Shepherd Constr. Co. v. Commissioner

51 T.C. 890, 1969 U.S. Tax Ct. LEXIS 179

• Court: United States Tax Court
• Decided: March 3, 1969
• Docket: Docket No. 4585-66
• Status: Published

Opinions

Dawson, Judge:

Respondent determined deficiencies in income tax for the fiscal years ended on March 31, 1961 and 1962, in the amounts of $62,880.73 and $29,601.05, respectively. Certain minor adjustments for fiscal year 1962 relating to entertainment and sales promotion expenses and to depreciation have not been contested. The issues for decision are (1) whether petitioner, an accrual basis contractor engaged in highway construction, is entitled to deductions for amounts of “retainage” withheld from its subcontractors prior to final acceptance and approval of the work performed, and, if not, (2) whether, under the provisions of section 481 of the Internal Revenue Code of 1954,¹ respondent’s adjustment of petitioner’s taxable income for the taxable year ended March 31,1961, was proper.

FINDINGS OF FACT

Some of the facts have been stipulated by the parties. The stipulation of facts and exhibits attached thereto are incorporated herein by this reference.

Petitioner is a corporation chartered under the laws of the State of Georgia in 1949. Its principal office and place of business is and has been at all times in Atlanta, Ga. Its books and records are kept and its Federal tax returns are prepared on an accrual method of accounting and for fiscal years ended on March 31. Its Federal income tax returns for the taxable years ended in 1961 and 1962 were filed with the district director of internal revenue at Atlanta, Ga.

The petitioner is principally engaged in the highway construction business and dealt primarily with governmental agencies during the years in question and the years immediately prior and subsequent thereto. With respect to the issues presented in this case, all of petitioner’s income during the taxable years was received from the Highway Department of the State of Georgia (hereinafter referred to as the highway department).

Petitioner usually functions as a “prime” or general contractor and so acted during the years in issue. A prime contract sometimes requires 4 to 5 years to complete. A portion of the work called for by the prime contract was normally performed by the petitioner, including clearing, grading, paving, and pipe or cross-drainage structures exclusive of box culvert-type construction. Petitioner entered into separate contracts with various subcontractors for the performance of the remainder of the work, such as base and subbase work, concrete box culverts, bridges, concrete paving, masonry and brick work, guard rails, grassing, and certain other special items such as stripe painting, signs, and lighting. The contractor, petitioner herein, acting directly or through its agents, is responsible for the fulfillment of all of the terms of the contract and for the payment of all legal debts pertaining to the work.

“Standard Specifications” for the “Construction of Hoads and Bridges,” prescribed by the highway department and issued from time to time in the form of bound handbooks, are made a part of the highway department contracts, and were made a part of all contracts which petitioner had with the highway department during the years in issue.² Any amendments, modifications, or revisions made between periodic issues of the bound handbooks are specifically set forth in the highway department contracts. The “Standard Specifications,” insofar as they are pertinent to the issues presented herein, are as follows:

4.01. INTENT OF PLANS AND SPECIFICATIONS: The intent of the Plans, Specifications and Special Provisions is to prescribe a work or improvement which the Contractor undertakes to do, complete in every detail, in accordance with the Contract. The Contractor shall perform all items of The Work set forth in the Proposal and in the Plans, shall remove all obstructions from the highway and shall do such Extra Work as the Engineer may consider necessary to complete the Project to the finished lines, grades, cross-sections and other dimensions specified, in a satisfactory manner. He shall furnish, unless otherwise provided in the Contract, all the material, implements, machinery, equipment, tools, supplies, transportation, labor and supervision necessary for the prosecution and completion of The Work.

5.01. AUTHORITY AND DUTIES OF ENGINEER: The Work shall be done under the supervision of the Engineer.

a. Engineer’s Decision and Estimates Final: The Engineer will decide promptly all questions related to the quality and acceptability of materials furnished, work performed, and as to the manner of performance and rate of progress of The Work. His decision shall be final on all questions related to the interpretation of the Specifications and the Plans and as to the acceptable fulfillment of the Contract by the Contractor. The Engineer will determine the qualities of the several kinds of work performed and materials furnished which are to be paid for under the Contract and his estimate shall be final, and the Contractor shall not have a right to receive any money due under the Contract until the Engineer’s estimate has teen made; provided, however, that any decision of the Engineer regarding contractual questions as distinguished from technical questions may be appealed to the Board by the Contractor.

