T.C. Memo. 1998-184
UNITED STATES TAX COURT
GOLDEN GATE LITHO, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 6569-95. Filed May 18, 1998.
Jon R. Vaught, for petitioner.
Elaine L. Sierra, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
WRIGHT, Judge: Respondent determined a deficiency of
$133,906 in petitioner's Federal income tax and an accuracy-
related penalty under section 6662(a) of $26,781 for the taxable
year ending May 31, 1991.
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the year in issue, and
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all Rule references are to the Tax Court Rules of Practice and
Procedure. After concessions1 by the parties, the issues to be
decided are:
(1) Whether petitioner is required to change from the cash
method of accounting to the accrual method of accounting;
(2) if petitioner is required to change to the accrual
method of accounting, to what extent, if any, adjustments were
properly made under section 481; and
(3) whether petitioner is liable for the accuracy-related
penalty under section 6662(a).
FINDINGS OF FACT
Petitioner is a California corporation organized in 1980.
At the time of filing the petition in this case, petitioner's
principal place of business was in Oakland, California.
Petitioner is owned 76 percent by its president, Clifford Asher
(Mr. Asher), and 24 percent by Mr. Asher's son, Donald Asher.
Petitioner is in the lithography or commercial printing
business. The business was established by a prior owner in 1937.
In 1973, Mr. Asher purchased the business from the prior owner.
In 1980, Mr. Asher incorporated the business and changed its name
to Golden Gate Litho.
1
Respondent concedes that petitioner is entitled to deduct
commission expenses in the amount of $21,888. Petitioner
concedes that it is not entitled to deduct a loss of $6,215 on
the sale of an automobile.
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Petitioner prints calendars, napkins, greeting cards, and
forms according to the specifications of its customers.
Petitioner orders the types of paper and supplies needed for
print jobs after receiving job orders. Petitioner does not
maintain a stock of paper or other materials because each job
requires paper of a different weight and finish. Usually when a
job is completed, any materials left over are scraps and are not
used for other jobs.2
On average, it takes 2 to 3 weeks from the time an order is
placed to complete the job and ship the order to the customer.
Petitioner holds title to (and bears the risk of loss of) the
supplies and printed goods until the final goods are shipped to
its customers. After the goods are shipped, the client is billed
for the order. Petitioner usually receives payment for an order
within 45 days of shipment.
A large portion of petitioner's work is done for one
customer, Suzy's Zoo Greeting Cards. For the taxable year ending
May 31, 1991, Suzy's Zoo Greeting Cards accounted for
approximately 70 percent of petitioner's accounts receivable at
the start of the taxable year and approximately 80 percent of the
accounts receivable at the end of the taxable year.
2
Petitioner usually donates the scraps to a school or
makes scratch pads out of the them.
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Petitioner has used the cash receipts and disbursements
method of accounting (cash method) for tax purposes since its
incorporation. Petitioner reports sales at the time it receives
payment. Petitioner deducts the cost of materials and supplies
for each printing job in the year of purchase and deducts all
expenses in the year paid. Petitioner did not report any
beginning or ending inventory on its tax returns and did not use
inventory accounting for either tax or financial accounting
purposes for the year at issue or the immediately preceding tax
year. Since its incorporation, petitioner has reported no
opening or closing inventories on its tax returns.
Petitioner reported its income under the cash method for the
taxable years ending May 31, 1989 through 1995, as follows:
Taxable Year Ending
5/31/89 5/31/90 5/31/91 5/31/92 5/31/93 5/31/94 5/31/95
Gross receipts $1,450,643 $1,462,904 $1,678,433 $1,499,946 $1,399,727 $1,357,166 $1,135,232
Cost of goods
sold 939,217 890,986 1,026,832 900,459 834,879 94,623 759,113
Gross profit 511,426 571,918 651,601 599,487 564,848 462,543 376,119
Total deductions 468,360 585,688 615,220 562,412 541,842 531,526 480,820
1
Net income 43,066 (13,770) 36,381 37,075 23,006 (68,983) (104,701)
2
Other income 8,821 18,238 16,683 17,147 21,083 15,346 12,797
Special deductions -0- 670 3,064 4,222 6,293 6,007 6,117
Taxable income 51,887 3,798 50,000 50,000 37,796 (59,644) (98,021)
Schedule A (cost of
goods sold):
Inventory
beginning year -0- -0- -0- -0- -0- -0- -0-
Purchases 546,827 483,172 577,861 449,492 380,327 420,730 282,490
Labor 335,783 375,021 395,210 377,987 382,311 396,928 324,124
Union benefits 30,004 25,460 28,153 32,383 37,010 35,969 29,624
Misc. O/S
services -0- -0- 18,468 30,995 29,594 33,595 116,410
Sales Tax 20,543 -0- -0- -0- -0- -0- -0-
Freight 6,060 7,333 7,140 9,602 5,637 7,401 6,465
Inventory
end year -0- -0- -0- -0- -0- -0- -0-
Total 939,217 890,986 1,026,832 900,459 834,879 894,623 759,113
Schedule E
(compensation of
officers):
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C. F. Asher 156,250 205,000 228,000 182,500 165,000 165,000 135,000
D. Asher wage
in C.O.G.S. -0- 106,545 138,978 134,620 132,295 143,741 101,015
1
Taxable income excluding other income and before NOL and special deductions.
