Cleveland Trinidad Paving Co. v. Commissioner

*772 These proceedings, which were consolidated for hearing and decision, were brought to redetermine the following deficiencies in income taxes:

The issue in the proceedings is whether certain amounts retained by municipalities as a maintenance guarantee on streets payed by the Cleveland Trinidad Paving Co. constituted income in the year in which the paving was completed or in the year in which the retained amounts were released by the municipalities and received*2039 by the Paving Co. The facts were stipulated. By agreement of counsel the proceedings were consolidated for the sole purpose of allocating to the Contractors Construction & Supply Co. the proper portion of the tax as redetermined by the Board.

FINDINGS OF FACT.

The petitioners are Ohio corporations with their principal office and place of business at Cleveland.

The books of the Cleveland Trinidad Paving Co. (Ohio), hereinafter referred to as the "Paving Co.," and its affiliated companies were kept on the accrual basis and the consolidated income-tax returns of the affiliated group for the years 1924 to 1927, inclusive, were made on the same basis.

During the taxable years the Paving Co. completed the paving of certain streets for the cities of Columbus, Ohio, New York, *773 N.Y., and Lakewood, Ohio, under contracts theretofore entered into with said cities, a separate contract having been made for each street.

Each of the contracts entered into with the municipalities contained the following provisions with reference to maintenance and the retention of funds for maintenance purposes:

Contracts with the city of Columbus.

24. Maintenance. All settlements, *2040 defects, or damages in any portion of the pavement or any derangement in the alignment and grades of the curbing, before the expiration of five years for all wearing surfaces, except macadam, and two years for macadam shall be repaired and made good at the Contractor's expense and within thirty days after notice has been given by the Chief Engineer, and all rubbish which may accumulate during and by reason of the work herein provided for, shall be removed by the Contractor, and the street left clean and in good condition but the bond for the performance of contract shall not be held to cover the above guaranty.

25. Retention. There shall be retained out of the moneys payable to the Contractor ten per centum of the amount of the contract, the same to be expended in the manner hereinafter provided in making such repairs on the line of the street as the Engineer may deem necessary. Upon the expiration of the said maintenance period provided, the said pavement shall at that time be in good order, the contractor, upon the production of a certificate from the Chief Engineer, stating that the street is in good condition, shall receive the whole, or such part of the sum last aforesaid, *2041 as may remain after the expense of making said repairs in the manner aforesaid, shall have been paid therefrom.

Contracts with the city of New York.

(CC) The Contractor will not be entitled to demand or receive payment for any portion of the work or materials unless the same shall be fully completed in the manner set forth in this contract and specification, and such completion shall be duly certified by the Engineer of the Bureau of Highways, and until each and every one of the stipulations hereinbefore mentioned are complied with, and the work completed to the satisfaction of the President, and accepted by him, and the final certificate of the completion and acceptance thereof signed by the Engineer and President, shall be filed with the Comptroller, whereupon The City will pay to the Contractor, by City warrant, on or before the expiration of thirty days from the time of the completion of the work and the filing in the office of the Comptroller of said final certificate, all of the moneys accruing to the Contractor hereunder for the work done within the railroad franchise area and ninety (90) per cent. of the moneys accruing to the Contractor under this contract for work done*2042 outside of the railroad franchise area, and the balance of the moneys that may be due to the Contractor under this agreement, as follows: One (1) per cent. of the whole cost of the work on the expiration of the second (2d) year after the date of the final acceptance of the whole work, and a further sum of one (1) per cent. at the expiration of the third (3d) year, and three (3) per cent. at the end of the fourth (4th) year, and five (5) per cent. at the end of the fifth (5th) year, deducting, however, from each of said payments all sums that the City shall have expended in performance of any of the work stipulated under this agreement which the Contractor shall have failed to perform. Within thirty (30) days after the expiration of the said five (5) years, provided the pavement shall at that time be in good condition, and providing any defects which may develop shall have been remedied. *774 The City, upon the filing of the certificate of the Engineer, as by law provided, that the terms of the contract have been complied with, will pay to the Contractor the whole of the sum retained, or such part thereof as may remain after the expenses of making repairs in the manner aforesaid*2043 shall have been paid therefrom.

But the bond executed by the Contractor and sureties to insure the performance of the contract shall remain in full force and effect until the President shall have been reimbursed for the total expense of any and all repairs which have been made by The City, as herein provided.

During the said period of five (5) years, the Contractor expressly guarantees the sheet asphalt pavement against all defects, likewise the improved granite block pavement for a period of one (1) year, such guarantee so secured by the retention of the said ten (10) per cent. to be separate and distinct guarantee from the guarantee of such pavements, secured by the bond executed by the Contractor and sureties.