5.08. INSPECTION: The Contractor shall furnish the Engineer every reasonable means of ascertaining whether or not The Work as performed and the materials used are in accordance with the Specifications and Contract. If the Engineer requires it, the Contractor shall remove or uncover such portions of the finished Work as may be directed. After examination, the Contractor shall restore said portions of The Work to the standard required by the Specifications. Should work thus exposed or examined prove acceptable, the uncovering, or removing, and the replacing of the covering and making good of the parts removed will be paid for as Extra Work but should the work so exposed or examined prove unacceptable, the uncovering and removing, asid the replacing of the covering and making good of the parts removed, shall be done at the Contractor’s expense.

a. Inspection Always Required: No work shall be done nor materials used without suitable supervision and inspection by the Engineer or his representative. Failure to reject defective work or material shall not prevent later rejection when the defect is discovered, nor shall it oblige the Engineer to accept the defective work.

* * * * * * *

5.09. REMOVAL OF DEFECTIVE AND UNAUTHORIZED WORK:

a. Work Rejected or Done Outside Lines: All work which has been rejected shall be remedied or removed and acceptably replaced by the Contractor, and no payment will be made for the removal and replacement. Work done outside the lines and grades given or shown on the Plans, unless it is authorized by the Engineer, and all Extra Work done without written authority will be considered unauthorized and done at the expense of the Contractor, and no payment will be made for it. Woi'lc so done may be ordered removed at the Contractor's expense. *******

c. Failure to Comply: Should the Contractor fail to comply promptly with any order made by the Engineer as above provided, the Engineer shall have authority to cause the defective work to he remedied or removed and replaced, and the unauthorized work to he removed; and to deduct the cost of any such remedy, removal or replacement from any monies due or to become due to the Contractor. If no such monies are available, the amount will he charged against the Contractor’s Surety.

$ $ # j(: >jc $

5.13. FINAL CONSTRUCTION INSPECTION: Whenever the Engineer considers The Work provided by the Contract is nearing completion, or within 10 days after he is notified by the Contractor that The Work is completed, the Engineer will inspect The Work. If the Engineer finds that it has not all been satisfactorily completed when it is inspected, he shall advise the Contractor in writing as to the work to be done and the defects to be remedied to make The Work ready for Final Construction Inspection. After all the items of The Work required under the Contract, as modified by Work Orders or Supplemental Agreements have been satisfactorily completed, the Engineer shall make the Final Construction Inspection.

5.14. FINAL ACCEPTANCE: When, upon the completion of the Final Construction Inspection, The Work is found to conform to the Plans and all Specifications, Change Orders, Extra Work Orders and Supplemental Agreements, the Engineer will give the Contractor written notice of Final Acceptance and the Engineer’s representative assigned to The Work will notify the Engineer in writing that The Work has been completed and certify the amount of each item of work performed and the payments due the Contractor.

* * * * * '* *

9.07. PARTIAL PAYMENTS: Once each month the Engineer will make an approximate estimate, on the regular form of the Department, of the Fay Items complete in place and the value thereof according to the Contract unit prices.

a. Deductions: From the amount so determined, the Department will deduct and withhold 10 per cent, and these deductions will be continued until the value of the work done is equal to or more than one half the estimated value of all The Work to be done under the Contract, and the amounts so deducted will be retained by the Department until all of The Work has been finally accepted. The entire amount so withheld, which will then be at least 5 percent of the estimated value of all The Work to be done, will be retained by the Department until all of The Work has been finally accepted. If 'the progress of the work is satisfactory, the deductions thus far made (10 per cent of one half of the value of all The Work to be done), will be the last deductions made until all of The Work has been finally accepted, except those provided for in paragraphs d, e and f below.

h. Payment of Balance: The balance remaining after all deductions provided for in this Article have been made, will be paid to the Contractor.

* $ * * * $ ‡

f. Estimates Approximate: The estimates here provided for are approximate and are subject to correction in the final estimate and payment.

*******

9.08. ACCEPTANCE AND FINAL PAYMENT: Final acceptance is stipulated to mean written final acceptance by the State Highway Engineer, followed by final payment in accordance with the Engineer’s final statement. Whenever, in the opinion of 'the Engineer, the Contractor shall have completed The Work in an acceptable manner and in accordance with the terms of the Contract, he shall certify to the Treasurer of the State Highway Department in writing as to said completion, and shall further certify as to the entire amount of every class of work performed and as to the value thereof. The Treasurer, upon receipt of said certificate, shall in turn furnish the Contractor with the Standard Release Form to be executed la duplicate. Upon receipt of said release, properly executed, the Treasurer shall make final payment jointly to the Contractor and his Surety. The aforesaid certificate, release and final payment shall be evidence of the action of the Board and the Engineer by which the Contractor is bound according to the .terms of the Contract; all prior certificates, releases, or estimates upon which payments may have been made being merely partial estimates and subject to correction in the final payment.