2
Dividends, interest, gross rents and royalties, capital gain, and other income.
Mr. Asher and petitioner's bookkeeper used a commercial
bookkeeping program to prepare balance sheets that included
estimates of petitioner's end-of-year accounts receivable,
accounts payable, salaries and wages payable, and work in
process. The bookkeeper determined the amount of accounts
payable by totaling bills that were due. The bookkeeper also
determined the amount of accounts receivable by compiling
amounts reflected on customer account cards. Mr. Asher
estimated the amount reflected on the balance sheet as work in
process. Mr. Asher's estimates of work in process were based on
the market value that included the expected profit from the
work. The balance sheets for the fiscal years ending May 31,
1989 through 1995, reflect the following amounts:3
Taxable Year Ending
Item 5/31/89 5/31/90 5/31/91 5/31/92 5/31/93 5/31/94 5/31/95
Accounts
receivable $176,580 $250,378 $196,378 $142,673 $221,248 $210,471 $212,379
Accounts payable 35,999 86,334 23,711 44,198 64,206 42,278 45,087
Salaries and
wages payable 16,250 12,250 13,250 13,250 14,250 15,250 16,250
Pension plan
accrual -0- 52,260 56,000 -0- -0- 20,000 73,597
Work in process 120,000 150,000 161,000 120,000 145,000 80,000 139,000
No later than July 1993, an agent of the Internal Revenue
Service (IRS) began an audit of petitioner's returns for the
3
Amounts are rounded to the nearest dollar.
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taxable years ending May 31, 1991 and 1992. The agent has a
bachelor of science and a master's in business administration in
accounting. The audit was extensive and lasted longer than 12
months. Petitioner provided the agent with all its books and
records. Although petitioner had previously been audited and
had not been required to change from the cash method of
accounting, the agent determined that petitioner was required to
account for inventories and use the accrual method of
accounting.
During the examination of petitioner's returns, petitioner
provided the following breakdown of the work in process as of
June 1, 1991:
Paper $55,000
W.I.P. camera 5,000
W.I.P. press 30,000
W.I.P. bindery 16,000
Jobs completed and shipped 38,000
Jobs ready to bill 13,500
Jobs at outside service 3,500
Total 161,000
Adjustments to Taxable Year Ending May 31, 1991
In the notice of deficiency, respondent determined that
petitioner was required to maintain inventories and use the
accrual method of accounting with respect to purchases and sales
of inventory items. Respondent increased petitioner's income
for the taxable year ending May 31, 1991, by $36,002 ($11,000 +
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$78,464 - $53,462) to account for the change to the accrual
method as follows:
(1) Respondent reduced petitioner's gross receipts or sales
by $53,462 computed as follows:
1
Accounts receivable at close of year, less $196,916
Accounts receivable at beginning of year (250,378)
Adjustment to gross receipts or sales (53,462)
1
Respondent used the amount of accounts receivable provided
during the examination of petitioner's return rather than the
amount reflected on petitioner's balance sheet for the fiscal
year ending May 31, 1990.
(2) Respondent increased petitioner's income by $11,000 to
reflect an $11,000 reduction of petitioner's cost of goods sold4
to account for inventories as follows:
Work in process at beginning of year, less $150,000
Work in process at end of year (161,000)
Reduction in cost of goods sold (11,000)
(3) Respondent increased petitioner's income by $78,464 to
reflect a $78,464 reduction of petitioner's cost of goods sold
to account for purchases on the accrual method as follows:
1
Accounts payable at close of year, less $20,120
2
Accounts payable at beginning of year (98,584)
Reduction in cost of goods sold (78,464)
1
This amount is the portion of the accounts payable at the
close of the taxable year that is related to cost of goods sold.
