
    352 F. 2d 807
    HACKENSACK WATER COMPANY v. THE UNITED STATES
    [No. 308-62.
    Decided November 12, 1965]
    
      
      Karl R. Price, attorney of record, for plaintiff. Alvord and Alvord, of counsel.
    
      Sheldon P. Migdal, with, whom was Acting Assistant Attorney General Richard M. Roberts, for defendant. C. Mox-
      
      ley Featherston, Lyle M. Turner and Philip B. Miller, of counsel.
    Before Cowen, Chief Judge, Laramore, Durfee, Davis and Collins, Judges.
    
   Per Curiam :

This case was referred pursuant to former Buie 45(a) (now Buie 57 (a)) to Trial Commissioner Mastín G. White, with directions to make findings of fact and recommendation for conclusions of law. The commissioner has done so in an opinion and report filed on August 20, 1964. The plaintiff has excepted to the opinion and certain of the findings of fact. The parties have filed briefs and the case has been submitted to the court upon oral argument of counsel. The court agrees with the commissioner’s findings, with a slight change in finding 16, his opinion and his recommended conclusion of law, as hereinafter set forth, and hereby adopts the same as the basis for its judgment in this case. Plaintiff is therefore not entitled to recover and the petition is dismissed.

OPINION OE COMMISSIONER

The plaintiff in this case seeks an income tax refund for the calendar year 1953. The problem involved in the litigation relates to the deductibility, under the rather unusual circumstances set out in the factual findings, of the property taxes which the State of New Jersey assessed against the plaintiff in 1953 and which the plaintiff subsequently paid in 1954. The plaintiff is a New Jersey corporation and conducts its business in that State.

New Jersey property taxes are assessed on October 1 of each year. Such taxes assessed against the plaintiff have always been paid by the plaintiff in quarterly installments on February 1, May 1, August 1, and November 1 of the calendar year immediately following the year of assessment. On its books of account, the plaintiff has always treated these taxes as an expense for the year in which such taxes are paid, although the plaintiff has otherwise kept its books on the accrual rather than the cash basis of accounting.

On October 1, 1953, New Jersey property taxes in the total amount of $1,377,248.39 were assessed against the plaintiff. These taxes for 1953 were subsequently paid by the plaintiff in quarterly installments during 1954; and they were charged by the plaintiff on its books of account as an expense for 1954.

In preparing its Federal income tax return for the calendar year 1953, the plaintiff deducted the New Jersey property taxes in the amount of $1,242,810.79 which were assessed against the plaintiff on October 1, 1952, which were paid in quarterly installments during 1953, and which were charged on the plaintiff’s books as an expense for 1953. This was in accordance with a practice which the plaintiff had uniformly followed for at least 30 years of treating New Jersey property taxes as an expense for the year of payment and deducting such taxes on its Federal income tax return for the same year, although the plaintiff, as to other items of expense and income, kept its books of account and prepared its income tax returns on the accrual rather than the cash basis.

Beginning with its Federal income tax return for the calendar year 1954 and continuing thereafter, the plaintiff departed from its previous practice of utilizing New Jersey property taxes as a deduction for the year of payment, and deducted the property taxes which the State of New Jersey assessed against the plaintiff on October 1 of the year covered by the particular return. For example, on the plaintiff’s income tax return for 1954, the plaintiff deducted the property taxes which the State of New Jersey assessed against the plaintiff on October 1, 1954, and which the plaintiff paid in 1955. Since 1954, therefore, the plaintiff, on each annual income tax return, has treated New Jersey property taxes in the same manner as other expenses and income, and has deducted such taxes on the accrual rather than the cash basis.

The plaintiff did not seek the approval of the Internal Bevenue Service prior to making the change referred to in the previous paragraph, whereby New Jersey property taxes were no longer deducted for income tax purposes on the return for the year of payment, but were deducted on the return for the year of assessment. However, the Internal Revenue Service did not make any objection to the change when it audited the plaintiff’s returns for 1954 and subsequent years.