[Emphasis supplied.]

In accordance with the standard specifications, the State highway-engineer made during the taxable years monthly estimates of the value of pay items complete in place according to the contract unit prices with respect to work in progress under highway department contracts, including its contracts with petitioner. The highway department made partial payments under its contracts with petitioner during the taxable years based upon the highway engineer’s monthly estimates and retained 10 percent of each such partial payment until the contract involved became 50-percent completed, after which all subsequent partial payments under the contract were made without re-tainage of any additional amounts. With each succeeding partial payment after a contract became 50-percent completed the percentage comprising the ratio of the retainage to the total price of the completed work under the prime contract declined so that when the petitioner’s contracts became 100-percent completed the retainage withheld by the highway department constituted only 5 percent of the total prime-contract price.

During the years 'in issue, petitioner entered into both oral and written contracts with its subcontractors. The oral subcontracts resulted primarily from the fact that petitioner continued to obtain prices for the subcontracted work until an hour or so before its bid for the prime contract was submitted. Some of the oral contracts were confirmed by letter or were reduced to writing and signed by the parties. The terms of the various contracts were not uniform. In general, however, the subcontractors agreed to perform specific portions of the prime contracts in accordance with the plans and specifications of the highway department. Partial payments were to be made to the subcontractors based upon the pay items in place, as determined by the highway engineers’ monthly estimates of satisfactorily completed work on the prime contract, which were attributable to the individual subcontractors. It was understood that a retainage would be withheld from the partial payments in the same proportion as the retainage withheld by the highway department from petitioner on the prime contract. Final payment for completed work was to be made when petitioner received payment of the retainage withheld by the highway department for such work.

In a standard-form written contract sometimes nsed by petitioner, tbe petitioner was expressly given tbe right in tbe event of breach by a subcontractor to set off the retainage withheld from partial payments to the subcontractor against the cost of completing the subcontract work.

In practice, petitioner made partial payments to the subcontractor promptly after receiving partial payment from the highway department on the prime contract. Eetainages on all the subcontracts were withheld but were in some cases paid over to subcontractors before petitioner received final payment from the highway department. The subcontractors sometimes assigned to others their rights to receive the retainages withheld by petitioner. In such case, petitioner was notified so that direct payment could be made by it to the assignees. Petitioner has never had any work performed by a subcontractor which, having been approved for partial payment on an engineer’s monthly estimate, subsequently failed to pass final inspection. On one prime contract, petitioner was required to pay a penalty of $1,400 because it required 7 more days to complete the contract than specified. No reductions were made by petitioner in its final payments to subcontractors as a result of the penalty.

Prime contractors, including petitioner, were during the taxable years required to file written application for and obtain approval from the highway department before employing each subcontractor to perform work required under a highway department contract, and the highway engineer’s monthly estimates were available to subcontractors. For the ones able to do so, petitioner required its subcontractors to supply a 100-percent performance bond.

During the taxable years in issue and during all taxable years prior thereto, petitioner accrued on its books and deducted on its Federal income tax returns the amounts withheld from subcontractors for work performed by them, the payment of which was delayed pending receipt by petitioner from the highway department of retainage relating to such work. The balances of such accrued amounts at the end of each of the taxable years ended March 31,1953, through March 31, 1963, were as follows:

Aa of Mar. SI— Accrues amount

1953 - ¹ $2, 871. 05

1954_ None accrued

1955 _ 6,226. 37

1956 _ 3,859. 77

1957 _ ¹34, 717. 74

1958 _ 45,062.40

As of Mar. SI— Accrues amount

1959 _ $87, 562.73

1960 - 101,869.35

1961_ 126, 813.49

1962 _ ²197,663.66

1963 _ 348, 535. 66

Petitioner’s gross receipts, cost of goods sold, and subcontract expense, which was shown as a part of cost of sales, were reported on its Federal income tax returns for the fiscal years ended March 31,1961 and 1962, as follows:

1961 1962

Gross receipts_$2,917, 976.74 $4,394,363. 59

Cost of goods sold_ 2, 710,417. 74 4,292, 735.49

Subcontract expense_ 1,357,324. 86 1, 852, 540.62

Petitioner does not report as income on its Federal income tax returns amounts withheld from it by the highway department as re-tainage until the work to which such retainage relates has been completed and finally inspected and approved by the highway department.