It does not include $5,111 in accounts payable related to
operating expenses and $11,250 in salaries and wages payable to
Mr. Asher.
2
This amount includes all accounts payable ($86,334), plus
all salaries and wages payable ($12,250) at the beginning of the
4
The notice of deficiency identifies the $11,000 increase
as an adjustment to "work in process".
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taxable year. It includes payables related to operating
expenses as well as those related to cost of goods sold.
Respondent determined that adjustments were required by
section 481(a) and adjusted petitioner's taxable year ending May
31, 1991, as follows:
(1) Respondent increased petitioner's income by $250,378
for the amount of accounts receivable reflected on its balance
sheet for fiscal year ending May 31, 1990;
(2) respondent increased petitioner's income by $150,000
for the value of work in process reflected on its balance sheet
for fiscal year ending May 31, 1990; and
(3) respondent decreased petitioner's income by $98,584 for
the amount of accounts payable and wages and salaries payable
reflected on its balance sheet for fiscal year ending May 31,
1990.
Respondent made the entire section 481 adjustment to the
year of the change (taxable year ending May 31, 1991) and did
not consider the application of section 481(b). Respondent also
disallowed $21,888 in commission expenses and $6,215 that
petitioner claimed as the loss on the sale of an automobile.
As a result of the adjustments, respondent determined that
petitioner's taxable income for the taxable year ending May 31,
1991, was $415,899 rather than $50,000 as reported on the
return.
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Adjustments to Taxable Year Ending May 31, 1992
In the notice of deficiency, respondent also adjusted
petitioner's taxable income for the taxable year ending May 31,
1992. Respondent reduced petitioner's income by $113,875
because of the change in accounting method. Specifically,
respondent decreased petitioner's income by $54,243 to reflect a
reduction in gross receipts, decreased petitioner's income by
$41,000 to reflect the reduction in the amount of petitioner's
work in process, and decreased petitioner's income to reflect an
$18,632 increase in the cost of goods sold. Respondent also
disallowed a repair expense of $23,624 and reduced petitioner's
depreciation deduction by $2,411. As a result of the
adjustments, respondent determined that petitioner had a $37,636
net operating loss for the taxable year ending May 31, 1992,
rather than $50,000 of taxable income as reported on the return.
OPINION
I
Whether Petitioner Is Required To Change From The Cash Method of
Accounting to The Accrual Method of Accounting
Section 446(a) requires a taxpayer to compute his taxable
income under the same method of accounting by which he regularly
computes his income in keeping his books. Section 446(b),
however, provides that "if the method used [by the taxpayer]
does not clearly reflect income, the computation of taxable
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income shall be made under such method as, in the opinion of the
Secretary, does clearly reflect income."
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. 1969-70; 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). Both the cash method and the accrual method are
permissible methods of accounting. Sec. 446(c)(1) and (2).
Additionally, section 471(a) provides:
SEC. 471(a). General Rule.-- Whenever in the
opinion of the Secretary the use of inventories is
necessary in order clearly to determine the income of
any taxpayer, inventories shall be taken by such
taxpayer on such basis as 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.
By regulation, the Secretary has determined that
inventories are necessary if the production, purchase, or sale
of merchandise is an income-producing factor. Sec. 1.471-1,
Income Tax Regs. The regulations provide that, unless otherwise
authorized by the Commissioner, a taxpayer who is required to
account for inventories must use the accrual method of
accounting with regard to purchases and sales. Sec. 1.446-
1(c)(2)(i), Income Tax Regs.
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A. Whether Petitioner Is Required To Maintain Inventories
Petitioner prints calendars, napkins, greeting cards, and
forms according to the specifications of its customers.
Petitioner does not maintain a stock of paper or other materials
because each job requires paper of a different weight and
finish. Petitioner orders the types of paper and supplies
needed for a job after the customer's order is placed. Usually
when a job is completed, any materials left over are scraps and
are not used for other jobs.
Respondent asserts that petitioner's production, purchase,
and sale of merchandise is an income-producing factor, and
therefore petitioner must account for inventories. Petitioner
argues that it provides a service, and the printed items it
sells to its customers and the materials it uses are not
merchandise. Petitioner argues, therefore, it is not required
to maintain inventories.
Although not specifically defined in the Internal Revenue
Code or regulations, courts have found that the term
"merchandise", as used in section 1.471-1, Income Tax Regs., is
defined as an item held for sale. Wilkinson-Beane, Inc. v.
