume all liabilities as if they had fee simple title.
(5) The property is to be used as a primary single family residence for the buyer(s), and for no other purpose. - 6 -
(6) The buyer may not transfer or assign their [sic] rights or interest in this contract.
(6a) Fire Insurance in the amount of $__________ from a company approved by the Seller must be kept in force at all times, seller named as loss payee, until all terms are met by buyer.
(7) Payment of the monthly installments of $_______ are required to be tendered to the seller at its offices stated above or other place so designated by the seller or its assigns, and payable in United States Currency, on or before the due date. Any payment accepted more than ten (10) days beyond the due date will require an additional charge of 10% of the amount payable, and the acceptance of same will not modify or novate any other terms and conditions and will not act as a waiver of the sellers [sic] right to declare the contract in default and null and void and of no effect.
The seller agrees to convey to the buyer(s), a Warranty Deed, free of any leins [sic] and encumbrances within ten (10) days after all of the terms and conditions of this agreement are met by the buyer(s).
Should the buyer(s) elect to acelerate [sic] this agreement, then the terms and conditions of the promissory note executed contemporaneously with this agreement by the buyer(s) would determine the amount to be tendered by the buyer(s) for the acceleration in order to prematurely obtain a warranty deed.
Should the buyer(s) default or breach or not meet any of the conditions of the terms herein specified, then this contract and the note attached evidenced by this contract will be immediately declared NULL & VOID, and no futher [sic] benefits or equities would be accrued to the buyer(s), except that the buyer(s) would be liable for any monies unpaid under the terms and conditions of the contract to the date that the contract was declared null and void.
It is understood and agreed by the Buyer(s) and the Seller that the $________ ernest [sic] money down payment, and the monthly installments and other charges tendered by the buyer(s) from inception, and any - 7 -
improvements to the property made by or on the behalf of the buyer(s) during the life of this contract, if forfeited by the buyer(s) as a result of default or breach of the contract, is a fair value for the liquidated damages incurred by the seller as a result of said breach or default.
No warranties as to the condition or usability of the property are either expressed or implied by the seller.
It is herein disclosed to the buyer(s) that the subject property may presently have existing debt being serviced by the seller, and that future debt (not to exceed the amount payable under this contract) may be incepted by the seller.[1]
The conditions of sale, as well as the provisions related to
default, voidability, and liquidated damages, were substantially
identical in all material respects in each of the contracts.
Printed descriptions or handwritten notations indicate that the
subject property of most of the agreements was a residence. A
small percentage of the contracts may have been for land alone.
The majority of the contracts were for terms of between 240 and
300 months and specified interest at a rate of 11 to 18 percent.
The sales prices ranged from a low of less than $3,000 to a high
of $40,000. The total gain represented by the contracts,
1 With respect to this final paragraph, we note that neither party has referenced its existence or discussed its intended operation. Our own research has similarly yielded no insight into the precise meaning of such a provision or its potential impact on the buyer-seller relationship. Hence, since the parties apparently regard it as insignificant boilerplate, we shall do likewise and shall give it no further consideration. - 8 -
calculated as the difference between the sales price and GIA’s
basis, was $58,373, $62,517, and $11,500 for agreements executed
in 1993, 1994, and 1995, respectively.
GIA’s Accounting and Reporting
With their 1993, 1994, and 1995 Federal income tax returns,
petitioners included Schedules C, Profit or Loss From Business,
with respect to GIA. On each such Schedule C, petitioners
indicated GIA’s accounting method by checking the box labeled
“Accrual”. A like designation was made on Schedules C filed with
returns for the preceding years 1984 through 1992.
As regards accounting for the above-described real estate
transactions in particular, the methodology generally utilized by
petitioners has been stipulated by the parties. During the term
of a contract for deed, petitioners would report as income the
interest received on the promissory note entered into in
conjunction with the contract. The portion of any payment
allocable to principal would be treated as a deposit on the
purchase and would be recorded as a liability on the books of the
company. If a property were repossessed prior to completion of
the contract, this deposit would be applied first to repairs and
maintenance, and any remaining amount would be reported as
miscellaneous income. The properties would also be depreciated
by GIA during the payment period. - 9 -
Upon full payment of the contract price, petitioners would
recognize income on the disposition of the property. Gain on the
sale would be computed by reducing the total sale price by
petitioners’ adjusted basis in the property.
