John M. Cameron and Caroline D. Cameron, and John P. and Teena G. Broadaway v. Commissioner

105 T.C. No. 25

• Court: United States Tax Court
• Decided: November 29, 1995
• Docket: 2137-94
• Status: Unknown

Opinion

105 T.C. No. 25

UNITED STATES TAX COURT

JOHN M. CAMERON AND CAROLINE D. CAMERON, AND JOHN P. AND TEENA G. BROADAWAY, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 2137-94. Filed November 29, 1995.

Ps were shareholders of X, which computed its earnings and profits under the percentage of completion method of accounting. X elected to be taxed as an S corporation and, in a subsequent taxable year, distributed a dividend to Ps. Held, for purposes of measuring the amount of the dividend, X's earnings and profits for its last taxable year as a C corporation must be computed on the basis of year-end estimates of the total costs of its long- term contracts. The estimates may not be revised retroactively to reflect actual costs, and earnings and profits may not be adjusted for subsequent taxable years to which the subchapter S election applied.

Edgar J. Tyler, for petitioners.

Michael F. O'Donnell, for respondent. - 2 -

OPINION

LARO, Judge: The Camerons and Broadaways (petitioners)

jointly petitioned for redetermination of Federal income tax

deficiencies determined by respondent as follows:

Year Deficiency

Broadaways 1989 $18,705.89

Camerons 1989 $45,102.35 1990 6,289.11

After concessions by the parties, we must decide two remaining

questions that will determine the extent to which petitioners

recognized dividend income from a distribution by Cameron

Construction Co. (Company) in 1989:

(1) Whether Company's contemporaneous estimates of the cost

of completing its long-term contracts may be revised

retroactively in computing earnings and profits under the

percentage of completion method. We hold that they may not.

(2) Whether Company's earnings and profits may be adjusted

for taxable years to which its subchapter S election applied. We

hold that they may not.

Stipulations

This case was submitted on the basis of a fully stipulated

record. The stipulations of fact and attached exhibits are

incorporated herein by this reference. - 3 -

At the time they filed their joint petition, the Broadaways

resided in Bono, Arkansas, and the Camerons resided in Jonesboro,

Arkansas. Petitioners were shareholders in Company during the

taxable years at issue. Company is engaged in the road and

highway construction business. Company calculated its income

from construction contracts under the completed contract method

of accounting. Accordingly, it was required by section

312(n)(6)1 to compute its earnings and profits as if it used the

percentage of completion method of accounting. Company elected

to be taxed as an S corporation, pursuant to section 1362(a),

effective following the close of its taxable year ended

October 31, 1988. As an S corporation, Company's first tax year

was a short year ending December 31, 1988, and Company thereafter

reported on a calendar year basis.

At some time during its 1989 taxable year, Company made a

distribution to petitioners. The distribution is taxable to

petitioners as a dividend to the extent of the accumulated

earnings and profits of the Company existing on December 31,

1989. The parties have specified four alternatives:

(1) If Company's earnings and profits must be computed as

of the end of each taxable year on the basis of reasonable

contemporaneous estimates of the costs to complete its

1 Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the taxable years at issue, and all Rule references are to the Tax Court Rules of Practice and Procedure. - 4 -

construction contracts, and may not be adjusted for taxable years

ended after October 31, 1988, then the accumulated earnings and

profits and resulting deficiencies for the 1989 taxable year are:

E&P Broadaways Camerons

$251,650.13 $19,126.69 $46,014.36

(2) If Company's earnings and profits may be computed as of

the end of each taxable year on the basis of the actual contract

costs determined thereafter, but may not be adjusted for taxable

years ended after October 31, 1988, then the accumulated earnings

and profits and resulting deficiencies for the 1989 taxable year

are:

$163,580 $12,860.57 $30,901.69

(3) If Company's earnings and profits must be computed as

construction contracts, and may be adjusted for taxable years

ended after October 31, 1988, then the accumulated earnings and

profits and resulting deficiencies for the 1989 taxable year are:

$141,738.76 $11,392.81 $27,153.55

(4) If Company's earnings and profits may be computed as of

the end of each taxable year on the basis of the actual contract

costs determined thereafter, and may be adjusted for taxable - 5 -

years ended after October 31, 1988, then the accumulated earnings

and profits and resulting deficiencies for the 1989 taxable year

($21,851.09) $2,323 $3,109

Our task is to select the one alternative, if any, that is in

accordance with the governing law.

