Bell Electric Co. v. Commissioner

*159 The Commissioner determined the following deficiencies in the income tax of petitioners:

*17 Several of the matters raised by the pleadings in these cases have been settled and will be disposed of under Rule 50. The principal remaining question is whether a seller of appliances may exclude from income or defer recognition of income as to a portion of the sales price received for an item which is allocable to the services which the seller may be required to perform in the future under a product warranty. Also at issue are the useful lives of several assets owned by Bell Electric Co., and the exclusion from income by the individual petitioners of the value of two trips which were awarded to them.

FINDINGS OF FACT

The stipulations of fact filed by the parties together with the exhibits attached thereto are incorporated herein by this reference.

Petitioner Bell Electric Co. is a corporation organized under the laws of the State of Florida on November 24, 1950, having its principal place of business in Fort Lauderdale, Fla. It maintains its books and filed Federal corporate income tax returns for the fiscal years ended November 30, 1958, November 30, 1959, November 30, 1960, and November 30, 1961, with the district director of internal revenue, Jacksonville, Fla., on an accrual*18 basis.

Petitioners Elmer P. Chaddock and Vera Jane Chaddock are husband and wife who, during the taxable years herein involved, resided in Fort Lauderdale, Fla., and filed joint Federal income tax returns on a cash basis for the calendar years 1959 and 1960 with the district director of internal revenue, Jacksonville, Fla.

Bell Air Conditioning Co. of Ft. Lauderdale is a corporation organized under the laws of the State of Florida in August 1958, having its principal place of business in Fort Lauderdale, Fla. It is an *160 elective small business corporation under the provisions of subchapter S of the Internal Revenue Code of 1954 and maintains its books and filed its U.S. Small Business Corporation Return of Income, Form 1120-S, for the fiscal years ended August 31, 1959, and August 31, 1960, with the district director of internal revenue, Jacksonville, Fla., on an accrual basis.

Bell Electric Co. (hereinafter sometimes referred to as Electric) had, during its taxable years herein involved, 50 shares of outstanding no-par-value capital stock; 40 shares of which were issued in the name of E. P. Chaddock, and 10 shares of which were issued in the name of V. J. Chaddock.

Bell *19 Air Conditioning Co. of Ft. Lauderdale (hereinafter sometimes referred to as Air Conditioning) had, during its taxable years herein involved, three shares of issued and outstanding capital stock. Two of those shares were issued to E. P. Chaddock, with the remaining share being issued in the name of V. J. Chaddock.

During their taxable years herein involved, Electric was engaged in the business of selling major household appliances at retail and service other than pursuant to manufacturers warranties, and Air Conditioning was engaged in the business of selling at retail room air conditioners and central air-conditioning equipment. Each was required to be a franchised dealer representative of the manufacturers whose products it sold.

The manufacturers of the appliances and air-conditioning equipment which Electric and Air Conditioning sell warrant their products to the ultimate retail purchasers thereof to the extent of 1-year free labor and material for repairing and servicing of defects, and also warrant any sealed refrigeration systems for an additional 4 years. Although the warranty is between the manufacturer and the retail purchaser, the terms of the franchise*20 agreements obligate Electric and Air Conditioning to perform the actual services necessary under the first year warranty. Such services are performed only upon demand by a customer. Failure on the part of a dealer to supply warranty service may result in cancellation of the franchise by the manufacturer.

Frigidaire Division of General Motors Corp. is one of the manufacturers with whom Electric has a franchise agreement. The wholesale distributor for Frigidaire products in the South Florida area is the Domestic Refrigeration Co., Inc. (Domestic), a Florida corporation. During the years involved herein, Domestic provided Electric with a suggested dealer price schedule which set forth the portion of the total sales price which was to be allocated to the requirements of the first year warranty. The amount which Domestic determined to *161 be applicable to the warranty on any particular appliance was arrived at by the use of both national and local averages.

Although Frigidaire was the only manufacturer which set forth the amount of the sales price allocable to the first year warranty, Electric, and apparently Air Conditioning, relied on that allocation in determining the amount*21 of the sales prices of other manufacturers' products which was to be allocated to the first year warranty.

