Mingo v. Comm'r

*157 (a) if amounts received attributable to unrealized receivables were recognized as ordinary income for tax year 2003, Mrs. Mingo would have a basis in the note of $126,240; or

(b) if amounts received attributable to unrealized receivables were recognized as ordinary *160 income for 2007, Mrs. Mingo would have a reduction in capital gain because of the reclassification of this income.

Respondent's notice of deficiency also determined an accuracy-related penalty under section 6662(a) of $11,905.40; however, respondent has since conceded that petitioners are not liable for this penalty. On October 4, 2010, petitioners timely filed a petition in this Court for review of respondent's determination for tax year 2007.

Section 453(a) provides that, except as otherwise provided, income from an installment sale shall be taken into account under the installment method. An installment sale is defined as a disposition of property where at least one payment is to be received after the close of the taxable year in which the disposition occurs. Sec. 453(b)(1). The installment method is defined as a method under which the *158 income recognized for any taxable year from a disposition is that proportion of the payments received in that year which the gross profit (realized or to be realized when payment is completed) bears to the total contract price. Sec. 453(c).

In the case of a sale or exchange of a partnership *161 interest, gain or loss recognized to the transferor is considered gain or loss from the sale or exchange of a capital asset, except as otherwise provided by section 751. Sec. 741. Section 751(a) provides that the amount received by a transferor partner in exchange for all or part of a partnership interest shall be considered as an amount realized from the sale or exchange of property other than a capital asset, to the extent such amount is attributable to unrealized receivables or inventory items of the partnership. The term "unrealized receivables" includes, to the extent not previously includible in income under the method of accounting used by the partnership, any rights (contractual or otherwise) to payment for services rendered or to be rendered. Sec. 751(c)(2).

The purpose of section 751 is to prevent the conversion of potential ordinary income into capital gain when a partnership interest is sold or exchanged. See Madorin v. Commissioner, 84 T.C. 667, 682 (1985). The effect of section 751 is to sever certain income items to effectuate this purpose. For the amount of a partnership interest attributable to inventory or unrealized receivables described in *159 section 751, the tax consequences *162 to the transferring partner are "the same tax consequences which would be accorded an individual entrepreneur." H.R. Rept. No. 83-1337, at 70-71 (1954), 1954 U.S.C.C.A.N. 4017, 4098; S. Rept. No. 83-1622, at 99 (1954), 1954 U.S.C.C.A.N. 4621, 4732. Essentially, the transferring partner is treated as disposing of section 751 property "independently of the rest of his partnership interest." H.R. Rept. No. 83-1337, supra at 70, 1954 U.S.C.C.A.N. at 4097; S. Rept. No. 83-1622, supra at 98, 99, 1954 U.S.C.C.A.N. at 4731, 4732. It follows that the portion of gain attributable to section 751 property in the sale or exchange of a partnership may only be reported under the installment method to the extent that income realized on a direct sale of such property would be reportable under the installment method.

Gross income includes the fair market value of property or services received in exchange for other services. Sec. 61(a); Baker v. Commissioner, 88 T.C. 1282, 1288 (1987); Badell v. Commissioner, T.C. Memo. 2000-303; sec. 1.61-2(d)(1), Income Tax Regs. In the context of a direct sale, Mrs. Mingo was essentially given a property interest (a portion of the note) in exchange for the right to *163 collect unpaid amounts in satisfaction of services her partnership had previously rendered (unrealized receivables). Standing alone, this transaction is a barter exchange, one in which a taxpayer would properly report the proceeds as ordinary income on his *160 Federal income tax return for the year in which the exchange occurred. Absent some authority to the contrary, a taxpayer would be unable to defer recognition of such income to a subsequent year.

In Sorensen v. Commissioner, 22 T.C. 321 (1954), a taxpayer was given several options to purchase stock as compensation for his services. He sold these options rather than exercising them and attempted to report his gain under section 44(b), I.R.C. 1939, the predecessor to section 453. The Court held that the installment sale provisions did not apply to the sale because "[t]he provisions of section 44 relate only to the reporting of income arising from the sale of property on the installment basis. Those provisions do not in anywise purport to relate to the reporting of income arising by way of compensation for services." Sorensen v. Commissioner, 22 T.C. at 342.

The reasoning of the Court in Sorensen still holds true. Nothing in section 453*164 or its associated legislative history suggests that Congress intended to allow taxpayers to escape the basic principles of revenue recognition by deferring compensation for services under the installment method. Petitioners do not dispute that $126,240 of the $823,090 face value of the note was attributable to unrealized receivables of the PwCC partnership. As illustrated above, those unrealized receivables, if sold in a direct sale, would not be eligible for installment *161 method reporting under section 453. Accordingly, the gain realized on Mrs. Mingo's partnership interest, to the extent attributable to partnership unrealized receivables, was likewise ineligible for installment method reporting under section 453. Petitioners should have properly reported an additional $126,240 of ordinary income on their 2002 Federal income tax return instead of reporting it under the installment method.