Contracts with the city of Lakewood.

39. Upon the satisfactory completion and acceptance of the work, and at the time the final esimate is paid, City shall retain the sum of 5 per cent. of the total cost of the work, as a guarantee that the workmanship and material furnished under these specifications, and used in said pavement, are in all respects, first class and of such a kind and quality, that for a period of five (5) years from and after the completion and*2044 final acceptance thereof, by the City, the said pavement should require no repairs, the necessity for which shall be occasioned by the defects of said workmanship or materials.

If, however, during the said period, in the opinion of the Director of Public Works, the said pavement shall require repairs, and the necessity for such repairs shall, in his opinion, be occasioned by settlement of foundation, defective workmanship, or materials furnished in the construction of said pavement, then such repairs, on ten (10) days' notice being given at any time during the guarantee period, by the Director of Public Works to the Contractor, shall promptly be made by and at the expense of the Contractor as follows:

Upon notice from the Director of Public Works, served at any time during the period of guarantee, the Contractor shall at his own expense take out and remove all soft, inferior or defective materials found in either the base, pavement, curbing, gutters, sidewalk, or catch-basins constructed by him and good and acceptable materials shall be substituted therefor, including any pavement or material that has become injured or has settled out of place by reason of its being in close proximity*2045 to any such soft or imperfect material. The Contractor shall take up and relay or reset all pavement, or curbing, that has settled out of place or become uneven and will repair all work done by him if found defective during the term of the guaranty.

The sum of money retained as guaranty shall be subject to the order of the City in the event of the Contractor's failure to make repairs or other work herein required under the terms of the guaranty and until said guaranty has been released by the City, the said sum may at any time be drawn upon by the City and the Contractor hereby agrees that he shall have no cause for action by reason of said draft upon the guaranty fund.

In case the Contractor shall make all repairs as ordered by the Engineer and shall leave said improvement in good and sound condition, at the expiration of said guaranty, to the acceptance of the Engineer and the Director of Public Works, then at the expiration of said term of Guaranty said amount together with all accrued interest and dividends thereon, if not withdrawn, less *775 any expense which the City may have incurred in connection herewith shall be returned to said Contractor as full payment of*2046 any balance due on said contract.

Upon completion of the paving of each street under the contracts the Paving Co. received 90 per cent of the contract price from the cities of Columbus and New York and 95 per cent from the City of Lakewood, which amounts the Paving Co. accrued on its books and returned as taxable income in the year in which the paving for the particular street was completed. The following remaining amounts due under the contracts were retained by the municipalities, pursuant to the terms of the agreements:

No part of the amount retained by the cities of Columbus and Lakewood was received by the Paving Co. during the year 1924 to 1927, inclusive. No expenditures were made or incurred during such years for the repair of streets paved for the cities of Columbus and New York. The respondent included the amounts withheld by the municipalities under the contracts in the consolidated taxable income of the petitioners for the respective years in which the sums*2047 were retained.

During the taxable years the Paving Co. received or acquired the right to receive the following amounts retained by the cities in prior years under contracts similar to those referred to above:

No other amounts were received in any of the taxable years under similar contracts. The amounts set forth in the above tabulation were included in the consolidated incomes returned by the petitioners for the respective years and were excluded therefrom by the respondent.

OPINION.

ARUNDELL: The respondent contends that the decision in this case should be controlled by our earlier decisions in other paving contract cases. See ; ; . In those cases, as in this, there were contracts which required the taxpayer to maintain *776 the paving for a period of years. In the Consolidated Asphalt and Uvalde cases the*2048 full contract price was paid to the contractors in cash or receivables upon completion of the paving and the contractors set up reserves to provide for the estimated cost of maintenance of the paving over the guarantee period. We sustained the respondent's disallowance of claimed deductions in the amounts of the reserves and said in the Consolidated Asphalt case:

* * * When a taxable corporation in the course of its business of making profits receives contractual compensation for work done and material furnished, it can not contend that a part of the amount received is not income because the taxpayer is subject to a collateral obligation the fulfillment of which may require it to spend some of the amount. * * * this result is not changed because in the light of general experience the taxpayer feels reasonably certain of the necessity to expend the amount and is impelled by business prudence to set up a reserve therefor.

We quoted the above language in the Uvalde Co. decision and added:

* * * We can not find in the revenue law any authority for deducting from income in any taxable year sums as expenses, neither paid nor incurred within the year.