Discussion
I. Contentions of the Parties
Petitioners contend that their method of accounting for and
recognizing gain attributable to the contracts for deed is
appropriate and clearly reflects income. According to
petitioners, the contracts are mere voidable, executory
agreements and as such do not effect a closed and completed sale
in the year signed. Hence, in petitioners’ view, there is no
disposition of the properties for tax purposes and no consequent
realization of gain until final payment is received and title
transferred.
Conversely, respondent asserts that petitioners’ method of
accounting for sales under the subject contracts for deed is
improper and fails to clearly reflect income. Respondent avers
that each instrument produced a completed sale in the year of
execution, as the benefits and burdens of ownership were
transferred from petitioners to the buyer at that time.
Respondent, characterizing petitioners as accrual method
taxpayers, therefore concludes that no grounds exist for
deferring recognition of gain on these completed transactions. - 10 -
In addition, respondent argues that petitioners’ incorrect method
of accounting resulted in inflated losses in prior years such
that the net operating loss carryovers to the years at issue
should be reduced accordingly.
II. Method of Accounting and Recognition of Gain
A. Existence of Gain--Completed Sale
As a general rule, the Internal Revenue Code imposes a
Federal tax on the taxable income of every individual. See sec.
1. Section 61(a) specifies that gross income for purposes of
calculating such taxable income means “all income from whatever
source derived”. Expressly encompassed within this broad
pronouncement are “Gains derived from dealings in property”.
Sec. 61(a)(3). Section 1001(a) then defines such gains as the
amount realized “from the sale or other disposition of property”,
less the adjusted basis. Accordingly, section 1001(a) indicates
that gross income within the meaning of section 61(a) does not
arise until property is considered sold or otherwise disposed of
for Federal tax purposes.
Case law then sets forth the standard for determining when a
sale is complete for tax purposes. With respect to real
property, a sale and transfer of ownership is complete upon the
earlier of the passage of legal title or the practical assumption
of the benefits and burdens of ownership. See Major Realty Corp.
& Subs. v. Commissioner, 749 F.2d 1483, 1486 (11th Cir. 1985), - 11 -
affg. in part and revg. in part T.C. Memo. 1981-361; Dettmers v.
Commissioner, 430 F.2d 1019, 1023 (6th Cir. 1970), affg. Estate
of Johnston v. Commissioner, 51 T.C. 290 (1968); Baird v.
Commissioner, 68 T.C. 115, 124 (1977). This test reaffirms the
longstanding principle, evidenced by the following early
statement, that transfer of legal title is not a prerequisite for
a completed sale: “A closed transaction for tax purposes results
from a contract of sale which is absolute and unconditional on
the part of the seller to deliver to the buyer a deed upon
payment of the consideration and by which the purchaser secures
immediate possession and exercises all the rights of ownership.”
Commissioner v. Union Pac. R.R. Co., 86 F.2d 637, 639 (2d Cir.
1936), affg. 32 B.T.A. 383 (1935).
In determining whether passage either of title or of
benefits and burdens has occurred, we look to State law. It is
State law that creates, and governs the nature of, interests in
property, with Federal law then controlling the manner in which
such interests are taxed. See United States v. National Bank of
Commerce, 472 U.S. 713, 722 (1985). Here, execution of the
contracts for deed was not accompanied by a transfer of legal
title, so we must decide whether these instruments were
sufficient under State law to confer upon the purchaser the
benefits and burdens of ownership. This inquiry is a practical
one to be resolved by examining all of the surrounding facts and - 12 -
circumstances. See Clodfelter v. Commissioner, 426 F.2d 1391,
1393 (9th Cir. 1970), affg. 48 T.C. 694 (1967); Baird v.
Commissioner, supra at 124. As all contracts at issue appear to
involve Georgia properties and to have been executed in Georgia,
the relevant State law is supplied by the statutes and courts of
that jurisdiction.