It was because of the. change previously mentioned that the New Jersey property taxes in the amount of $1,377,248.39 which were assessed against the plaintiff on October 1, 1953, and which the plaintiff paid in 1954, did not appear as a deduction on the plaintiff’s Federal income tax return either for 1953 or for 1954. As indicated heretofore, the plaintiff followed the old system in preparing its return for 1953 and deducted the New Jersey property taxes which were paid in 1953 (such taxes having been assessed in 1952) ; and it followed the new system in preparing the return for 1954 and deducted the New Jersey property taxes which were assessed in 1954 (such taxes being paid subsequently in 1955). Hence, the New Jersey property taxes which were assessed against the plaintiff in 1953 and paid in 1954 did not appear on the plaintiff’s income tax return for either 1953 or 1954.

On July 21, 1955, the plaintiff filed with the Internal Revenue Service a claim for an income tax refund with respect to the year 1953. The basis asserted for the claim was that the plaintiff was entitled to a 1953 deduction for the property taxes in the total amount of $1,377,248.39 which the State of New Jersey assessed against the plaintiff on October 1, 1953, and which the plaintiff paid in 1954. This claim was denied on November 17, 1960, and the present litigation followed.

Since this claim relates to the deductibility of an expense in connection with the plaintiff’s income tax for 1953, it involves the Internal Revenue Code of 1939, and particularly Section 41 of that Code (53 Stat. 24). Section 41 was in a part of the Code dealing with “Accounting Periods and Methods of Accounting”; and in 1953 it stated the “General Rule” to be in part as follows:

The net income shall be computed upon the basis of the taxpayer’s annual accounting period (fiscal year or calendar year, as the case may be) in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but * * * if the method employed does not clearly reflect the income, the computation'shall be made in aeeordánce with such method as in the opinion of the Commissioner [of Internal Revenue] does clearly reflect the income. * * *

It will be noted that, under the governing statutory provision, the items of income and the items of expense pertinent to the determination of a taxpayer’s net income were to be computed “in accordance with the method of accounting regularly employed in keeping the books” of the taxpayer, unless the method employed did not “clearly reflect the income” of the taxpayer, in which case the computation was to be made “in accordance with such method as in the opinion of the Commissioner does clearly reflect the income.”

The plaintiff’s system of accounting in 1953 was generally on the accrual basis, but one item of expense, New Jersey property taxes, was treated on the cash basis. Therefore, when the plaintiff, in preparing its income tax return for 1953, deducted the New Jersey property taxes which the plaintiff paid in 1953 (such taxes having been assessed in 1952), but deducted other expenses and reported income on the accrual basis, the plaintiff was actually computing its net income “in accordance with the method of accounting regularly employed in keeping the books” of the plaintiff, as prescribed by Section 41 of the 1939 Code.

A hybrid system of accounting, which mixes the accrual and the cash bases, is generally looked upon with disfavor. See Massachusetts Mutual Life Ins. Co. v. United States, 288 U.S. 269, 273-274 (1933). However, the plaintiff’s system of accounting in 1953, which treated New Jersey property taxes on the cash basis while treating other items of expense and income on the accrual basis, had been in effect for at least 30 years, and neither the plaintiff nor the Internal Revenue Service had indicated any dissatisfaction with it as failing to “clearly reflect the income” of the plaintiff. Moreover, there is no factual showing in the present case that the plaintiff’s system of accounting in 1953, which formed the basis for the preparation of the plaintiff’s income tax return for that year, actually did not “clearly reflect the income” of the plaintiff for 1953.

