Hudson v. Commissioner

T.C. Memo. 1996-106

UNITED STATES TAX COURT

RICHARD D. HUDSON AND BETTY L. HUDSON, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 4119-94. Filed March 7, 1996.

Philip A. Sallee, for petitioners.

Ronald T. Jordan, for respondent.

MEMORANDUM OPINION

LARO, Judge: This case is before the Court fully

stipulated. See Rule 122. Richard D. Hudson and Betty L. Hudson

petitioned the Court to redetermine respondent's determination of

deficiencies in their 1987 and 1988 Federal income taxes and
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additions thereto under sections 6653(b)(1)(A) and (B)1 (for

1987) and section 6653(b)(1) (for 1988). Respondent reflected

this determination in a notice of deficiency issued to Richard D.

and Betty L. Hudson on December 8, 1993. The notice of

deficiency shows the following deficiencies and additions

thereto:

Additions to Tax
Sec. Sec. Sec.
Year Deficiency 6653(b)(1)(A) 6653(b)(1)(B) 6653(b)(1)
1
1987 $12,989 $9,742 ---
1988 19,483 --- --- $14,612
1
50 percent of the interest due on $12,989.

Following concessions, we must decide:

1. Whether respondent abused her discretion in requiring

petitioner's business to use an accrual method of accounting for

purchases and sales. We hold she did not.

2. Whether petitioner may compute his adjustment under

section 481(a), which results from the change to an accrual

method, by reference to the 3-year rule under section 481(b).

We hold he may not.

Unless otherwise stated, section references are to the

Internal Revenue Code in effect for the years in issue. Rule

references are to the Tax Court Rules of Practice and Procedure.

Dollar amounts are rounded to the nearest dollar. We use the

1
Respondent’s notice of deficiency erroneously referred to
sec. 6653(b)(2)(B).
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term "petitioner" to refer solely to Richard D. Hudson.

Betty L. Hudson is a party mainly because she filed joint Federal

income tax returns with petitioner during the subject years.

Background

The stipulated facts and exhibits are incorporated herein by

this reference. Petitioner and Mrs. Hudson are husband and wife.

They resided in Bloomington, Indiana, when they petitioned the

Court. They filed 1987 and 1988 Forms 1040, U.S. Individual

Income Tax Returns, using the status of "Married filing joint

return".

During the subject years, petitioner operated a sole

proprietorship that sold diamonds and other gemstones at

wholesale and retail prices. Petitioner started this business in

1965, and he has always used the cash receipts and disbursements

method (cash method). Petitioner did not maintain inventories

for purposes of computing his cost of goods sold, but he

currently expensed all costs that he paid to purchase the

diamonds and other gemstones. Following concessions by the

parties, petitioner's gross receipts, cost of goods sold, and

gross profit percentage for the subject years were:
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1987 1988

Gross receipts $321,596 $371,994

Cost of goods
sold $257,346 $353,118

Gross profit
percentage 20% 5%

Respondent determined that petitioner had no ending

inventory on December 31, 1987, and, consequently, no beginning

inventory on January 1, 1988. The parties have since stipulated,

however, that petitioner had $10,000 of inventory on January 1,

1988. Respondent also determined that petitioner had $61,305 of

inventory on December 31, 1988.

Discussion

1. Change in Method of Accounting

We must first decide whether respondent abused her

discretion by changing petitioner from the cash method to an

accrual method in order to reflect his inventory, beginning with

the 1988 tax year. We refer to sections 446 and 471 to make our

decision.

Taxable income generally is computed based on the method of

accounting on which the taxpayer regularly keeps his or her

books. Sec. 446(a). The term "method of accounting" includes

the adjustment of any "material item" involving the proper timing

of income and expense. Sec. 1.446-1(e)(2)(ii)(a), Income Tax

Regs. Inventories are a material item.
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Section 446(b) authorizes the Commissioner to exercise her

discretion with respect to tax accounting methods. As stated

therein, "if the method used [by the taxpayer] does not clearly

reflect income, the computation of taxable income shall be made

under such method as, in the opinion of the Secretary, does

clearly reflect income." Sec. 446(b); see also Thor Power Tool

Co. v. Commissioner, 439 U.S. 522 (1979). In general, a method

of accounting clearly reflects income when it accurately reports

taxable income under a recognized method of accounting.

Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d 352, 354

(1st Cir. 1970), affg. T.C. Memo. 1969-79; RLC Indus. Co. v.

Commissioner, 98 T.C. 457, 490 (1992), affd. 58 F.3d 413 (9th

Cir. 1995); Rotolo v. Commissioner, 88 T.C. 1500, 1513 (1987).

Courts do not interfere with the Commissioner's discretion with

respect to accounting methods unless she has abused it. Thor

Power Tool Co. v. Commissioner, supra at 532; Lucas v. American

Code Co., 280 U.S. 445, 449 (1930); Ford Motor Co. v.

Commissioner, 102 T.C. 87, 92 (1994), affd. 71 F.3d 209 (6th Cir.

1995). Whether the Commissioner has abused her discretion is a

question of fact, Rodebaugh v. Commissioner, 518 F.2d 73, 75 (6th

Cir. 1975), affg. T.C. Memo. 1974-36, and her determination will

not be set aside unless it is shown to be "plainly arbitrary",

Thor Power Tool Co. v. Commissioner, supra at 533. Petitioner

must prove that the exercise of the Commissioner's discretion was

plainly arbitrary. Asphalt Prods. Co. v. Commissioner, 796 F.2d
 - 6 -

843, 848 (6th Cir. 1986), affg. on this issue Akers v.

Commissioner, T.C. Memo. 1984-208, revd. on another issue 482

U.S. 117 (1987).

The Commissioner is given broad discretion to require a

taxpayer to comply with tax accounting regulations. For example,

the Commissioner can require that a taxpayer use an accrual

method to report his or her purchases and sales of inventory.

See, e.g., Knight-Ridder Newspapers, Inc. v. United States,

743 F.2d 781, 791 (11th Cir. 1984); Wilkinson-Beane, Inc. v.

Commissioner, supra at 355; see also Caldwell v. Commissioner,

202 F.2d 112 (2d Cir. 1953), affg. a Memorandum Opinion of this

Court dated June 29, 1951. The regulations under sections

446 and 471 provide detailed rules governing the costing and

computation of inventories. The regulations provide that a

taxpayer must keep inventories in computing his or her taxable

income whenever the production, purchase, or sale of merchandise

is an income-producing factor. Secs. 1.446-1(a)(4)(i); 1.471-1,

Income Tax Regs. We consider the facts and circumstances of each

case in deciding whether the purchase or sale of goods is an

income-producing factor. Honeywell, Inc. v. Commissioner, T.C.

Memo. 1992-453, affd. without published opinion 27 F.3d 571 (8th

Cir. 1994); Wilkinson-Beane, Inc. v. Commissioner, T.C. Memo.

1969-79. The facts and circumstances of the instant case support

the conclusion that petitioner's sale of diamonds and other gems

was an income-producing factor in his business. See Knight-
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Ridder Newspapers, Inc. v. United States, supra (newsprint used

in connection with a newspaper publishing business); Wilkinson-

Bean v. Commissioner, 420 F.2d. at 352 (purchase and sale of

caskets maintained by a funeral home); see also Thompson Elec.,

Inc. v. Commissioner, T.C. Memo. 1995-292 (materials used by an

electrical contractor); J.P. Sheahan Associates v. Commissioner,

T.C. Memo. 1992-239 (roofing materials used in a roofing repair

business); Surtronics, Inc. v. Commissioner, T.C. Memo. 1985-277

(metals used by a taxpayer in its electroplating business). We

find critical the fact that petitioner's sale of gems was the

only source of income from his business.