Among the factors which this and other courts have cited as
indicative of the benefits and burdens of ownership are: A right
to possession; an obligation to pay taxes, assessments, and
charges against the property; a responsibility for insuring the
property; a duty to maintain the property; a right to improve the
property without the seller’s consent; a bearing of the risk of
loss; and a right to obtain legal title at any time by paying the
balance of the full purchase price. See Goldberg v.
Commissioner, T.C. Memo. 1997-74; see also Major Realty Corp. v.
Commissioner, supra at 1487; Grodt & McKay Realty, Inc. v.
Commissioner, 77 T.C. 1221, 1237-1238 (1981); Musgrave v.
Commissioner, T.C. Memo. 2000-285; Berger v. Commissioner, T.C.
Memo. 1996-76; Spyglass Partners v. Commissioner, T.C. Memo.
1995-452. When a buyer, by virtue of such incidents, would be
considered to have obtained equitable ownership under State law,
a sale will generally be deemed completed for Federal tax
purposes. See Baird v. Commissioner, supra at 126; Berger v.
Commissioner, supra; Spyglass Partners v. Commissioner, supra. - 13 -
In the case at bar, we observe that the contracts for deed
gave the buyers possession of the property during the agreement
term (evidenced by the mandate to use the property as a
residence). The contracts also required purchasers to pay
property taxes from the date of execution, to keep fire insurance
in force during the payment term, to perform maintenance and
prevent deterioration, and to assume all liabilities as if they
held fee simple title. Moreover, the instruments allowed buyers
to accelerate the agreement and “prematurely obtain a warranty
deed” by tendering the full amount owing under the related
promissory note. Therefore, given these significant
accoutrements of ownership, we turn to whether Georgia courts
would construe an instrument so designating rights and
obligations as a transfer of equitable ownership to the buyer.
In Chilivis v. Tumlin Woods Realty Associates, Inc., 297
S.E.2d 4 (Ga. 1982), the Supreme Court of Georgia interpreted a
contract analogous to those at issue here. In that case, an
“Agreement for Deed” was executed by the parties. Id. at 5-6.
According to its terms, a deed was placed in escrow to be
delivered to the buyer upon completion of all payments called for
in the accompanying promissory note. See id. at 6. The
instrument specifically recited:
“Seller and Buyer acknowledge and agree that this Agreement is not a mortgage or security deed to secure a loan made to Buyer by Seller, that this is an agreement to convey the Property to Buyer upon the - 14 -
completion of the terms and provisions of this Agreement * * * , that this is not a loan secured by the Property and that no title in and to the Property has passed to Buyer or will pass to Buyer until Buyer fulfills and complies with each and every term and provision hereof.” [Id.]
The buyer was given immediate possession of the property and was
responsible for taxes, maintenance, and insurance thereon. See
id. Upon a default by the buyer, the seller’s remedy was either
to rescind the transaction or to exercise a power of sale over
the property. See id. The buyer would not be liable for any
deficiency in the event of such a sale. See id.
Faced with these facts, the court decided that the
“Agreement for Deed” was “for all practical purposes no different
from a bond for title”, an instrument formerly used in Georgia
real estate law in connection with sales of land. Id. at 7-8.
The court further noted that prior case law had said of a bond
for title:
“In the sale of land on credit where the vendor retains title, he has not the absolute estate, but is a trustee holding the title only as security. For many purposes the transaction may be treated in equity as though the vendor had made a deed to the vendee and the latter had thereupon given a common-law mortgage to secure the purchase-money.” [Id. (quoting Lytle v. Scottish Am. Mortgage Co., 50 S.E. 402, 406 (Ga. 1905)).]
Accordingly, the court then concluded with respect to the
instrument before it as follows: “In practicality, it is no
different than if * * * [the seller] had delivered a warranty
deed to * * * [the buyer] and accepted a deed to secure debt in - 15 -
return. The agreement created an equitable interest in * * *
[the buyer] and a security interest in * * * [the seller].” Id.
at 8.