The possibility that taxpayers might wish to change their systems of accounting from time to time was contemplated, and a procedure whereby such changes might be effected was prescribed in the Treasury Regulations which were issued under the Internal Revenue Code of 1939. The pertinent provision stated in part as follows:

(c) A taxpayer who changes the method of accounting employed in keeping his books shall, before computing his income upon such new method for purposes of taxation, secure the consent of the Commissioner. For the purposes of this section, a change in the method of accounting employed in keeping books means any change in the accounting treatment of items of income or deductions * * *. Application for permission to change the method of accounting employed and the basis upon which the return is made shall be filed within 90 days after the beginning of the taxable year to be covered by the return. The application shall be accompanied by a statement specifying the classes of items differently treated under the two methods and specifying all amounts which- would be duplicated or entirely omitted as a result of the proposed change. . Permission to change the method of accounting will not be granted unless the taxpayer and the Commissioner agree to the terms and conditions under which the change will be effected. * * * [Treas. Reg. 118 (1939 Code), §39.41-2.]

The validity of the quoted regulation, was upheld by the courts in a number of decisions (e.g., Commissioner v. O. Liquidating Corporation, 292 F. 2d 225 (3d Cir., 1961), cert. denied 368 U.S. 898; Wright Contracting Company v. Commissioner, 316 F. 2d 249 (5th Cir., 1963), cert. denied 375 U.S. 879; American Can Company v. Commissioner, 317 F. 2d 604 (2d Cir., 1963), cert. denied 375 U.S. 993; cf. Beacon Publishing Co. v. Commissioner, 218 F. 2d 697 (10th Cir., 1955)). The regulation was applicable not only to the making of a complete change in a system of accounting— from the accrual basis to the cash basis, or vice versa — but it was also applicable to the making of a change in the treatment of any significant item of income or expense (Commissioner v. O. Liquidating Corporation, supra, at p. 230; Wright Contracting Company v. Commissioner, supra, at p. 254).

Therefore, if the plaintiff, desired to change its treatment of New Jersey property taxes for income tax purposes from the cash to the accrual basis with respect to the year 1953, the plaintiff had the privilege of applying to the Commissioner of Internal Revenue for permission to make such a change, but it was encumbent upon the plaintiff to file its application within 90 days after the beginning of 1953. This was not done. Indeed, there was no indication until July 21, 1955, that the plaintiff was dissatisfied with the manner in which its books of account had been kept, and its income tax return had been prepared, for the year 1953.

Furthermore, if the plaintiff had submitted a timely application for permission to change its treatment of New Jersey property taxes for the year 1953, the Commissioner of Internal Revenue would have been vested with broad discretion in determining whether to grant or deny permission for such a change (Commissioner v. O. Liquidating Corporation, supra, at p. 231). The reason for the exercise of such discretionary power by the Commissioner was that a change in the method of reporting an important item of expense or of income would almost certainly result in some distortion of net income for the particular year in which the change was made, and it was encumbent upon the Commissioner to see that such distortion was not unduly detrimental to the revenue of the Government (Commissioner v. O. Liquidating Corporation, supra, at p. 230; American Can Company v. Commissioner, supra, at p. 606). The Commissioner could accomplish this objective by withholding his consent until the taxpayer agreed to adjustments that would prevent the duplication of items of expense or the omission of income with respect to the year of transition (Commissioner v. O. Liquidating Corporation, supra, at p. 230).

The necessity for the sort of control provided for in the pertinent regulation is illustrated by the present case. As stated earlier in this opinion, the plaintiff, in preparing its 1953 income tax return, deducted New Jersey property taxes in the amount of $1,242,810.79 which the plaintiff paid in 1953. If it had been the prerogative of the plaintiff to decide unilaterally — and retroactively in 1955 — that it would also deduct on its 1953 return the New Jersey property taxes in the amount of $1,377,248.39 which were assessed against the plaintiff in 1953 but not paid in that year, this obviously would have resulted in a substantial distortion of the plaintiff’s net income for 1953.

It is my opinion, therefore, that the Commissioner of Internal Revenue did not act erroneously in rejecting the claim which the plaintiff filed on July 21, 1955.

The conclusion stated in the preceding paragraph is not affected by an exchange of correspondence between the parties that occurred in 1954.