The franchise agreement which Electric has with Frigidaire is typical of all such agreements which Electric and Air Conditioning have with the manufacturers whose products they sell. With regard to warranty service on items which have been removed from the dealer's service area or in the event of termination of the franchise, the agreement provides as follows:

2. If Dealer is unable to perform Dealer's in-warranty service obligations with respect to Frigidaire products which are removed from and installed outside Dealer's Service Area, unless Dealer and Distributor shall agree otherwise in writing for the performance of such in-warranty service, Dealer shall pay to Distributor, within ten (10) days after notice of removal of such Frigidaire products from Dealer's Service Area the unexpired portion of the amount of first-year warranty reserves applicable to such products and furnish Distributor with all needed information in connection with the sale, and in that event Dealer shall be relieved of the obligation of performing in-warranty service on such products, and Distributor*22 will arrange for the performance of such in-warranty service.

3. In the event of termination of this Agreement, Dealer and Distributor shall compute the then unexpired part of the one-year warranty period on such Frigidaire products for which Dealer is obligated to provide in-warranty service. Dealer shall then pay to Distributor any unexpired first-year warranty reserves which Dealer has received from others or which relate to Frigidaire products sold by Dealer, whereupon Dealer will be discharged from any further in-warranty service obligation and Distributor shall provide such in-warranty service.

Manufacturers are not concerned with the manner in which a dealer such as Electric or Air Conditioning treats the warranty reserve on its books, or whether such reserve is maintained on its books at all. They do not require that the warranty reserve be kept in a separate bank account, and no such account was maintained by either Electric or Air Conditioning.

In practice, at the time of the sale of an item by Electric or Air Conditioning the portion of the sales price deemed to be allocable to the first year warranty is credited to a warranty reserve account, with the remaining portion*23 of the sales price being credited to income. To certain purchasers of five or more of its appliances, Electric offers an extended service warranty agreement which is in addition to the first year warranty. This warranty covers all labor regardless of the parts or materials needed. Air Conditioning offers the same extended warranty agreement to certain purchasers of five or more air conditioners *162 and to purchasers of central air-conditioning systems. The agreement is entered into at the time of the sale of the equipment and the cost thereof is included in the total sales price. The amount paid for the extended warranty is credited to the warranty reserve account on Electric's or Air Conditioning's books at the time the sale is made.

Electric sells a preventive maintenance contract as part of its business of selling service apart from the manufacturers warranties. The agreements are entered into between Electric and purchasers of appliances from others and between Electric and purchasers of Electric's appliances on which there are no existing warranty obligations; such agreements cover only minor preventive maintenance. The general type of contract provides for regular*24 monthly payments which are credited at the time of receipt to an account entitled "Sales -- Service." As a further part of its business of selling service, Electric sells a full maintenance contract which is similar to the preventive maintenance contract except that it covers "full labor and parts." This contract is also sold on existing equipment which is not covered by an existing warranty obligation, and the payments under such agreement are handled in the same manner as those under the preventive maintenance contract.

In connection with the sale of an appliance by Electric and Air Conditioning, the amount of the sales price determined to represent either the first year warranty, the preventive maintenance warranty, or the full maintenance warranty, is set out on a permanent record copy of sales invoice at the time of the sale. Both corporations maintain daily sales journal sheets which contain a column designated "Warranty reserve" to which each of the warranty amounts is posted. The daily total of the warrantly reserve column in the sales journal sheet is posted to a monthly control sheet. The monthly totals are then posted to the warranty reserve account in the general ledger*25 and form the basis for the credits contained in that account.

During each of its taxable years herein involved, the following amounts were credited to Electric's warranty reserve account:

During each of its taxable years herein involved, the following amounts were credited to Air Conditioning's warranty reserve account:

*163 During the years herein involved, all work performed under Air Conditioning warranties was performed by Electric, inasmuch as Air Conditioning had no employees. The work was performed by Electric and was billed to Air Conditioning at the estimated cost of both labor and parts, if any.

In connection with the expenditure of either time or money in carrying out any of the various warranties, a work order is prepared by Electric which reflects the name and address of the customer, make, model, and serial number of the appliances to be repaired. After the needed repairs have been made, the servicing technician records on the work order the kind and value*26 of parts used, and the number of labor hours required to make the repairs. Each day's work orders are recorded on a daily warranty reserve expense sheet and the monthly totals of the warranty reserve expense sheet are charged against the warranty reserve accounts in the general ledger. The credit balance at the close of each fiscal year is carried forward as a continuing reserve for warranty repairs on those appliances which were sold in the prior year or years, and which are still covered by warranty obligations.