Section 446(a) requires a taxpayer to compute taxable income under the method of accounting it regularly uses in keeping its books. Section 446(b) provides that if the method of accounting regularly used by the taxpayer does not clearly reflect taxable income, the computation of taxable *165 income shall be made under such method as, in the Commissioner's opinion, does clearly reflect income. The Commissioner's authority under section 446(b) reaches not only to overall methods of accounting but also to a taxpayer's method of accounting for specific items of income and expense. Ford Motor Co. v. Commissioner, 102 T.C. 87, 100 (1994), aff'd, 71 F.3d 209 (6th Cir. 1995); Wang v. Commissioner, T.C. Memo. 1998-127.

A change in accounting method includes a change in the overall plan of accounting for gross income or deductions or a change in the treatment of any *162 material item used in such overall plan. Sec. 1.446-1(e)(2)(ii)(a), Income Tax Regs. A "material item" includes any item that involves the proper time for the inclusion of the item in income or the taking of a deduction. Id. An accounting practice involves the proper time for reporting income when it merely postpones the reporting of income rather than permanently avoiding the reporting of income over the taxpayer's lifetime. Wayne Bolt & Nut Co. v. Commissioner, 93 T.C. 500, 510 (1989).

As discussed above, the portion of the note attributable to unrealized receivables should have been properly characterized as ordinary *166 income for 2002. The election to use the installment method here cannot change the character of the amount attributable to unrealized receivables, nor would it result in the avoidance of income over petitioners' lifetime. The result would merely delay the recognition of such ordinary income from tax year 2002, where it should have properly been recognized, to tax year 2007. Petitioners' use of the installment method to report the note implicates the proper timing for reporting income. Accordingly, the sale of Mrs. Mingo's partnership interest is a "material item" for the purposes of section 1.446-1(e)(2)(ii)(a), Income Tax Regs.

Although a method of accounting may exist without the necessity of a pattern of consistent treatment of an item, in most instances an accounting method *163 is not established for an item without such consistent treatment. Id. Petitioners elected to report the sale of Mrs. Mingo's partnership interest on the installment method by attaching a Form 6252 to their joint 2002 Federal income tax return. For tax years 2003 through 2006 petitioners filed tax returns reflecting only interest income from the note. In tax year 2007 petitioners reported the proceeds from the *167 sale when Mrs. Mingo converted the note into IBM stock as would typically be proper under the installment method of reporting income. Therefore, petitioners established a pattern of consistent treatment under the installment method of reporting for this material item.

Once the Commissioner determines that a taxpayer's method of accounting does not clearly reflect income, he has broad discretion to select a method of accounting that he believes properly reflects the income of the taxpayer. RACMP Enters. v. Commissioner, 114 T.C. 211, 219 (2000). The Commissioner's determination may be challenged only upon the showing of abuse of discretion. Id. Whether an abuse of discretion occurred depends upon whether the Commissioner's determination is without sound basis in fact or law. Id.

The foregoing analysis has shown the proceeds from the sale of Mrs. Mingo's partnership, to the extent those proceeds were attributable to partnership unrealized receivables, were not able to be reported under the installment method *164 of accounting. Such proceeds should properly have been reported as ordinary income in the year they were received as petitioners were not entitled to defer income recognition to a *168 later year. It is clear that petitioners' chosen accounting method did not clearly reflect income with respect to the portion of the note attributable to partnership unrealized receivables.

Respondent changed petitioners' method of accounting with respect to partnership unrealized receivables from the installment method under section 453 to the cash receipts and disbursements method. Had the cash receipts and disbursements method been adopted at the time of the sale, petitioners would have properly reported $126,240 of ordinary income for tax year 2002 from the unrealized receivables. Such reporting would have clearly reflected income for tax year 2002. Respondent's determination to initiate a change in petitioners' accounting method was not without sound basis in fact or law and, therefore, was not an abuse of discretion.

Section 481(a) provides that in computing a taxpayer's taxable income after a change of accounting method has occurred, 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. A section 481(a) adjustment may include amounts attributable to tax *169 years outside the period *165 of limitations on assessment. Bosamia v. Commissioner, 661 F.3d 250, 257-258 (5th Cir. 2011), aff'gT.C. Memo. 2010-218. Respondent made a section 481(a) adjustment of $126,240 for tax year 2003, the year for which respondent initiated the change of accounting method. This adjustment was necessary to remedy the omission of ordinary income that occurred for tax year 2002 as a result of petitioners' impermissible election to use the installment method. Accordingly, respondent's determination that petitioners had additional ordinary income of $126,240 for tax year 2003 is sustained.