On May 17, 1954, the plaintiff wrote a letter to the Commissioner of Internal Revenue and asked for “a ruling with respect to the proper accrual date for federal income taxes of New Jersey real and personal property * * * taxes.” The letter stated that the plaintiff “keeps its books on the accrual basis,” and it explained that New Jersey property taxes were assessed each year as of October 1 and were paid during the succeeding year.

The Internal Revenue Service responded on July 15, 1954, to the plaintiff’s request for a ruling. The response stated in part that:

Real and personal property taxes accrue on October 1st of the year preceding the year payable.

With respect to the exchange of correspondence previously mentioned, it is to be noted in the first place that the plaintiff’s letter merely asked a general question regarding “the proper accrual date for federal income taxes of New Jersey real and personal property * * * taxes.” There was nothing in' or connected with the plaintiff’s letter to indicate that the plaintiff-had in mind (if it actually did at that time) the possibility of making a change, under the pertinent Treasury Regulation, in the accounting and income tax treatment of New Jersey property taxes. For example, the letter was not filed within 90 days after the beginning of a taxable year, it was not accompanied by the statement which the regulation required, and it did not request the consent of the Commissioner to any change. Actually, the plaintiff’s letter misstated the facts, because it stated generally — and without referring to New Jersey property taxes as an exception— that tbe plaintiff “keeps its books on the accrual basis.” It is not surprising, therefore, that the Internal Revenue Service merely replied to a general inquiry by furnishing general information to the effect that New Jersey property taxes “accrue on October 1st of the year preceding the year payable.”

Furthermore, the letter from the Internal Revenue Service to the plaintiff was written on July 15,1954, and the plaintiff did not file its income tax return for the year 1953 until about 2 months later. When the plaintiff filed its income tax return for 1953 on or about September 15, 1954, the plaintiff did not rely on the IRS letter to make a change, but continued the custom which it had followed for at least 30 years of deducting the New Jersey property taxes which were paid during the year covered by the return, rather than the New Jersey property taxes which were assessed against the plaintiff in such year.

The 1954 exchange of correspondence does not, in my judgment, provide any reasonable basis for the plaintiff’s effort to obtain a refund in connection with its income taxes for 1953.

For the reasons indicated above, it is my opinion that the plaintiff is not entitled to recover. Accordingly, I recommend that the petition be dismissed.

Findings op Fact

1. The plaintiff, Hackensack Water Company, at all times hereinafter mentioned was, and it is, a corporation organized and existing under the laws of the State of New Jersey, engaged in the distribution and sale of water as a public utility, and having its principal place of business at 4100 Park Avenue, Weehawken, New J ersey.

2. The plaintiff keeps its books in accordance with the “State of New Jersey Uniform System of Accounts for Water Utilities” in effect for each year.

3. The plaintiff has always kept its books and records, and has always prepared and filed its Federal income tax returns, on the calendar year basis and on the accrual method of accounting, except as noted in subsequent findings.

4. (a) The plaintiff’s income arises principally from the sale of water to residential and industrial consumers, but income is also derived from supplying fire protection to municipalities.

(b) The larger users (with meters 1% inches and larger) are approximately 3,000 in number, and they are billed monthly. The meters are read within the last 6 days of the month, and the amount billed is recorded as income as of the last day of that month.

(c) The smaller users (with meters from %ths of an inch up to 1 inch, inclusive) are approximately 140,000 in number, and they are billed quarterly. The billing is done on a cycle basis, approximately 2,000 to 2,500 being billed each day. The bill covers the usage for the previous 3 months, and is recorded on the books in the month billed. The reason for the cyclical billing is that it is impossible to read all the small meters in a 1-month period.

(d) The method of billing described in paragraphs (b) and (c) of this finding has been used by the plaintiff for approximately 35 years, and is used by it today.

5: The New Jersey property taxes assessed against the plaintiff under New Jersey law on October 1 have always been paid by the plaintiff in quarterly installments on February 1, May 1, August 1, and November 1 of the calendar year following the year of assessment. On its books, the plaintiff has charged such taxes to an expense account for the year in which such taxes are paid.