Those parts which are expended or used in connection with carrying out the first year warranty are exchanged directly with the manufacturer so that they are not carried through the warranty reserve expense account. On Electric's and Air Conditioning's own extended type warranty, parts are billed through the reserve account at cost. In both instances, labor is billed in the amount of $ 4 per hour, which is intended to represent the approximate cost thereof.

The balances in Electric's warranty reserve account as of the end of the years herein involved, were as follows:

*27 The balances in Air Conditioning's warranty reserve account as of the end of each of its taxable years herein involved, were as follows:

Electric's main store, located at 201-203 East Broward Boulevard, Fort Lauderdale, Fla., was opened on or about December 1, 1950. Until July 27, 1953, the property was occupied by Electric under three consecutive short-term leases. On July 27, 1953, Electric executed a lease with the lessor for a term of 5 years. The lease provided that --

It is understood and agreed that should leasee [sic] desire to extend this lease beyond the five year term it is required to start arrangeing [sic] for same six months prior to said expiration the amount or rental rate to be agreed upon at that time.

On June 10, 1958, Electric executed a new lease for this property at the same rental, for a period of 5 years ending August 1, 1963; it contained no option to renew. On or about August 1, 1963, a 3-year lease was executed for this property under which Electric was operating at the time of trial. On September 30, *28 1959, Electric expended $ 881.40 for light fixtures and $ 1,093.09 for wall cabinets which were used in this store.

As of February 1, 1959, Electric leased a store located in a shopping center on Pompano Beach, for a period of 5 years, with no provision for renewal. Upon expiration of the original lease Electric obtained a renewal thereof for an additional 5-year period at the same rent, by written letter agreement with the lessor. During 1959, Electric purchased the following assets for this store:

On or about July 20, 1958, Electric acquired a used 1957 Cadillac automobile from a customer who was unable to pay his account. The customer's account was credited in the amount of $ 3,500, which was the basis assigned to the car. The car was operated for more than 3 but less than 4 years by Electric, and during that time it required some major mechanical repairs. As of the date of acquisition, the car had a 3-year useful life to Electric, with an expected salvage value of $ 350.

On or about February*29 28, 1958, Electric purchased a "gas machine" for $ 921. A gas machine, a device also known as a charging board, is a board to which a motor-driven vacuum pump and mounted gages are attached, and which is used for evacuating and recharging sealed refrigeration systems on appliances serviced by Electric and Air Conditioning.

Except for the board, which is a piece of lumber on which the equipment is hung, most parts have been replaced at various times. However, *165 when a part was replaced it was charged off to expense immediately rather than capitalized. The gas machine had a 5-year life with a salvage value of $ 92.

During the years here involved, Electric expended the following amounts for the purchase of small tools:

Some of the tools purchased were to replace similar items that *30 had been expended through normal use, lost, or stolen. Others were purchased to equip new service teams and trucks. Electric treated these as capital assets on its books and tax returns, depreciating them over a 2-year period.

In the year 1959, the Chaddocks received and took a trip awarded by the Fedders Corp. to Rome, Italy. The cost of that trip to Fedders and its distributors was $ 600. In the year 1960, the Chaddocks received and took a trip awarded by the Fedders Corp. to Israel. The cost of that trip to Fedders and its distributors was $ 700. These trips were awarded by Fedders to the Chaddocks and others because of successful sales efforts with regard to Fedders' products. They were primarily pleasure trips although some business meetings and discussions took place during the course of each trip. The Chaddocks did not include any portion of the amounts of these awards in their gross income.

It was necessary for the Chaddocks to expend funds of their own on these trips in addition to the awards made by Fedders. However, they did not claim any deduction for expenses incurred in connection with the trips.

OPINION

1. Warranty Reserve. -- Electric *31 and Air Conditioning, two corporations using an accrual method of accounting, are sellers of appliances and air-conditioning equipment. As part of their operations, they provide warranty service on the products that they sell. When an item is sold, a portion of the sales price is credited to a warranty reserve account rather than to income. As warranty service is performed the cost of such service is charged against the warranty reserve. The Commissioner refused to accept this method of *166 reporting income in respect of such sales. In substance, his position is that the full amount of the sales price which has in fact been received or properly accrued must be reflected in income in the year of receipt or accrual, undiminished by the amount credited to the warranty reserve account in respect of the sale, and that deductions may be taken when expenditures are in fact made or incurred in carrying out the obligations under the warranty. We hold that the Commissioner must be sustained.