Section 453B provides that if an installment obligation is sold or exchanged, gain or loss shall result to the extent of the difference between the basis of the obligation and the amount realized in the sale. Under section 1011, the adjusted basis for determining the gain or loss from the sale or other disposition of property, whenever acquired, shall be the basis determined under section 1012, adjusted as provided in section 1016. Section 1012 provides that, generally, the basis of property shall be the cost of such property. Section 1016 provides *170 that proper adjustments to basis in respect of property shall in all cases be made for expenditures properly chargeable to capital.

*166 Mrs. Mingo was issued the note at no cost to her. Therefore, her initial basis in the note was zero. However, respondent agrees that in finding that petitioners must recognize $126,240 of ordinary income relating to partnership unrealized receivables in 2003, petitioners should be afforded a basis adjustment in that amount. Respondent further agrees that the application of that basis should result in a decrease in petitioners' reported long-term capital gain for tax year 2007. Accordingly, petitioners are afforded a reduction in reported long-term capital gain of $126,240 for tax year 2007.

Generally, taxpayers may claim as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise. Sec. 165(a). Losses from sales or exchanges of capital assets are allowed to the extent prescribed in sections 1211 and 1212. Sec. 165(f). Under those limitations, noncorporate taxpayers must first offset capital losses against capital gains.

On their 2007 return petitioners claimed a long-term capital loss *171 of $217,402. The entry related to this loss was labeled "debt converted to stock (non-taxable)". Respondent disallowed this loss, claiming that petitioners "do not *167 have basis ³ in the [N]ote and have not otherwise substantiated their entitlement to the loss".

On the worksheet the preparer used to prepare Schedule D of petitioners' 2007 return, there is a numerical breakdown of how the $217,402 claimed capital loss was calculated. Petitioners, using the market price of the IBM stock at the time the note was issued, divided the stock pledged in the note into shares attributable to partnership unrealized receivables and shares not attributable to partnership unrealized receivables. The resulting split reflects that 1,834.617 shares of IBM stock were attributable to partnership unrealized receivables (valued at $126,240 at the issuance of the note) and 10,127.162 to the remainder (valued at $696,850 at the issuance of the note).

Petitioners applied this allocation to the stock price at the time the note was redeemed to ascertain the amount of appreciation allocable to shares *172 of stock attributable to partnership unrealized receivables. Petitioners determined that $91,162 of appreciation was allocable to the 1,834.617 shares attributable to partnership unrealized receivables. This $91,162 of appreciation, when added to *168 the $126,240 attributable to unrealized receivables, equals the $217,402 that petitioners claimed as a capital loss.

Petitioners' position appears to be that, if they were liable to pay tax on the $126,240 portion of the note attributable to unrealized receivables in 2002, then they would have to have sold a portion of the stock equal to that amount to satisfy the liability. Had they sold that portion of the stock, it would not have had the opportunity to appreciate over the life of the note, and therefore petitioners should not be liable to pay tax on the amount of appreciation allocable to that portion of the note.

However, petitioners' position is misguided. While it may have been a matter of economic necessity based on petitioners' liquidity at the time, petitioners were not required by any authority to sell stock to satisfy their 2002 tax liability. Had petitioners paid the liability from another source at the time, they would have been *173 entitled to a basis of $126,240 in the note. Partitioning the note only further illustrates the point that petitioners would still have been liable for $91,162 of capital gain with respect to those shares attributable to unrealized receivables, the difference between the $126,240 basis in those shares and the $217,402 sale price.

Even if the Court were to grant petitioners' argument that the stock had to be sold in 2002 to satisfy the liability, petitioners' position is untenable. Had *169 petitioners sold a portion of the stock and paid $126,240 to the IRS, they would not have had a right of access to that money anymore. They would forfeit all right to any appreciation or interest that would result from the investment of that money. Petitioners would have never been afforded the opportunity to amass the $91,162 of appreciation attributable to that portion of the stock. Granting their argument, petitioners have been treated to an undeniable accession to wealth which would not have occurred had they satisfied their liability timely. See Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431, 75 S. Ct. 473, 99 L. Ed. 483, 1955-1 C.B. 207 (1955).

In accordance with the preceding section, petitioners will be allowed to claim basis in the *174 note of $126,240 for tax year 2007 for amounts that will be paid in satisfaction of the Court's determination with respect to tax year 2003. With respect to the remaining $91,162 petitioners claimed as a capital loss for tax year 2007, respondent's determination is sustained.

All other adjustments reflected on petitioners' 2003 and 2007 statutory notices of deficiency are computational.

To reflect the foregoing,

Decisions will be entered under Rule 155.