Commissioner, supra at 354-355; Tebarco Mechanical Corp. v.
Commissioner, T.C. Memo. 1997-311; Galedrige Constr., Inc. v.
Commissioner, T.C. Memo. 1997-240; Honeywell Inc. & Subs. v.
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Commissioner, T.C. Memo. 1992-453, affd. without published
opinion 27 F.3d 571 (8th Cir. 1994).
Petitioner sells items that it prints according to the
specifications of its customers. The printed items are items
held for sale and, thus, are merchandise. All of petitioner's
gross receipts are generated by the sale of the items petitioner
produces for its customers. Therefore, the production and sale
of merchandise is an income-producing factor.
Furthermore, even if we agreed that petitioner performs a
service, courts have held that, if the cost of materials a
taxpayer uses to provide a service is substantial compared to
its receipts, the material is a substantial income-producing
factor. Wilkinson-Beane, Inc. v. Commissioner, supra at 355.
Petitioner reported the following gross receipts and purchases
for the taxable years ending May 31, 1989 through 1995:
Taxable Year Ending
5/31/89 5/31/90 5/31/91 5/31/92 5/31/93 5/31/94 5/31/95
Gross receipts $1,450,643 $1,462,904 $1,678,433 $1,499,946 $1,399,727 $1,357,166 $1,135,232
Purchases $546,827 $483,172 $577,861 $449,492 $380,327 $420,730 $282,490
Percentage 38% 33% 34% 30% 27% 31% 25%
The cost of materials petitioner uses to provide its
service is substantial compared to its receipts. Therefore,
the material petitioner uses is a substantial income-producing
factor. Petitioner's arguments have previously been considered
and rejected by this Court. See Thompson Elec., Inc. v.
Commissioner, T.C. Memo. 1995-292; J.P. Sheahan Associates,
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Inc. v. Commissioner, T.C. Memo. 1992-239; Akers v.
Commissioner, T.C. Memo. 1984-208, affd. on this issue sub nom.
Asphalt Prods. Co. v. Commissioner, 796 F.2d 843 (6th Cir.
1986), revd. on another issue 482 U.S. 117 (1987). We find
that petitioner's sale of merchandise is an income-producing
factor and, therefore, petitioner is required to maintain
inventories.
B. Whether It Was an Abuse of Respondent's Discretion To
Change Petitioner From the Cash Method to Respondent's
Method of Accounting
The regulations provide that, unless otherwise authorized
by the Commissioner, a taxpayer who is required to account for
inventories must use the accrual method of accounting with
regard to purchases and sales. Sec. 1.446-1(c)(2)(i), Income
Tax Regs. Respondent argues that petitioner must account for
inventories and must use the accrual method of accounting. In
this case, however, the facts show that respondent completely
disregarded the applicable provisions of the Internal Revenue
Code and regulations and made no attempt to properly value
petitioner's inventory or compute petitioner's income using a
proper accrual method of accounting.
1. Respondent's Method of Valuing Petitioner's Inventory
Was Improper
Rules governing the valuation of inventories are set forth
in regulations promulgated under section 471 and the uniform
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capitalization rules of section 263A. See secs. 1.471-1,
1.471-2, 1.471-3, 1.471-5, Income Tax Regs.; sec. 1.263A-1T,
Temporary Income Tax Regs., 52 Fed. Reg. 10060 (Mar. 30, 1987).
Respondent failed to comply with the rules for identifying
items properly included in inventory and for properly valuing
inventory items.
a. Items Included in Inventory
Respondent increased petitioner's income for the taxable
year ending May 31, 1991, by $11,000 to reflect a reduction of
petitioner's cost of goods sold to account for inventories
based on the increase in the value of work in process at the
end of the year ($161,000) over the value at the beginning of
the year ($150,000). In making the computation respondent used
the value of the work in process as reflected on petitioner's
balance sheets. During the examination of petitioner's return
for the taxable year at issue, petitioner provided the
following breakdown of the work in process as of June 1, 1991:
Paper $55,000
W.I.P. camera 5,000
W.I.P. press 30,000
W.I.P. bindery 16,000
Jobs completed and shipped 38,000
Jobs ready to bill 13,500
Jobs at outside service 3,500
Total 161,000
Section 1.471-1, Income Tax Regs., provides in part:
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Merchandise should be included in the inventory only
if title thereto is vested in the taxpayer.