The Court of Appeals of Georgia subsequently relied on
Chilivis v. Tumlin Woods Realty Associates, Inc., supra, in
interpreting a similar agreement in Tucker Fed. Sav. & Loan
Association v. Alford, 311 S.E.2d 229 (Ga. Ct. App. 1983). The
appellate case likewise involved a land sale contract under which
the seller agreed to deliver a warranty deed upon full payment
(or the assumption by the buyers of two outstanding mortgages on
the property). See id. at 230. Again the instrument recited
that no title passed upon execution of the agreement, but the
buyers took possession and control of the premises. See id. The
court first opined that “The transaction clearly granted * * *
[the buyers] all the benefits and responsibilities of ownership.”
Id. On that basis, the conclusion ultimately reached was that
“The contract of sale, of course, did not vest legal title in * *
* [the buyers], but it did give them an equitable interest and
rights of ownership.” Id. at 231.
Given the foregoing, we conclude that Georgia courts would
similarly construe the contracts for deed at issue here to pass
equitable ownership to the purchasers and to leave GIA
essentially with a security interest. In addition, we note that
certain statements made by petitioners on brief are not - 16 -
inconsistent with the notion that security concerns may in fact
have motivated the transactional form chosen: “GIA sells real
property to low-income families in Western Georgia near Columbus.
Because these families are poor and have little or no credit
history the properties are sold using a ‘Contract for Deed’”.
Hence, we hold that these instruments upon their execution
effected a completed sale for Federal tax purposes. Petitioners’
reliance on Hambrick v. Bedsole, 91 S.E.2d 205 (Ga. Ct. App.
1956), and on the voidability of their agreements, in support of
a contrary conclusion, is misplaced.
Hambrick v. Bedsole, supra at 208-209, involved a contract
under which title to property was not to pass and possession was
not to be delivered until the full, lump-sum purchase price was
paid. The agreement did not provide for either a downpayment or
installment payments. See id. The court decided that the
contract “was a mere executory agreement to sell and did not
constitute a sale”, on the grounds that the buyer “gained by the
contract neither title to, nor the right of possession of” the
subject property. Id. at 209. The situation in Hambrick v.
Bedsole, supra, thus bears almost no resemblance to that in the
instant case and cannot inform our analysis.
As regards the voidability of the contracts for deed, we see
no material difference between the provisions on default here and
those contained in the agreement in Chilivis v. Tumlin Woods - 17 -
Realty Associates, Inc., supra. In either case, if the buyer
were to default and refuse to complete the transaction, the
seller would have no further recourse against the buyer
personally. The seller could look only to the property itself as
a means to recover the full value of the aborted deal and would
be unable to enforce remaining payments or deficiencies against
the buyer as a personal liability. Yet, the court still
characterized the Chilivis instrument as creating an equitable
interest in the buyer and leaving the seller with a mere security
interest. Hence, we do not believe that Georgia courts would
hold a lack of recourse against the purchaser, following default
of an otherwise binding agreement, to prevent a finding that the
benefits and burdens of ownership, i.e., an equitable interest,
were nonetheless transferred when the contract was signed.
Accordingly, the sale should be considered complete for tax
purposes, regardless of the possibility of future voidance.
The foregoing conclusion is further buttressed by the
weight, or lack thereof, that other courts have given to various
types of nonrecourse clauses in evaluating the completeness of a
sale. For instance, the sales agreement at issue in Commissioner
v. Baertschi, 412 F.2d 494, 497 (6th Cir. 1969), revg. 49 T.C.
289 (1967), contained the following language:
The remedy or recourse of said parties of the first part for the non-performance of any obligation of the parties of the second part hereunder shall be limited solely to the moneys paid hereunder, and to the herein - 18 -
described property, and said parties of the second part shall not be liable for any deficiency arising from the sale of said property in any way, capacity or manner whatsoever, nor shall said parties of the first part have the right to, nor seek, a deficiency or other money judgment against said parties of the second part.
The court, however, noted such factors as the buyers’ absolute
right to title on full payment; the sellers’ lack of any right to
cancel except upon the purchasers’ default; and the buyers’
possession of, and responsibility for taxes and insurance on, the
property. See id. at 498. Given these elements, the court
declared: “we do not feel that the single fact of a ‘no
recourse’ clause served to delay the finality of this sale until
final payment of the total purchase price had been made.” Id.
An identical result was reached on similar facts in Clodfelter v.
Commissioner, 426 F.2d 1391, 1395 (9th Cir. 1970).