6. (a) On its 1953 Federal income tax return, and on each return for at least 30 years prior thereto, the plaintiff deducted its New Jersey property taxes paid during the year, and not the New Jersey property taxes assessed during the year.

(b) The amounts of the New Jersey property taxes which the plaintiff paid during 1953, charged on its books as an expense for 1953, and deducted in the computation of its 1953 Federal income tax, were as follows:

Heal property taxes_ $327, 980. 69
Personal property taxes- 914, 830.10
Total_$1,242,810.79

Such taxes were assessed against the plaintiff on October 1, 1952.

7. The corporation income tax return form (Form 1120) for 1951, 1952, and 1953 included the question: “Check whether this return was prepared on the cash basis □ or accrual basis On its return for each of these years, the plaintiff checked “accrual basis.”

8. (a) On October 1, 1953, the plaintiff was assessed for, and incurred a liability to pay, New Jersey real and personal property taxes, which became payable and which the plaintiff actually paid in four installments during 1954. The amounts of such taxes were as follows:

Real property taxes___ $360,098.95
Personal property taxes_ 1, 017,149.44
Total_$1, 377,248.39

(b) The taxes mentioned in paragraph (a) of this finding were not charged by the plaintiff on its books as an expense for the year 1953, but were charged as an expense for 1954.

(c) The taxes mentioned in paragraph (a) of this finding have not been allowed as a deduction in the computation of the plaintiff’s Federal income tax either for 1953 or for any other year.

9.On or about May 17,1954, the plaintiff submitted to the Commissioner of Internal Revenue, Washington, D.C., a request for a ruling, as follows:

This Company is desirous of obtaining a ruling with respect to the proper accrual date for federal income taxes of New Jersey real and personal property and franchise taxes.
Information is submitted below regarding the taxpayer and the taxes involved.
Hackensack Water Company is a corporation engaged in serving water to residents, industrial organizations and municipalities. The corporation was organized in the year 1869 under the laws of New Jersey. It keeps its books on the accrual basis.
The Company is liable for real and personal property taxes which under the laws of New Jersey are assessed as of October 1st in each year. The taxes on the property so. assessed are billed to the owners during the succeeding year. This Company is of the opinion that under present provisions of the Internal Revenue Code, said taxes are accruable as of the assessment date, namely October 1st. For your convenience we refer you to G.C.M. 15305 which supports the deductibility of New Jersey real and personal property taxes as of October 1st, the assessment date.
This Company is also liable for a franchise tax under Chapter 5, Laws of 1940 of the State of New Jersey measured by 5% of its gross receipts. This tax is based on a return which is filed February 1st of each year in which there is reported the gross receipts of the preceding year. This tax is collected by the State and apportioned to the several taxing authorities in which the Company has property. All of the information _necessary to determine the exact amount of the franchise tax is known as of December 31st of each year.
This Company desires your ruling as to the proper dates under the Internal Revenue Code for the taxes referred to above.
The taxpayer would appreciate a prompt ruling in this matter and should there be any questions which, in your opinion, could better be disposed of at a conference in your office, the taxpayer will arrange to be present at such a conference on a date agreeable to you.

10. In response to the request referred to in finding 9, a ruling was issued to the plaintiff by Bruce E. Lambert, District Director of Internal Revenue, Newark, New Jersey, under the date of July 15,1954. The text of the ruling was as follows:

Re: Proper accrual dates for Federal Income Tax purposes of New Jersey real property, personal property and franchise taxes.
Reference is made to your letter of May 17, 1954 requesting a ruling on the above-mentioned matter addressed to the Commissioner of Internal Revenue, Washington, D.C. which has been forwarded to this office for reply.
This is to advise you, therefore, that the proper accrual dates of these taxes for Federal Income Tax purposes are as follows:
Real and personal property taxes accrue on October 1st of the year preceding the year payable.
Franchise Taxes imposed on gross receipts of public utilities under Chapters 4 and 5 of the Laws of 1940 of the State of New Jersey accrue January 1st of the privilege year, which is the year following the year in which the gross receipts, the basis of the tax, are accounted for.
Should you desire any further information with respect to the above matter please do not hesitate to communicate with the District Director of Internal Revenue, attention: Chief, Audit Division, 581 Broad Street, Newark 2, New Jersey.