Accordingly, the seller should include in his
inventory goods under contract for sale but not yet
segregated and applied to the contract * * *, but
should exclude from inventory goods sold * * * title
to which has passed to the purchaser. A purchaser
should include in inventory merchandise purchased
(including containers), title to which has passed to
him, although such merchandise is in transit or for
other reasons has not been reduced to physical
possession, but should not include goods ordered for
future delivery, transfer of title to which has not
yet been effected. * * *
Petitioner holds title to goods until they are shipped to
the purchaser and bills the customer after the order is
shipped. Therefore, petitioner does not hold title to work in
process for jobs completed and shipped and work in process for
jobs ready to bill. Under the regulations, such goods are not
properly included in valuing petitioner's inventory, and it was
improper for respondent to do so.
b. Respondent's Use of Estimated Market Value
"The bases of valuation most commonly used by business
concerns and which meet the requirements of section 471 are (1)
cost and (2) cost or market, whichever is lower." Sec. 1.471-
2(c), Income Tax Regs. Section 1.471-4(c), Income Tax Regs.,
provides:
Where the inventory is valued upon the basis of cost
or market, whichever is lower, the market value of
each article on hand at the inventory date shall be
compared with the cost of the article, and the lower
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of such values shall be taken as the inventory value
of the article.
Section 1.471-3, Income Tax Regs., defines "cost" as
follows:
(a) In the case of merchandise on hand at the
beginning of the taxable year, the inventory price of
such goods.
* * * * * * *
(c) In the case of merchandise produced by the
taxpayer since the beginning of the taxable year, (1)
the cost of raw materials and supplies entering into
or consumed in connection with the product, (2)
expenditures for direct labor, and (3) indirect
production costs incident to and necessary for the
production of the particular article, including in
such indirect production costs an appropriate portion
of management expenses, but not including any cost of
selling or return on capital, whether by way of
interest or profit. See section 1.263A-1T for more
specific rules regarding the treatment of production
costs. * * *
The uniform capitalization rules of section 263A apply to
real or tangible property produced by the taxpayer.5 Sec.
263A(b)(1). Section 263A(a) provides that inventory costs
include the direct costs of such property and such property's
proper share of those indirect costs part or all of which are
allocable to such property. Section 1.263A-1T, Temporary
5
Sec. 263A also applies to real or personal property
described in sec. 1221(1) which is acquired by the taxpayer for
resale except for taxpayers who have annual gross receipts of $10
million or less. Sec. 263A(b)(2). There is no exception
provided for producers who have annual gross receipts of $10
million or less.
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Income Tax Regs., supra, provides complex rules for allocating
indirect costs to inventory.
In valuing petitioner's inventory, respondent used the
value of petitioner's work in process as reflected on
petitioner's balance sheets. The value reflected on the
balance sheets was based on Mr. Asher's estimate of the market
value of work in process and included the expected profit from
the work.
The regulations permit the use of market value only when
that value is less than cost. Therefore, respondent's use of
the value of work in process as reflected on petitioner's
balance sheets is improper. Additionally, the regulations
require a comparison of the market value of each article on
hand at the inventory date with the cost of the article.
Respondent made no attempt to properly identify inventory items
or the direct costs of such items or to properly allocate
indirect costs associated with such items under the uniform
capitalization rules of section 263A.
We find that respondent's method of valuing petitioner's
work in process was arbitrary and without sound basis in fact
or law.
2. Respondent's Method Is Not a Proper Accrual Method
a. Accounts Receivable
Respondent reduced petitioner's gross receipts by $53,462
to account for accounts receivable. Respondent excluded from
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gross receipts $250,378 attributable to accounts receivable at
the beginning of the year and included $196,916 attributable to
accounts receivable at the close of the year. The amount of
receivables, however, was determined by compiling amounts
reflected on customer account cards.
Accrual method taxpayers recognize income when "all the
events have occurred which fix the right to receive such income
and the amount thereof can be determined with reasonable
accuracy." Sec. 1.446-1(c)(1)(ii), Income Tax Regs.
Generally, under the "all events" test, accrual method
taxpayers recognize income when it is paid, due, or earned,
whichever occurs first. See, e.g., Schlude v. Commissioner,
372 U.S. 128, 133 n.6 (1963).
As discussed above, the breakdown of the work in process
at the end of the year included amounts that had been earned,
even though not billed to the client. Those amounts were
accounts receivable at the close of the taxable year.
Consequently, gross receipts should have been increased by
those amounts. Similarly, any portion of the work in process
at the beginning of the year representing completed work that
had been shipped by the close of the previous tax year properly
was a receivable attributable to the prior taxable year.
Consequently, gross receipts should have been reduced by that
amount.