While we acknowledge that our opinion in Baertschi reached a
contrary conclusion on this issue, we have now reconsidered our
holding in light of reversal by the Court of Appeals for the
Sixth Circuit. We are persuaded that the position of the Court
of Appeals on the effect of a non-recourse provision rests on
sound legal principles. Accordingly, Baertschi v. Commissioner,
49 T.C. 289 (1967), will no longer be followed. We further note
that this approach better harmonizes with our earlier ruling that
contracts with provisions closely analogous to those here and
which by their terms became “utterly null and void” on the
buyer’s default, with the seller retaining all moneys paid, - 19 -
represented closed sales in the year entered. See Arnold v.
Commissioner, a Memorandum Opinion of this Court dated Mar. 17,
1953. We see no reason to infer differently here.
B. Reporting of Gain--Timing of Inclusion
Thus, having decided that petitioners’ contracts for deed
effected a completed sale when executed, we proceed to the
question of when gain from such sales must be included in gross
income. The general rule for the taxable year of inclusion is
set forth in section 451(a): “The amount of any item of gross
income shall be included in the gross income for the taxable year
in which received by the taxpayer, unless, under the method of
accounting used in computing taxable income, such amount is to be
properly accounted for as of a different period.” Regulations
then specify as follows:
Under an accrual method of accounting, income is includible in gross income when all the events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy. * * * Under the cash receipts and disbursements method of accounting, such an amount is includible in gross income when actually or constructively received. * * * [Sec. 1.451-1(a), Income Tax Regs.]
Taxable income, in turn, generally “shall be computed under the
method of accounting on the basis of which the taxpayer regularly
computes his income in keeping his books”, with the exception
that “if the method used does not clearly reflect income, the - 20 -
computation of taxable income shall be made under such method as,
in the opinion of the Secretary, does clearly reflect income.”
Sec. 446(a) and (b).
As used in section 446, the term “method of accounting”
encompasses “not only the over-all method of accounting of the
taxpayer but also the accounting treatment of any item”. Sec.
1.446-1(a)(1), Income Tax Regs. Furthermore, it has been
recognized repeatedly that this section grants the Commissioner
broad discretion, such that to defeat a proposed change
thereunder, the taxpayer must establish that the Commissioner’s
determination is “‘clearly unlawful’” or “‘plainly arbitrary’”.
Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 532-533 (1979)
(quoting Lucas v. American Code Co., 280 U.S. 445, 449 (1930),
and Lucas v. Kansas City Structural Steel Co., 281 U.S. 264, 271
(1930)). However, if the taxpayer’s method does clearly reflect
income, the Commissioner cannot require the taxpayer to change to
a different method even if the Commissioner’s method more clearly
reflects income. See Ford Motor Co. v. Commissioner, 71 F.3d
209, 213 (6th Cir. 1995), affg. 102 T.C. 87 (1994).
In the case at bar, the only evidence in the record which
speaks to GIA’s overall method of accounting is the Schedules C
filed with petitioners’ tax returns. On each such Schedule C,
the box indicating “Accrual” was checked. We therefore have no
basis on which to conclude that GIA was other than an accrual - 21 -
method business and must proceed on the assumption that,
excepting the contract for deed transactions, its items of income
and expense were reported using this method.
Under the accrual method, gain arising from the contracts
for deed would be reportable in the year when the right to
receive the income became fixed and the amount of the income
became reasonably determinable. Since the instruments at issue
expressly dictated price, the latter requirement regarding amount
of income is not in question here. Concerning the former element
of a fixed right to the income, we reiterate the well-established
principle that “In applying the all events test, this and other
courts have distinguished between conditions precedent, which
must occur before the right to income arises, and conditions
subsequent, the occurrence of which will terminate an existing
right to income, but the presence of which does not preclude
accrual of income.” Charles Schwab Corp. & Subs. v.
Commissioner, 107 T.C. 282, 293 (1996), affd. 161 F.3d 1231 (9th
Cir. 1998).
Here, the only circumstance in which GIA could fail to
receive the full amount of the purchase price would be a default
by the buyer. A default, however, is a condition subsequent. As
we stated regarding the similar sales contract in Clodfelter v.