11.(a) On or about September 15, 1954, the plaintiff filed with the District Director of Internal Revenue at Newark, New Jersey, a Federal income tax return for its taxable year January 1 to December 31, 1953, reflecting an income tax liability of $1,278,678.65, which amount the plaintiff paid in installments as follows:

March 15,1954_$586, 800. 00
June 15, 1954___ 586, 800.00
September 15, 1954_ 41,144.72
December 15, 1954_ 68, 983. 93

(b) As indicated in finding 6, the plaintiff’s income tax return for 1953 deducted New Jersey property taxes in the amount of $1,242,810.79 which were assessed on October 1, 1952, paid by the plaintiff during 1953, and charged on the plaintiff’s books as an expense for 1953. This was in accordance with the plaintiff’s long-standing practice of utilizing New Jersey property taxes as a deduction for the year of payment.

12. On its Federal' income tax return for 1954 and each subsequent year, the plaintiff deducted its New Jersey property taxes assessed on October 1 of such year, and not its New Jersey property taxes paid during the year.

13. (a) The plaintiff did not file a request with the Internal Revenue Service for permission to change its method of accounting either for the year 1953 or for the year 1954.

(b) The plaintiff did not receive from the Internal Revenue Service permission to change its method of accounting for the year 1953.

14. The New Jersey property taxes for which the plaintiff was assessed in each year during the period 1954-1960, inclusive, were greater than the New Jersey property taxes paid in the same year. Schedule M of the plaintiff’s Federal income tax return for each such year showed the amount of the New Jersey property taxes assessed and the amount of the taxes paid during the year; and such schedule further showed that the New Jersey property taxes deducted on the return were those assessed in the taxable year and not those paid in the taxable year.

15. The plaintiff’s Federal income tax returns for all of the years 1954-1960, inclusive, have been examined by examining officers in the office of the District Director of Internal Revenue at Newark, New Jersey, and the plaintiff’s deductions of New Jersey property taxes assessed were accepted as filed. The revenue agents’ reports did not propose any adjustments to any of the returns on the ground that it was improper for the plaintiff to deduct New Jersey property taxes assessed during the year.

16. (a) On July 21, 1955, the plaintiff filed with the District Director of Internal Revenue at Newark, New Jersey, a. claim for refund for its taxable year 1953 in the amount of $710,669.16. The, asserted basis of the claim was that the plaintiff was entitled to a 1953 deduction for property taxes aggregating $1,377,248.39 assessed by the State of New Jersey on October 1, 1953, which the plaintiff paid in 1954.

(b) The claim mentioned in paragraph (a) of this finding was rejected by the District Director in a registered letter mailed November 17, 1960.

(c) As stipulated by the parties (Joint Exhibit No. 1, par. (2)), on January 24, 1961, plaintiff paid an additional assessment of Federal income tax for 1953 of $10,775.98 tax and $4,397.83 interest.

17. The only waiver of the statute of limitations executed by the plaintiff and the Internal Revenue Service for 1954 was dated January 13, 1958, and extended, the period in which additional taxes for 1954 might be assessed to June 30, 1959. The plaintiff did not file a claim for refund for 1954 relating to New Jersey property taxes assessed in 1953 and paid in 1954 until February 9, 1961. In that claim, the plaintiff asserted the right to deduct such taxes in 1954 under Section 481 of the Internal Revenue Code of 1954, and contended that the statute of limitations on 1954 could be reopened under Sections 1311-1315. The plaintiff has not been advised by the Internal Revenue Service of any action taken on such claim.

CONCLUSION OP LAW

Upon the foregoing findings of fact, which, are made a part of the judgment herein, the court concludes as a. matter of law that the plaintiff is not entitled to recover, and the petition is therefore dismissed.  