About 30 to 40 percent of the retainage withheld by the highway department is equal in amount to the retainage withheld by petitioner from its subcontractors.

The balance of $101,869.35 subcontractors’ retainage as of April 1, 1960, represents subcontractors’ retainage accrued and unpaid by petitioner as of that date pending final inspection and final approval by the highway department but deducted by petitioner on its Federal income tax returns during taxable years prior to such date.

In the statutory notice of deficiency the respondent determined that the increases in the “subcontractors’ retainage” account in the taxable years ended March 31, 1961, and March 31, 1962, in the amounts of $24,944.14 and $70,850.37 were not allowable deductions and increased the petitioner’s income accordingly. In addition, he included the $101,869.35 balance in the “subcontractors’ retainage” account as of April 1, 1960, in petitioner’s taxable income for the taxable year ended March 31, 1961, as an adjustment under section 481. A 3-year allocation of the adjustment in determining its tax effect was made under section 481(b) (1).

OPINION

Our decision requires a determination of the proper time, under petitioner’s accrual method of accounting, for the deduction of a business expense which is concededly ordinary and necessary. Both parties agree that this determination ultimately depends upon a proper application of the “all events” test established in United States v. Anderson, 269 U.S. 422 (1926) ,³ and incorporated into section 1.461-1 (a) (2), Income Tax Begs.⁴

Petitioner argues that its liability to compensate its contractors in full, notwithstanding the retainages withheld from payments to them, for work which they satisfactorily performed was fixed, and determinable in amount with reasonable accuracy, at the time the subcontractors’ work was approved in the highway engineers’ monthly estimates. To the contrary, respondent contends that petitioner was not legally obligated to pay the retainage to the subcontractors until the prime contract was completed, finally inspected, and finally approved and petitioner had received the retainage withheld by the highway department.

The liabilities between petitioner and the highway department on the prime contracts were carefully and uniformly stated according to the “Standard Specifications.” Under these contracts petitioner was entitled to partial payments measured by the engineers’ monthly estimates of the value of pay items complete in place less a 10-percent retainage (which was subject to suspension after the contracts were 50-percent completed). It had no right to additional payment until final inspection and acceptance of the entire work under the contract and then only if the cost of removal of defective or unauthorized work did not exceed the total retainage. In such case we have no doubt that “all events” fixing the liability of the highway department to pay over to petitioner some portion of the retainage had not occurred until the time of the final accounting. Petitioner delayed accrual of these retainages as income until such time, a practice which respondent has not questioned in this proceeding.

Petitioner’s agreements with its subcontractors were both oral and written and were not uniform in their provisions. Under all, however, petitioner withheld retainage from partial payments to the subcontractors in the same proportion as the retainage withheld by the highway department. In addition, it was clearly understood that all work under the subcontracts would be performed in accordance with the specifications and plans as set out in the prime contracts. In the standard-form written subcontract sometimes used, petitioner was given the same rights with respect to satisfaction of claims out of the retainage as the highway department was given in the prime contracts. We conclude that petitioner possessed similar rights under all its subcontracts through an express understanding or an implied condition.

It appears from this record that petitioner generally completed its work under the prime contracts efficiently and according to specifications. Only one instance was alluded to in which petitioner was required to pay a penalty on a prime contract. We do not draw from the fact that petitioner did not reduce its final payment to any subcontractor in this instance, the conclusion that it could not ¡have done so had the delay in performance been occasioned by a subcontractor or that it would not have the legal right to do so in future instances.

Section 446 (b) gives respondent the broad discretion to compute taxable income under a method of accounting which, in his opinion, clearly reflects income. See Lucas v. American Code Co., 280 U.S. 445 (1930). We cannot say that respondent has abused Ms discretion when, on this record, we discern no significant differences in the terms of payment under the prime contracts 'and the subcontracts sufficient to justify petitioner’s inconsistent treatment of retainages provided for under the two types of contracts. The consequence of the exclusion from income on the one hand and the inclusion of an expense on the other was a distortion of petitioner’s annual profits. See and compare Wright Contracting Co., 36 T.C. 620 (1961), affd. 316 F. 2d 249 (C.A. 5, 1963), certiorari denied 375 U.S. 879; Ohmer Register Co. v. Commissioner, 131 F. 2d 682 (C.A. 6, 1942).