Commissioner, 48 T.C. 694, 701 (1967):
the purchaser was given immediate possession; it thereupon assumed the rights and obligations of - 22 -
beneficial ownership; and thereafter such property interest and beneficial ownership would not be subject to termination or forfeiture, except on the happening of a condition subsequent--i.e., a default.
Thus, because the buyer’s obligation to pay the full price under
the agreements in the instant case was otherwise unconditional,
execution of the contracts fixed petitioners’ right to these
sums. Our declaration that “the amount of and right to the
purchase price were fixed and unqualified”, in the context of
another sales agreement which provided for forfeiture of the
contract and retention of all moneys paid in liquidation of
damages, is equally applicable here. Elsinore Cattle Co. v.
Commissioner, a Memorandum Opinion of this Court dated Feb. 21,
1950. Accordingly, both elements for inclusion were met in the
year of signing, the year the transaction was completed for tax
purposes.
This is consistent with the longstanding position of this
Court that the factual predicate requiring income inclusion in a
given year by an accrual method taxpayer is completion of a sale
in that year. For instance, it was held as early as 1925, with
respect to a contract entered in 1918 with all payments to be
made in subsequent years: “The transaction was a completed sale
in the year 1918, and, as the taxpayer kept its books of account
on the accrual basis, the sale price was properly accruable in
that year. We hold, therefore, that the profits arising from the - 23 -
sale in question were income to the taxpayer in the year 1918.”
Parish-Watson & Co. v. Commissioner, 2 B.T.A. 851, 860 (1925);
see also sec. 15A.453-1(d)(2), Temporary Income Tax Regs., 46
Fed. Reg. 10717 (Feb. 4, 1981). But see sec. 1.1001-1(g), Income
Tax Regs., for sales or exchanges occurring on or after August
13, 1996.
We additionally point out that, to the extent petitioners
argue no income is required to be recognized because the voidable
notes evidencing the debt have no fair market value and thus are
not the equivalent of cash, this consideration has no place in
the analysis of an accrual method entity. The following
explanation clearly distinguishes between accrual and cash
accounting in this regard:
An agreement, oral or written, of some kind is essential to a sale. If payment is made at the same time that the obligation to pay arises under the agreement, then the profit would be reported at that time no matter which method was being used. However, the situation is different when the contract merely requires future payments and no notes, mortgages, or other evidence of indebtedness such as commonly change hands in commerce, which could be recognized as the equivalent of cash to some extent, are given and accepted as a part of the purchase price. That kind of a simple contract creates accounts payable by the purchasers and accounts receivable by the sellers which those two taxpayers would accrue if they were using an accrual method of accounting in reporting their income. But such an agreement to pay the balance of the purchase price in the future has no tax significance to either purchaser or seller if he is using a cash system. [Johnston v. Commissioner, 14 T.C. 560, 565 (1950).] - 24 -
Consequently, unless a specific exception to the above general
rules will permit deferral, we are satisfied that GIA, as an
accrual method business, must recognize and report income
attributable to the contracts for deed in the years of their
respective executions.
The primary exception for income deferral is section 453,
which provides for the “installment method” to be used in
reporting an “installment sale”. Petitioners do not, however,
appear to argue that this statute is applicable. We also note
that a “dealer disposition”, including “Any disposition of real
property which is held by the taxpayer for sale to customers in
the ordinary course of the taxpayer’s trade or business”, is
excluded from the definition of an installment sale. Sec.
453(b)(2)(A), (l)(1)(B). The parties here have stipulated that
“GIA was in the business of selling, financing, and renting
residential real property.” Additionally, although a further
exception can permit use of the installment method for sales of
residential lots, see sec. 453(l)(2)(B), the record before us
fails to establish that petitioners could qualify under this
provision. The contracts indicate that the majority of the
properties were houses, not lots. Also, as to the contracts
which may have been for land alone, no evidence shows that the
remaining requirements for this election have been met. See sec.
453(l)(2)(B)(ii), (l)(3); Wang v. Commissioner, T.C. Memo. 1998- - 25 -
127. In any event, petitioners have nowhere contended that the
various transactions should be treated differently.