Petitioner argues that he has consistently used the cash

method from the start of his business, and that the cash method

is (1) authorized by the Internal Revenue Code and (2) clearly

reflects his income. Under the facts at hand, however, we

conclude that the cash method is not an authorized method for

reporting petitioner's purchases and sales of gems.2 Because the

cash method is not an authorized method, the Commissioner did not

commit an abuse of discretion in changing petitioner's method to

an authorized method. An accrual method is authorized for the

2
In this regard, the record does not indicate that the
results under the cash method would be substantially identical
with the results under an accrual method. See Wilkinson-Bean,
Inc. v. Commissioner, 420 F.2d 352 (1st Cir. 1970), affg. T.C.
Memo. 1969-79; Ansley-Sheppard-Burgess Co. v. Commissioner, 104
T.C. 367, 377 (1995);
 - 8 -

purchase and sale of merchandise.3 Knight-Ridder Newspapers,

Inc. v. United States, supra at 789; Sec. 1.446-1(c)(2)(i),

Income Tax Regs.

We hold that respondent did not abuse her discretion in

changing petitioner's method of accounting to an accrual method.

2. Section 481 Adjustment

A taxpayer who changes his or her method of accounting,

whether voluntarily or involuntarily, must compute an adjustment

under section 481(a). Section 481(a) provides that a taxpayer's

taxable income for the year of an accounting method change is

computed by taking into account those adjustments that are

necessary (solely due to the change), to prevent amounts from

being duplicated or omitted. See also sec. 1.481-1(a)(1), Income

Tax Regs. An item of income or deduction will be duplicated if

the taxpayer, in a prior year: (1) Recognized income that would

be recognized again under the new method of accounting or

(2) deducted an item that would be deducted again under the new

method of accounting. An item of income or deduction would be

omitted if the taxpayer, in a prior year: (1) did not recognize

income that will not be recognized under the new method of

accounting or (2) Did not deduct an item that will not be

deducted under the new method of accounting.

3
Generally, where an individual has been required to
maintain inventories, he or she must use the accrual method of
accounting with regard to purchases and sales. See sec.
1.446-1(c)(2)(i), Income Tax Regs.
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Respondent determined (and reflected in her notice of

deficiency) that petitioner’s inventory had increased from an

opening inventory of zero on January 1, 1988, to a closing

inventory of $61,305 on December 31, 1988. Thus, respondent

determined that petitioner’s 1988 gross income should be

increased by $61,305 to reflect this adjustment. See Hitachi

Sales Corp. of America v. Commissioner, T.C. Memo. 1995-84.

Respondent did not determine that any of this increase qualified

as an adjustment under section 481(a). Respondent has since

conceded that petitioner’s opening inventory was $10,000 on

January 1, 1988. Respondent further concedes that petitioner’s

gross income for 1988 should be increased by only $51,305.

Petitioner does not dispute the fact that he must recognize

$51,305 of income in 1988 on account of this adjustment. The

parties disagree on whether the $51,305 adjustment is subject to

section 481(a). If it is, petitioner claims that he can account

for this adjustment under the rules of section 481(b). Section

481(b) applies when: (1) A taxpayer changes a method of

accounting, (2) the taxpayer’s income in the year of the change

is increased by more than $3,000 solely by reason of the change

in order to prevent amounts from being duplicated or omitted, and

(3) the taxpayer used the former method of accounting during the

2 taxable years immediately preceding the year of the change.

Sec. 481(b)(1).
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Respondent argues that the adjustment in question is not an

adjustment to which section 481(a) applies. We agree with

respondent. None of her $51,305 adjustment is an adjustment

under section 481(a). Because respondent changed petitioner’s

method of accounting effective with his 1988 taxable year, the

change is considered to have been made on January 1, 1988. Sec.

1.481-1(c)(1), Income Tax Regs. On January 1, 1988, petitioner

had $10,000 of inventory. Under the cash method, the cost of

this inventory was deducted by petitioner in a previous year.

Because petitioner would be allowed to treat the cost of this

inventory as an offset against receipts from sales again under

the accrual method, a $10,000 adjustment under section 481(a) is

necessary to prevent the amount from being duplicated.

Respondent, however, does not contend that the $10,000 must be

included in petitioner’s income as a section 481 adjustment.

Accordingly, we consider the adjustment under section 481(a) to

be zero. Cf. Jasionowski v. Commissioner, 66 T.C. 312 (1976).

Thus, we need not concern ourselves with the mechanics of section

481(b), because the adjustment under section 481(a) is zero.

To reflect concessions,

Decision will be entered

under Rule 155.