Discussion

It is undisputed that Company was required to use the

percentage of completion method for purposes of computing its

earnings and profits. Sec. 312(n)(6). The first issue is how to

perform this computation. Under section 460 as enacted by the

Tax Reform Act of 1986, Pub. L. 99-514, sec. 804, 100 Stat. 2358,

gross income from a long-term contract is taken into account as

the work progresses. The amount of gross income from a long-term

contract that is accrued for each taxable year is that proportion

of the expected total contract income that the amount of costs

incurred through the end of the taxable year bears to the total

expected costs, reduced by cumulative amounts of contract income

that were reported for previous taxable years. Sec. 460(b); H.

Rept. 99-426, at 630 (1986), 1986-3 C.B. (Vol. 2) 630; see also

Kollsman Instrument Corp. v. Commissioner, T.C. Memo. 1986-66,

affd. 870 F.2d 89 (2d Cir. 1989); Berger Engg. Co. v.

Commissioner, T.C. Memo. 1961-292. - 6 -

The second issue is how the computation of Company's

earnings and profits was affected by its election under

subchapter S effective November 1, 1988. Absent the election,

Company would have continued to accrue income from its long-term

contracts for earnings and profits purposes on the basis of year-

end estimates of total contract costs. The earnings and profits

available for distribution to petitioners in 1989 would have been

determined on the basis of estimated costs to complete contracts

in progress on the last day of Company's 1989 taxable year. The

result is not the same under subchapter S.

The basic purpose of the earnings and profits account is to

keep track of the amount of corporate funds that have not yet

been taxed to shareholders. When a corporation elects

pass-through treatment under subchapter S, its net income earned

as an S corporation is taxed currently to the shareholders and

thereafter is generally distributed tax-free. Secs. 1366(a),

1368(b)(1), (c)(1). In accordance with the much more limited

role of earnings and profits in a pass-through system of

taxation, section 1371 provides, for taxable years after 1982,

that the accumulated earnings and profits that an S corporation

carries over from pre-election years when it was a C corporation,

generally are not adjusted for the taxable years during which the

election is in effect. Sec. 1371(c)(1); S. Rept 97-640, at 20

(1982), 1982-2 C.B. 718, 720 (accompanying Subchapter S Revision

Act of 1982, Pub. L. 97-354, 96 Stat. 1669). While exceptions - 7 -

apply in certain cases, none are relevant on these facts. Sec.

1371(c)(2) and (3), (d)(3). It follows that after its conversion

to an S corporation, through the end of 1989 there was no change

in the amount of Company's earnings and profits computed on the

basis of estimates made as of October 31, 1988.

Petitioners' argument starts with the proposition that

earnings and profits for a given taxable year should measure as

accurately as possible the current ability of the corporation to

make distributions to shareholders without impairing its capital.

They concede that in preparing annual tax returns using the

percentage of completion method Company would have been required

to compute earnings and profits on the basis of the limited

information that was available at the time. Yet, they contend,

where, as here, earnings and profits for the years at issue can

be recomputed when more information about the costs of Company's

long-term contracts is known, they should not be bound by the

estimates reflected on Company's original returns. In

petitioners' view, accuracy requires the use of additional

information that has subsequently become available. Although

petitioners' primary position is that the concern for accuracy in

computation of earnings and profits should override the freeze on

earnings and profits provided for by section 1371(c)(1), they

argue in the alternative that even if earnings and profits were

frozen as of the effective date of Company's subchapter S

election, "I.R.C sec. 1371(c)(1) does not disallow or forbid - 8 -

'correcting' the 'C' corporation earnings and profits if the

figures as of the date of the conversion were inaccurate."