A second basis for potential income deferral, to which
petitioners do make reference on brief as an apparent alternative
argument, is the recovery of cost approach. However, substantive
requirements for use of this method aside, we have refused to
allow taxpayers to switch to cost recovery accounting without
following the established procedures under section 446(e) for
requesting such a change from the Commissioner. See Wang v.
Commissioner, supra; see also Witte v. Commissioner, 513 F.2d 391
(D.C. Cir. 1975) (holding that section 446(e) requires that
consent be sought even for a change from an improper to a proper
accounting method), revg. in part and remanding T.C. Memo. 1972-
232. It is undisputed that petitioners have never filed the
requisite Form 3115. See sec. 1.446-1(e)(3)(i), Income Tax Regs.
The Commissioner thus was not obligated to consider this approach
in analyzing whether petitioners’ accounting clearly reflected
income or in determining a method which did so.
To summarize, respondent determined that gain of an accrual
method business must be reported consistently with that method in
order to clearly reflect income. Given the above, we now
conclude that such determination accords with settled law and
precedent. Hence, petitioners have not shown that the proposed
change is either clearly unlawful or plainly arbitrary. We hold - 26 -
that petitioners must include the gain attributable to GIA’s
contracts for deed, the excess of sales price over basis, in
their gross income for the respective years of the agreements’
execution.
III. Reduction of Net Operating Loss Carryovers
Section 172(a) authorizes a net operating loss deduction.
Essentially, a net operating loss is the excess of deductions
over gross income, with enumerated modifications. See sec.
172(c) and (d). The net operating loss so determined may be
carried back to the 3 preceding taxable years and carried forward
to the 15 succeeding years, until absorbed by taxable income.
See sec. 172(b).
On their returns for 1993 through 1995, petitioners claimed
deductions for net operating loss carryovers from prior years.
In the notice of deficiency, respondent disallowed a portion of
the amount claimed for 1993 and the full amount for years 1994
and 1995. Respondent argues that the net operating loss
carryovers were overstated and should be allowed only to the
extent the underlying losses were incurred and remain unabsorbed
after taking into account certain adjustments.
Two primary adjustments are referenced in the parties’
stipulations and briefs. First, both parties are apparently in
agreement that the net operating loss carryovers should be
increased to reflect the insurance commissions and mortgage - 27 -
placement fees which we previously held should have been reported
by Mr. Latzak. See Latzak v. Commissioner, T.C. Memo. 1994-416.
Second, however, respondent also contends that the carryovers
should be reduced to reflect the income attributable to contracts
for deed entered in years 1989 through 1992, as such gain was
properly reportable in those years.
In general, the taxpayer bears the burden of establishing
both the actual existence of net operating losses in the prior
years and the amount of such losses that may be carried to the
years at issue. See Rule 142(a); Jones v. Commissioner, 25 T.C.
1100, 1104 (1956), revd. and remanded on other grounds 259 F.2d
300 (5th Cir. 1958); Ocean Sands Holding Corp. v. Commissioner,
T.C. Memo. 1980-423, affd. without published opinion 701 F.2d 167
(4th Cir. 1983); Moyer v. Commissioner, T.C. Memo. 1976-69, affd.
without published opinion 565 F.2d 152 (3d Cir. 1977). We have
jurisdiction to consider such facts related to years not in issue
as may be necessary for redetermination of tax liability for the
period before the Court. See sec. 6214(b).
Here, petitioners have not and could not, given our
conclusions above, establish their incurrence of and entitlement
to deduct losses premised in part on a failure to report income
attributable to the contracts for deed entered in the loss years.
We agree with respondent that these adjustments should be taken
into account along with those based on the income properly - 28 -
reportable by Mr. Latzak. Thus, we hold that to the extent
recomputation applying these adjustments shows that GIA’s net
operating loss carryovers do not exceed the amount allowed by
respondent for 1993, petitioners are not entitled to deduct such
further amounts.
To reflect the foregoing and the parties’ concessions,
Decision will be entered
under Rule 155.
Reviewed by the Court.
WELLS, CHABOT, WHALEN, COLVIN, HALPERN, CHIECHI, LARO, FOLEY, VASQUEZ, GALE, THORNTON, and MARVEL, JJ., agree with this majority opinion.
SWIFT and RUWE, JJ., concur.