The opinion of the court was delivered by: MURPHY
Defendant moves for a directed verdict on the issue of the correctness of the assessed deficiencies and the incident interest. All agree that the correctness of the assessed penalties involves a question of fact for the jury's determination.
The material facts are relatively simple. Plaintiff is in the business of buying, processing and selling sheepskins. Over ninety per cent of his business is done on credit. He maintained his books on an accrual basis with one exception. Inventories were taken, used by his accountant in preparing a yearly profit and loss statement, but were not entered in the regular books of account.
The plaintiff insists that he had the right to file returns in 1943 and 1944 on a cash receipts and disbursements basis. The Commissioner recomputed his income on an accrual basis and assessed the deficiencies in dispute. The amount of income and the tax due under the respective methods of computation are conceded.
The method of accounting to be used in computing taxable income is governed by Section 41 of the Internal Revenue Code 1939, 26 U.S.C.A. § 41. It provides:
'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 no such method of accounting has been so employed, or if the method employed does not clearly reflect the income, the computation shall be made in accordance with such method as in the opinion of the Commissioner does clearly reflect the income. * * *'
Apart from the question of what method of accounting the plaintiff actually used, and assuming here that the books were kept on a cash receipts and disbursements basis, the power of the Commissioner to recompute the income using a different accounting method depends, insofar as this statute is concerned, on a showing that 'the method employed does not clearly reflect the income.' On the face of it this appears to be a question of fact.
The plaintiff, relying on language in Osterloh v. Lucas, 9 Cir., 1930, 37 F.2d 277, which was echoed in a per curiam opinion in Glenn v. Kentucky Color & Chemical Co., 6 Cir., 1951, 186 F.2d 975, 977, reads the statute as requiring only that the taxpayers books 'shall be kept fairly and honestly.' This language has been rejected in the Ninth Circuit, which gave it birth in Herberger v. Commissioner, 1952, 195 F.2d 293. It is not the law in this circuit. Caldwell v. Commissioner, 2 Cir., 1953, 202 F.2d 112.
Section 41 must be read in conjunction with Section 22(c), 26 U.S.C.A. § 22(c), which governs the use of inventories in computing taxable income. It provides:
'Inventories. Whenever in the opinion of the Commissioner the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer upon such basis as the Commissioner, with the approval of the Secretary, may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income.'
Pursuant to this clear delegation of authority the Commissioner has promulgated Reg. 111, Sec. 29.22(c)-1:
'Need of inventories. In order to reflect the net income correctly, inventories at the beginning and end of each taxable year are necessary in every case in which the production, purchase, or sale of merchandise is an income-producing factor. * * *'.
That this regulation is within the delegated power of the Commissioner is not subject to doubt. He has been given broad discretion in this area. Lucas v. Kansas City Structural Steel Co., 1930, 281 U.S. 264, 50 S. Ct. 263, 74 L. Ed. 848. The report of the Ways and Means Committee accompanying the Revenue Act of 1918, which first included this section, expressly indicated that in many cases inventories were necessary to determine net income and specifically mentioned 'manufacturing and merchandising concerns.' H.R.Rep. 767, 65th Cong., 2nd Sess., p. 4. The regulation was first promulgated under the 1918 Act and has been included without change in every set of regulations issued since that time. The statute has been reenacted continuously without change. Under these circumstances the regulations have received the approval of the Congress and approach the statute itself in force and effect. See Helvering v. R. J. Reynolds Tobacco Co., 1939, 306 U.S. 110, 59 S. Ct. 423, 83 L. Ed. 536; Lykes v. United States, 1952, 343 U.S. 118, 72 S. Ct. 585, 96 L. Ed. 791.
Treasury Regulation 111, Sec. 29.41-a states:
'* * * in any case in which it is necessary to use an inventory, no method of accounting in regard to purchases and sales will correctly reflect ...