In the Mead*2049 Construction case the paving contracts provided for the deposit of bonds by the contractor to guarantee maintenance of the pavement and did not, as in this case, provide for withholding any part of the contract price. In practice a short cut was taken and instead of paying over the contract price and receiving back a guarantee fund, the city in some instances withheld a part of the amount owing to the contractor who set up a reserve equal to the amount withheld and claimed a deduction therefor. In the opinion in that case we said:

If, in the present appeal, the contractor in fact received the contract price and in fact transferred cash or bonds to the city for deposit as required, the contract price would have been income notwithstanding the deposit or pledge for proper maintenance. But the procedure was simplified, and the city retained the deposit fund in the first instance. The fact that it did so with the heavy hand of its municipal power does not change the taxpayer's contractual right to the full compensation and its obligation to make deposit.

In each of the above mentioned paving cases the question presented was primarily that of whether a deduction from income*2050 was allowable by reason of the taxapyer's obligation to keep the paving in repair for a period of years. The claimed deductions were disallowed because the estimated expenses were neither paid nor incurred within the taxable year. We also held in each of those cases that the entire contract price was in the first instance income to the taxpayer. In the Consolidated Asphalt case, where the taxpayer's accounts were kept on the cash basis, the taxpayer actually received the entire sum. In the Uvalde and Mead Construction cases, in which the taxpayers *777 kept their accounts on the accrual basis, the taxpayers had the contractual right to full compensation without deduction for any contingent maintenance costs and it was held that the entire contract price should be accrued as income. The present case presents solely a question of income and does not involve deductions. While the contracts here involved named a contract price for the several paving jobs, petitioners did not have the unqualified right to receive the full amount of such contract price upon completion of the work, as the contracts specifically provided that a portion was to be retained by the several*2051 municipalities as a guarantee fund for a specified period of time. The taxpayer had no unqualified contractual right in the taxable years to demand or receive the amounts withheld pursuant to the contracts. It did not know, and had no way of determining, what portion of the amounts withheld it would ultimately receive. The city governments might have found it necessary to spend the entire sum for maintenance and left nothing for the contractor. In the city of Lakewood contracts the taxpayer specifically waived any cause of action against the city by reason of expenditures from the guarantee fund.

In , where the taxpayer, keeping its accounts on an accrual basis, did not accrue as income interest due and owing to it by debtor corporations which were continually operating at a deficit and the evidence indicated that the interest never could be collected, we held that the respondent erred in adding such interest to income and said in part:

Where books are kept on the accrual basis there is no requirement that there shall be accrued as income that which may never be received. The position of the respondent in this case carried*2052 to its logical conclusion would require a taxpayer keeping its books of account upon the accrual basis to accrue as income interest on the bonds held as an investment which it did not collect and which in all probability it never would collect. It the theory of the respondent is correct an insolvent corporation keeping its books of account upon the accrual basis might merely by the purchase of bonds of insolvent corporations upon which interest was neither being earned or paid, easily show a large income.

In , the taxpayer reported as accrued income in 1916 the profit on a sale of land which it contracted to sell in 1916 but the completed transfer of which was not made until early in 1917. The Supreme Court held that the profit was not to be accounted for as 1916 income and said:

An executory contract of sale was created by the option and notice, December 30, 1916. In the notice the purchaser declared itself ready to close the transaction and pay the purchase price "as soon as the papers were prepared." Respondent did not prepare the papers necessary to effect the transfer or make tender of title or possession*2053 or demand the purchase price in 1916. The title and right of possession remained in it until the transaction was closed. Consequently *778 unconditional liability of vendee for the purchase price was not created in that year.

In , the question was whether renewal commissions on policies of insurance written by the taxpayer prior to March 1, 1913, were taxable income when received by him after the date. The court held the commissions taxable, saying:

No doubt they [commissions] were earned by work done and money spent in the earlier years; the agent's work was complete when he obtained the application and the society issued the policy; his right to commissions on future renewals came then into being, and he himself was required to do no more. * * * Although the right had value, it lacked an essential element; no renewal premium might ever be paid, and in that event he would receive nothing more; or renewals might be paid only in part, and then he would be entitled to commission on that part only. * * * The right, therefore, was contingent; his contracts so provided, for they declared that commission should*2054 accrue only as premiums should be paid in cash, and certainly until such payment should be made he had no collectible claim against the society. He had a property right that had value, but contained also an element of risk, and unless he turned it into money it remained contingent. The act taxes money, or its equivalent, or its representative, and a contingent right such as this is not "income" in the sense used by the act.

These decisions establish the principle that a taxpayer on the accrual basis is not required to include in income sums to be received in the future where there is a substantial contingency as to the amount to be received or the time of its receipt. In our opinion the resent case falls within that principle, as during the time the funds were withheld petitioner's right to receive any part of them was entirely contingent. Until the expiration of the guarantee period there was, as said in the North Texas Lumber case, no unconditional liability on the part of the cities to pay any part of the guarantee funds.

Decision will be entered until Rule 50.