National Adjusting Asso. v. Commissioner

*315 This is a proceeding for the redetermination of an asserted deficiency in income tax for the year 1927 in the amount of $6,231.90.

The petition alleges the following assignments of error:

(a) Respondent does not recognize petitioner's full liability to clients.

(b) Respondent refuses to accept petitioner's detailed list of liabilities to clients.

(c) Respondent substitutes a percentage method of his own, the basis for which is erroneous.

This proceeding was submitted upon the pleadings, a stipulation of facts read into the record, and testimony, from which we make the following findings of fact.

FINDINGS OF FACT.

Petitioner is a corporation, organized May 7, 1918, under the laws of the State of Illinois, and is engaged in the business of operating a collection agency, the principal office of which is at 173 West Madison Street, Chicago, Illinois.

The contracts of petitioner with its clients are in printed form, which has been substantially the same over a period of years. The contracts of petitioner with each client provide, in*970 substance, that in consideration of the services to be rendered by the petitioner, the client assigns the therein listed claims to the petitioner and appoints it attorney in fact for the collection thereof with full power and authority to settle the same; that the client "will not be required to pay * * * any commissions on any claims unless collection is made"; that the petitioner is to receive out of collections made the following fees: A docket fee of 50 cents for office filing, plus commissions upon the accounts collected as follows: For the first $100, 50 percent; for all above $100, 10 percent; for all amounts collected on outlawed claims, or by partial payments, 50 percent; for claims placed in the hands of its attorney for collection, 50 percent; that the specified commissions are payable to the petitioner regardless of whether payments on the claims are made to petitioner or to the client directly; and that if payments on the listed claims are made to the client, the commission on such payments shall be remitted immediately to the petitioner.

Petitioner maintains statistical records consisting of large "master" cards on which are entered as soon as received lists of the*971 claims sent to it for collection. As collections are made by petitioner for its clients, a record of the collections are entered on the cards. As petitioner receives reports from clients of payments received by clients from debtors directly, such information is recorded on the cards. On the cards are also recorded the commissions to which *316 the petitioner is entitled and the amounts sent to clients in settlement of accounts.

Petitioner maintains a double-entry bookkeeping system and its transactions relating to collections for its clients and disbursements to its clients of the collections made less commissions due from the clients under the contracts are recorded on its books in the following manner: Collections received on behalf of clients are credited to an account designated "Contracts" and debited to "Cash." When settlements are made with clients, "Cash" is credited with the amount paid to clients, and the same amount is debited to "Contracts." Settlements are made with clients only when petitioner has received from the clients a statement of the amounts collected directly by the clients. However, some of the clients do not notify the petitioner promptly of payments*972 received from debtors. At the end of each year there is a credit balance in the contracts account, a portion of which represents income while the remainder belongs to clients. In order to reflect in its income tax return that portion of the amount of the credit balance in the contracts account to which petitioner is entitled, the petitioner has for many years (including the year before us) estimated the portion of the credit balance in the contracts account which represents income. The difference between such estimated income and the credit balance in the contracts account represents estimated liabilities to petitioner's clients.

The petitioner's estimate of income is a percentage of the year's collections determined shortly after the close of each calendar year by petitioner's accountants for the purpose of preparing a timely income tax return. The percentages, as estimated for the years 1924 to 1927, inclusive, are 71.48, 75, 75, and 70 percent, respectively. Commencing with the year 1924 and every year thereafter, a certified public accountant caused to be made a so-called "physical inventory" of the petitioner's liability to its clients. This embraced an examination of*973 the individual master cards; the amounts collected by the petitioner from the debtors of clients were reduced by commissions to which the petitioner is entitled thereon; and the balances on all the master cards, 50,000 to 75,000 in number, were then totaled. The grand total for each year was taken by the petitioner and its accountant to represent the so-called "actual liability" of petitioner to its clients. The amounts of the so-called "actual liability" of petitioner to its clients so computed, and the liabilities as estimated, are as follows:

*317 This system was arranged for some time in 1924, to take effect as of December 31, 1924, and has been continued to the present time.

The percentage estimated and used by petitioner at the end of 1924 to determine its liability to its clients was 28.32 percent, which figure was obtained from a compilation of figures, based upon the experience of two organizations, prepared by the president of petitioner after its*974 organization. At December 31, 1925, the so-called "physical inventory of liabilities" for 1924 having been completed, a comparison of the "estimated liability" and so-called "actual liability" for 1924 indicated to petitioner and its accountant that the 28.32 percent used for 1924 was too high; and it was therefore reduced to 25 percent for 1925. The same percentage was used for 1926. Upon a comparison of the so-called "actual liability" for 1926 and the 1926 "estimated liability", the petitioner concluded that 25 percent was too low and it was changed to 30 percent for 1927.