At the time of the partial payments to its subcontractors, all events had not occurred which rendered petitioner’s obligation to pay some amount of the retainage to them fixed and certain. Peoples Bank & Trust Co., 50 T.C. 750 (1968); Oberman Manufacturing Co., 47 T.C. 471 (1967). We hold that petitioner improperly accrued the retainage as an expense at that time.

Our holding on the first issue raises the additional question whether respondent made a proper adjustment under section 481. The prerequisite to the application of section 481 is a finding that there has been a change in a “method of accounting.” ⁵ For the purposes of this section, as well as for the complementary provisions of section 446, “method of accounting” means the consistent treatment of a recurring, material item, whether that treatment be correct or incorrect. Peoples Bank & Trust Co., supra; Dearborn Gage Co., 48 T.C. 190 (1967) ; Oberman Manufacturing Co., supra; Hulond R. Ryan, 42 T.C. 386 (1964); Fruehauf Trailer Co., 42 T.C. 83 (1964), affd. 356 F. 2d 975 (C.A. 6, 1966), certiorari denied 385 U.S. 822.

The retainage 'herein was a recurring item which was consistently accrued by petitioner as an expense in the year withheld from payments made to subcontractors. During the years in issue the retainage balance averaged approximately $150,000 with a yearly increment of about $50,000. Clearly the retainage constituted a material item. We find that the change in the treatment of retainage initiated by respondent was a change in petitioner’s “method of accounting.”

A total retainage of $101,869.35 was improperly accrued and deducted by petitioner in years barred by the statute of limitations (petitioner’s taxable year ended March 31, 1960, and years prior thereto). Under its new method of accounting, this entire amount will be properly accruable in years 1961 and thereafter upon final inspection and acceptance of the prime contracts. Section 481 was enacted for the express purpose of allowing in the year of change an adjustment of just such an amount, whether that amount relates to gross income or deduction, “in order to prevent amounts from 'being duplicated or omitted.” Dearborn Gage Co., supra; S. Rept. No. 1622, to accompany H.R. 8300 (Pub. L. No. 591), 83d Cong., 2d Sess., p. 307.

Since respondent initiated the change in petitioner’s method of accounting, no adjustment may be made for the balance of improperly accrued expenses ($2,871.05) existing in years prior to 1954. Sec. 481(a) (2); see Peoples Bank & Trust Co., supra; Oberman Manufacturing Co., supra; Fruehauf Trailer Co., supra. Therefore, we hold that respondent’s adjustment under section 481 was proper to the extent of $98,998.30.

Reviewed by the Court.

Decision will be entered under Bule 50.

1 All section references herein are to the Internal Revenue Code of 1954 unless otherwise Indicated.

2 Specific contracts between the highway department and petitioner in effect during the taxable years were not placed in evidence, apparently because of their bulk.

1 Includes additional estimated amounts payable to subcontractors not related to retainage receivable from tbe highway department.

2 In the computation attached to the notice of deficiency respondent used the figure $197,663.86 as the “Balance in ‘Subcontractors’ retainage’ account on March 81, 1962.”

3 “In advance of the assessment of a tax, all the events may occur which fix the amount of the tax and determine the liability of the taxpayer to pay it.” (p, 441)

4 Sec. 1.461-1 General rule for taxable year of deduction.

(a) General rule — * * *

(2) Taxpayer using an accrual method. Under an accrual method of accounting, an expense is deductible for the taxable year in which all the events have occurred which determine the fact of the liability and the amount thereof can be determined with reasonable accuracy. However, any expenditure which results in the creation of an asset having a useful life which extends substantially beyond the close of the taxable year may not be deductible, or may be deductible only in part, for the taxable year in which incurred. While no accrual shall be made in any case in which all of the events have not occurred which fix the liability, the fact that the exact amount of the liability which has been incurred cannot be determined will not prevent the accrual within the taxable year of such part thereof as can be computed with reasonable accuracy. * * *

5 SEC. 481. ADJUSTMENTS REQUIRED BY CHANGES IN METHOD OF ACCOUNTING.

(a) Genekai, Rum. — In computing the taxpayer’s taxable income for any taxable year (referred to in this section as the “year of the change”)—

(1) if such computation is under a method of accounting different from the method under which the taxpayer’s taxable income for the preceding taxable year was computed, then

(2) there shall be taken into account those adjustments which are determined to be necessary solely by reason of the change in order to prevent amounts from being duplicated or omitted, except there shall not be taken into account any adjustment in respect of any taxable year to which this section does not apply unless the adjustment is attributable to a change in the method of accounting initiated by the taxpayer.