Petitioners' contention that retroactive adjustments are

necessary if earnings and profits are to perform their intended

function would be more persuasive if no other means of correcting

inaccuracies in the accrual of long term contract revenue under

the percentage of completion method were available. That is not

the case, however. The percentage of completion method has a

built-in mechanism for correcting mistaken estimates; it differs

from the mechanism that petitioners propose. See Herwitz,

"Accounting for Long-term Construction Contracts: A Lawyer's

Approach", 70 Harv. L. Rev. 449, 465 & n.49 (1957); H. Rept. 99-

426, at 630 (1986), 1986-3 C.B. (Vol. 2) 1, 630. For each year,

the cumulative amount of contract revenue that has already been

reported in prior years is subtracted from the cumulative amount

of contract revenue that is otherwise reportable as of the close

of the current year. If in year 1 the taxpayer reports too much

revenue and overstates earnings and profits as a result of

underestimating the amount of its costs to complete contracts in

progress, there will be correspondingly less revenue that remains

to be reported for those contracts in succeeding years. The

overstatement of earnings and profits in the earlier year may

cause shareholders to report a larger amount of any distribution

in that year as a dividend. But the lower revenues and higher

costs generated in completion of the contracts will reduce - 9 -

earnings and profits available for distribution in later years,

which, in turn, may reduce dividend income for shareholders in

these years. In this way, the percentage of completion method is

self-correcting when used consistently over the life of the

taxpayer's long-term contracts.

If this self-correcting mechanism had operated to adjust

Company's earnings and profits after October 31, 1988, the

unexpectedly high costs incurred and the revision of cost

estimates in the 1989 taxable year would apparently have had the

effect of reducing accumulated earnings and profits as well as

the dividends to petitioners in that year. That petitioners

could not take advantage of this mechanism to reduce their

dividend income for 1989 was the consequence of electing the

provisions of subchapter S, one of which is the freeze on

earnings and profits. Sec. 1371(c)(1). We do not find this

result to be inequitable to petitioners, considering that they

would have had no complaint about the accuracy of earnings and

profits measurement under the percentage of completion method had

Company overestimated its total contract costs as of the time of

its subchapter S election rather than underestimating them. The

normal operation of the tax laws will not be adapted to suit the

convenience of individual taxpayers.

Petitioners' argument that in the interest of accuracy they

should be entitled to use a different adjustment mechanism from

that provided for under the percentage of completion method finds - 10 -

no support in general principles of tax accounting. On the

contrary, the general rule for the timing of income accruals as

stated in the regulations is that "Where an amount of income is

properly accrued on the basis of a reasonable estimate and the

exact amount is subsequently determined, the difference, if any,

shall be taken into account for the taxable year in which such

determination is made." Sec. 1.451-1(a), Income Tax Regs. To

allow a taxpayer to reopen the taxable year of the original

estimate would, moreover, be inconsistent with the annual

accounting principle upon which the Federal income tax is

predicated. The courts have long maintained:

Income tax liability must be determined for annual periods on the basis of facts as they existed in each period. * * * No other system would be practical in view of the statute of limitations, the obvious administrative difficulties involved, and the lack of finality in income tax liability, which would result. * * *

Estate of Block v. Commissioner, 39 B.T.A. 338, 341 (1939), affd.

sub nom. Union Trust Co. v. Commissioner, 111 F.2d 60 (7th Cir.

1940); accord Hillsboro Natl. Bank v. Commissioner, 460 U.S. 378,

377 & n.10, 378 n.11 (1983); Healy v. Commissioner, 345 U.S. 278,

284-285 (1953); Burnet v. Sanford & Brooks Co., 282 U.S. 359, 365

(1931).

It does not appear from the stipulated facts that an attempt

was made to correct the estimates reflected on Company's original

return for the taxable year ended October 31, 1988, by means of

an amended return. The implication of petitioners' argument, - 11 -

however, is that if a taxpayer in similar circumstances filed an

amended return, respondent would be obligated to accept it. The

cases hold otherwise: As a corollary to the annual accounting

principle, it is well established that where a transaction was

properly reported on the original return and the original filing

deadline has passed, the acceptance of an amended return that

alters the tax consequences of the transaction is generally

within the discretion of respondent. Goldstone v. Commissioner,

65 T.C. 113 (1975); Coons v. Commissioner, T.C. Memo. 1983-777;

see also Hillsboro Natl. Bank v. Commissioner, supra at 377 n.10.

Accordingly, Company's earnings and profits for its last

taxable year as a C corporation must be determined from Company's

reasonable estimate, as of October 31, 1988, of its costs to

complete construction contracts in progress. The parties have

stipulated that this amount is $251,650.13. The rules of

subchapter S precluded any adjustment to Company's earnings and

profits in the circumstances of this case. See sec. 1371(c)(1).

As a result, Company's earnings and profits remained $251,650.13

on December 31, 1989, and the dividend distributed to petitioners

in 1989 must be measured by reference to this amount. In - 12 -

accordance with the parties' stipulation, the deficiency in

Federal income tax for 1989 was $19,126.69 for the Broadaways and

$46,014.36 for the Camerons.

To reflect the foregoing,

Decision will be entered

under Rule 155.