The respondent, upon audit of petitioner's returns, determined that its method of determining its earned commissions did not clearly reflect its taxable income. In recomputing the tax liability of the petitioner for the years 1924 to 1927, inclusive, the respondent, in order to determine the earned commissions, used an average percentage based upon the total collections and total remittances to clients, of the preceding five years. As the only year before us is the year 1927, we set forth only the method of the calculation made by respondent of the percentage used for 1927 as shown by the statement attached*975 to the notice of deficiency:

The same method was applied in preceding years and the following percentages were obtained and used to determine what portion of the annual collections represented earned commissions and what portion a liability to clients, as shown by the statement attached to the notice of deficiency.

*318

OPINION.

MCMAHON: The respondent, upon an audit of petitioner's returns covering a period of years, determined*976 that the petitioner's method of estimating earned commissions failed to reflect the commissions to which petitioner was entitled on payments made by debtors to clients, particularly in view of the fact that petitioner retained collections made by it until clients reported on payments received from debtors. The respondent, therefore, pursuant to section 212(b) of the Revenue Act of 1926, ¹ recomputed the earned commissions by using an average percentage based upon total collections and remittances for a period of five preceding years.

*977 The petitioner contends that the total of collections received by it in each year, in excess of its commissions thereon, is a liability and remains a liability until settlement is made, or until the expiration of the statute of limitations; and that, therefore, no part thereof, until settlement or expiration of the statutory period, can possibly be included in its gross income.

The practice of the petitioner of examining the master cards did not aid in determining the commissions to which petitioner was entitled on both collections made by it and on all payments made by debtors to clients. While payments made by debtors to clients were entered on the cards, such payments and the commissions thereon were entered only if and when the clients reported such payments to the petitioner. Hence, the cards did not disclose the commissions on unreported payments to clients to which the petitioner was entitled. The practice of checking up the master cards, therefore, does not disclose the actual amount of commissions to which petitioner is entitled under its contracts because it fails to disclose the commissions to which the petitioner is entitled on unreported payments made to clients, *978 and discloses merely (1) the commissions *319 to which it is entitled on collections made by it, and (2) commissions to which it is entitled on reported payments made by debtors to clients.

The petitioner does not make settlements with its clients until the amount of its offsetting claims against the clients for commissions on payments made by debtors to clients has been ascertained. Hence collections made by petitioner, less its commission thereon, which ordinarily would be due and payable to clients, are retained by the petitioner until clients make reports of payments received.

The earned commission reported by petitioner on its return was estimated by using the following percentages for 1924 to 1927, inclusive: 71.48, 75, 75, and 70 percent, respectively, while the respondent used the following percentages: 84.373, 85.493, 86.519, and 85.313 percent, respectively. There is no evidence to show how, or the method by which, the percentages used by the petitioner were determined or arrived at, except that the first percentage used was based on some figures submitted by petitioner's president and that changes in the percentages were made when the annual check up of the*979 master cards indicated to petitioner that a change should be made. On the other hand, the percentages used by respondent are based upon the total collections from debtors of clients and remittances from petitioner to clients over a period of five years. They are based on known and actual figures resulting from petitioner's own business experience covering a period of five years.

The petitioner adduced no evidence pertaining to the collections ordinarily due clients which petitioner retained each year awaiting reports from clients as to payments received by them. There is no evidence as to the amounts of collections so retained by petitioner, if any, which were never remitted to clients. There is no evidence as to the amount of commissions earned each year by the petitioner on collections made by it, or the amount of commissions earned each year on reported payments made by the debtors directly to clients, both of which were ascertainable from its own records.

The petitioner contends that the entire amount collected by it in excess of its commission thereon is a liability and remains a liability until settlement is made or until the expiration of the statutory period of limitations. *980 No doubt there were some clients who failed to make reports to petitioner and as to these, according to petitioner's practice, no settlements have been made. Hence, some of these retained collections were probably never remitted to clients. The petitioner has been in existence since 1918. In the meantime claims of clients for collections retained by petitioner have probably been outlawed, but there is no evidence that petitioner included such items in income at any time.

The petitioner contends that the respondent's method is inconsistent and erroneous because, while he based his computation of the petitioner's *320 liability to its clients on the amount of $109,620.07, the amount which petitioner estimated to be due to its clients as of December 31, 1923, he assumes that there is no further liability to clients for each succeeding year. The petitioner is in error in this respect. The respondent in determining the amount due to clients as of December 31 each year recognized the fact that petitioner is continually incurring and reducing its liability to its clients. Commencing with the amount of $109,620.07, as the amount of liabilities due clients as of January 1, 1924, he*981 deducted each year the amount remitted to clients and added each year the difference between the amount collected and the amount determined to be earned commissions, or 15.627 percent of the collections in 1924, 14.507 percent of collections in 1925, 13.481 percent of collections in 1926, and 14.687 percent of collections in 1927, with the result that at the end of 1927 the amount due to clients was estimated to be $68,252.64.

In our opinion the petitioner has failed to show that respondent's method of computation of petitioner's earned commissions is erroneous.

Furthermore, we are convinced, from the evidence presented, that the method of accounting employed by the petitioner and its method of estimating its earned commissions do not clearly reflect its annual income. We must, therefore, approve the respondent's determination.

Decision will be entered for the respondent.