In , and , the Supreme*32 Court ruled that in the absence of a specific statutory exception it is not open to a taxpayer under the Internal Revenue Code of 1954 to defer income to a later period, when anticipated expenses may offset such income. ; . No such specific statutory provision is relied upon here, and we hold similarly that no portion of the amounts actually received or properly accrued herein may be excluded from currently reportable income.

We think that American Automobile Association and Schlude are controlling in the present case. We reject as unsound petitioner's attempt to distinguish those cases on the ground that the warranties herein are third-party obligations on the part of Electric and Air Conditioning. This is a completely irrelevant circumstance, for the basic question is simply whether a taxpayer may exclude from current income amounts actually received or accrued merely because future expenditures may offset such amounts in part or in whole. The statute does not permit the deferral of such income to be offset in a later year by expenses incurred *33 in that later year; nor does it permit the same result to be reached by excluding a portion of the receipts from current income through the medium of crediting such excluded amounts to a reserve for future expenditures which are thus in effect deducted prior to the time they are actually made or incurred. Cf. . And this is so regardless of whether its obligation is direct or otherwise.

Petitioners rely in part upon (C.A. 2), and (C.A. 5). Apart from possible distinctions between those decisions and the present case, they must be considered in the light of the subsequent authoritative decisions of the Supreme Court in Schlude and American Automobile Association, which, when fairly read, support the Commissioner's position herein.

2. Useful Lives of Certain Depreciable Assets. -- There is in dispute between petitioners and the Government the useful lives over which depreciation may properly be claimed for a used automobile, a gas machine, *34 and so-called small tools, all acquired and owned by Electric *167 Upon the record before us we have found a useful life of 3 years with a $ 350 salvage value for the used automobile and a useful life of 5 years with a $ 92 salvage value for the gas machine.

During the fiscal years herein involved Electric purchased small tools at various times. In its returns for those years Electric treated them as capital assets, depreciable over a 2-year useful life, and the Commissioner accepted this treatment. Electric now claims that these items were all used up in less than a year. While we are satisfied that some of the tools had useful lives of less than 1 year, we are equally convinced that others had useful lives of at least 2 years and possibly more. The taxpayer has not shown that, in the aggregate, the tools had a composite average life of less than 2 years, and has therefore not shown any error in computing the deduction upon the basis of a 2-year life for all of the tools.

3. Depreciation of Certain Assets Used in Leased Premises. -- During the year 1959 Electric purchased various assets for use in two of its stores. Petitioners contend that the cost of each item should*35 be amortized over the comparatively short life of the current lease of the store in which it is used. However, there has been no showing by petitioners, upon whom the burden of proof rests, that these assets could not have been removed at the expiration of the leases involved and used at other locations. The determination by the Commissioner that these assets otherwise had useful lives of 10 years is presumptively correct and has not been rebutted. It is therefore unnecessary to consider whether there was in any event a reasonable expectation that these assets would continue to be used by Electric in the leased premises over their useful lives notwithstanding that the existing leases were due to expire prior thereto.

4. Trips to Rome and Israel. -- In 1959 the Fedders Corp. awarded a $ 600 European trip (to Rome, Italy) to the Chaddocks, and in 1960 it awarded them a $ 700 trip to Israel. Both awards were made because of successful sales efforts in respect of Fedders' products. Petitioners did not include these amounts as income in their returns.

These were predominantly pleasure trips, awarded for services rendered, and the amounts involved were correctly included in petitioners' *36 gross income by the Commissioner. Cf. (C.A. 5), certiorari denied , rehearing denied ; (C.A. 5), certiorari dismissed .

On brief, petitioners appear to make the argument that the trips were for business purposes, and that the amount of each award should be excludable from income or deductible as a business expense. The record is vague as to any business aspects of these trips. There was testimony that there were "certain meetings," but the nature and extent *168 of such meetings and their proximate relationship to petitioners' business were not clearly defined. Bearing in mind petitioners' burden of proof and the elusive character of their evidence in the context of the record as a whole, we have reached the conclusion and found as fact that the trips were predominantly pleasure excursions. The burden of proof was upon petitioners, and they certainly have not established that even a substantial portion of the trips*37 was devoted to business. Nevertheless, we think that there were some business discussions en route, and we find as a fact and hold that $ 25 of the amount of each award was expended for business purposes. Cf. ; (C.A. 2).

Decisions will be entered under Rule 50.