Hagen Advertising Displays, Inc. v. Commissioner

         UNITED STATES COURT OF APPEALS FOR THE SIXTH CIRCUIT

This is a petition to review a decision of the Tax Court upholding the Commissioner's determination that taxpayer must include advance payments from its customers in its gross income in the year of receipt.

Hagen Advertising Displays, Inc., petitioner-taxpayer, is a manufacturer of advertising signs with its principal office in Cincinnati, Ohio. Many of petitioner's customers are engaged in establishing new dealerships throughout the country and require a continuous supply of illuminated, plastic, dealer-identification signs. It was the practice of such customers, during the years in question, to estimate their requirements and to place "blanket orders" with petitioner covering periods of from one to three years. Upon receipt of a blanket order, taxpayer would begin to manufacture the required signs. In general, however, taxpayer did not complete a particular sign until shipping instructions were received from the customer for whom it was being made specifying the dealer to whom it was to be delivered; the extent of completion prior to that time depended on the nature of the sign in question. Shipping instructions were received intermittently, on a sign-by-sign basis, according to the needs of the customer.

Generally, taxpayer's customers did not make advance payments and, with certain limited exceptions, there was no requirement or understanding that they do so. They were billed for each sign within a day or two after it was shipped. However, some customers, on their own initiative, elected to pay for all or a portion of their blanket orders prior to delivery. These customers subsequently received a "memo billing" when each sign for which such payments had been made was shipped. In addition, when a blanket order had been outstanding for an extended period of time (usually twelve months) and the customer had not directed the shipment of some of the signs included therein, petitioner sometimes billed the customer for the undelivered signs. Advance billings of this latter type, however, were infrequent.

Until 1961, petitioner kept the amounts received as advance payments in a special bank account. In that year this account was closed out and the advance payments were comingled with taxpayer's other receipts and were used for current operating expenses and general corporate purposes. On its federal income tax returns for the years 1960 to 1962, petitioner deferred inclusion of advance payments in sales income until the year in which each sign was delivered. The Commissioner determined that these amounts should have been included in taxpayer's income in the year in which they were received and, accordingly, assessed deficiencies for the years 1960 and 1962, and determined an overassessment for 1961. The Tax Court, upon petition for redetermination of petitioner's taxes, upheld the Commissioner's action. Hagen Advertising Displays, Inc., 47 T.C. 139 (1966).

This petition requires us to determine whether a taxpayer who uses the accrual method of accounting and who receives unconditional ¹ advance payments for merchandise must report such payments, for tax purposes, in the year of receipt instead of deferring such reporting until the year in which the merchandise is delivered. In making this determination we must consider first whether any part of the unconditional advances constituted income for an accrual-basis taxpayer. In both Schlude v. Commissioner of Internal Revenue, 372 U.S. 128, 83 S. Ct. 601, 9 L. Ed. 2d 633 (1963), and American Automobile Ass'n v. United States, 367 U.S. 687, 81 S. Ct. 1727, 6 L. Ed. 2d 1109 (1961), reh. denied, 368 U.S. 870, 82 S. Ct. 24, 7 L. Ed. 2d 70 (1961), the Supreme Court considered the propriety of the deferral of inclusion of unconditional prepayments by an accrual-basis taxpayer until the year in which the services for which the advances were received would be performed. The Court, relying in part on its interpretation of the implications of Congress' retroactive repeal of Section 452 of the Internal Revenue Code of 1954, ² held that deferral would not be permitted. Admittedly, these cases are distinguishable from the instant case since amounts received for the sale of services constitute gross income at the time they are received regardless of the matching of related expense deductions. ³ In the instant case, on the other hand, the matching of gross receipts and related costs of goods sold is necessary in order to determine the amount of gross income, as distinguished from mere returned capital, which taxpayer has received. ⁴ However, prior to the repeal of Section 452 deferral would have been permissible in the instant case since the sale of both services and goods fell within the purview of that section's provisions. The implications of its repeal by Congress are, therefore, apposite in the instant case.

In assessing the implications of this legislative action, the Supreme Court stated in American Automobile Ass'n.:

     Whether or not the Court's judgment in Michigan controls

We note that our consideration of this question is not influenced by the so-called "claim of right doctrine" which was held inapplicable in Beacon and Bressner and which, as was observed by Justice Stewart in his dissenting opinion in American Automobile Ass'n., determines only whether amounts whose ownership is disputed are includible in gross income and not whether "* * * such funds must necessarily be reported by an accrual-basis taxpayer as income in the year of receipt, whether or not then earned." 367 U.S. at 700, 81 S. Ct. at 1734.

Finally, petitioner relies on Consolidated-Hammer Dry Plate & Film Co. v. Commissioner of Internal Revenue, 317 F.2d 829 (7th Cir.1963), Watkins v. United States, 287 F.2d 932 (1st Cir. 1961), Woodlawn Park Cemetery Co., 16 T.C. 1067 (1951), and Veenstra & DeHaan Coal Co., 11 T.C. 964 (1948). The advance payments in those cases, however, were received either conditionally or pursuant to a loan -financing arrangement.

The second question presented by this petition is what portion of the advance payments must be included in gross income in the year of receipt. Taxpayer correctly points out that inclusion of the entire amount of the advances, without an allowance for related costs of goods sold, would constitute taxation of the return of capital. Lela Sullenger, 11 T.C. 1076, 1077 (1948), not acquiesced in, 1949-1 Cum.Bull. 6, appeal dismissed, (5th Cir. 1950), acquiesced in, 1952-2 Cum.Bull. 3. But the economics of the marketplace requires that a manufacturer earn a profit on the merchandise which it sells, at least in the long run, in order to remain in existence. We must assume, therefore, that in general petitioner sells signs for more than their cost of manufacture, and, in the absence of any contention to the contrary, that a portion of the advances did constitute gross income in the year of receipt.

Petitioner seeks to defer inclusion of this portion until a tax year subsequent to that of its unconditional receipt because until each sign is delivered the cost of its manufacture, which must be subtracted from the sale price in order to determine gross income, ⁸ cannot be determined. This contention is without merit. Taxpayer has made no attempt to estimate the cost of goods sold of the signs for which advances were received. ⁹Cf. Schuessler v. Commissioner of Internal Revenue, 230 F.2d 722 (5th Cir.1956); Harrold v. Commissioner of Internal Revenue, 192 F.2d 1002 (4th Cir.1951). See Hilinski v. Commissioner of Internal Revenue, 237 F.2d 703 (6th Cir.1956). Since it is clear that taxpayer, not the Commissioner, must bear the burden of reporting in the proper tax year amounts which it claims are costs of goods sold, taxpayer cannot complain in this petition for review of the consequences of its failure to do so.

For the reasons stated above the decision of the Tax Court is affirmed.

² Section 452 was repealed by Pub.Law 74, Sec. 1, approved June 15, 1955, effective with respect to taxable years beginning after December 31, 1953, and ending after August 16, 1954.

³ Int.Rev.Code of 1954, Section 61(a) provides, in part:

Except as otherwise provided in this subtitle, gross income means all

     Gross Income Derived from Business. (a) In general. In a

⁶ The other ground relied on in those cases was the fact that the taxpayers' methods of accounting were inaccurate. It has long been clear that this is sufficient to allow the Commissioner to reject a taxpayer's method of computing taxable income. See Automobile Club of Michigan v. Commissioner of Internal Revenue, supra. Section 446 of the Internal Revenue Code of 1954 provides in part:

(a) GENERAL RULE. -- Taxable income shall be computed under the method

⁸See note 4, supra.

⁹ The Tax Court stated in this regard:

     Petitioner makes no argument that either its cost of goods sold