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b. Adjustment for Accounts Payable
Under an accrual method of accounting, a liability is
incurred and taken into account in the taxable year in which
all the events have occurred which determine the fact of the
liability and the amount thereof can be determined with
reasonable accuracy. Sec. 1.461-1(a)(2), Income Tax Regs.
Thus, for purposes of accrual method accounting and
ascertaining true income for a given accounting period, an
expense must be deducted in the taxable year in which all the
events have occurred which determine the fact of the liability
and fix the amount of the liability, even though the liability
is not due and payable until a later year. Aluminum Castings
Co. v. Routzahn, 282 U.S. 92 (1930); United States v. Anderson,
269 U.S. 422 (1926).
Respondent increased petitioner's income by $78,464 to
reflect a reduction of petitioner's cost of goods sold to
account for purchases on the accrual method as follows:
Accounts payable at close of year, less $20,120
Accounts payable at beginning of year (98,584)
Reduction in cost of goods sold (78,464)
The adjustment for accounts payable was based on the
accounts payable reflected on petitioner's balance sheets for
the close of the taxable years ending May 31, 1990 and 1991.
Although respondent's counsel would not stipulate the accuracy
of the amounts reflected on the balance sheets, it is those
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amounts upon which respondent's adjustments are based.
Further, petitioner's bookkeeper computed the payables by
totaling bills that were due. The payables did not include
expenses that may have properly accrued under the regulations
but for which petitioner had not yet been billed.
Additionally, "No method of accounting will be regarded as
clearly reflecting income unless all items of gross profit and
deductions are treated with consistency from year to year."
Sec. 1.446-1(c)(2)(ii), Income Tax Regs. In this case,
respondent did not treat petitioner's accounts payable with
consistency. The accounts payable of $98,584 at the beginning
of the taxable year included all accounts payable ($86,334)
plus all salaries and wages payable ($12,500) reflected on the
balance sheet for the taxable year ending May 31, 1990. The
accounts payable of $20,120 for the close of the taxable year
included only those payables identified as payables related to
the cost of goods sold and did not include $5,111 in accounts
payable not related to the cost of goods sold or $11,250 in
salaries and wages payable to Mr. Asher. Respondent made no
adjustments to account for accounts payable at the end of the
taxable year related to the $5,111 of operating expenses or
related to the $11,250 of salaries and wages payable.
Respondent's adjustment of these items was improper. In order
to clearly reflect petitioner's income, accounts payable at the
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beginning and the end of the year should have been treated in a
consistent manner.
If the accounts payable were to be allocated between those
related to the cost of goods sold and those related to
operating costs, an allocation should also have been made for
accounts payable at the beginning of the taxable year. Then
proper adjustments could be made to the cost of goods sold and
to the deduction for operating expenses.
Additionally, since respondent treated all accounts
payable at the beginning of the year as related to the cost of
goods sold, there would have been no accounts payable at the
beginning of the year related to operating expenses.
Therefore, respondent should have increased petitioner's
deduction for operating expenses (reducing petitioner's income)
by $16,361 to reflect the increase in payables related to
operating expenses at the close of the year.
We find respondent's determinations with respect to
petitioner's accounts receivable and payable to be
unreasonable, arbitrary, and without basis in law.
3. It Was an Abuse of Respondent's Discretion To Change
Petitioner From the Cash Method to Respondent's
Improper Method of Accounting
During the 12-month examination of petitioner's records,
the agent made no attempt to properly value petitioner's
inventories or value payables and receivables under the accrual
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method. Furthermore, although respondent's adjustments were
based on the amounts reflected on petitioner's balance sheets,
respondent's counsel would not stipulate the accuracy of those
amounts.
In Keneipp v. United States, 184 F.2d 263, 268 (D.C. Cir.
1950), the court addressed the Commissioner's power to allocate
items of income and stated:
We perceive no basis upon which the allocation
made by the Commissioner of the condemnation award
among the several pieces of property can be
sustained. * * * The Government's allocation is thus
completely erroneous on its face. The District Court
held that since there was a lump-sum award the
Commissioner of Internal Revenue had power to make
whatever allocation he pleased. The Commissioner has
no such arbitrary power. He has wide latitude in the
ascertainment of the fact as to what were the amounts
awarded on account of the several tracts and several
pieces of property. But his ascertainment must be
within the realm of the ascertainment of a fact. He
has no unilateral power to allocate as he pleases,
and thus to create income as he pleases, where no
income, or a different amount of income, exists. His
own published rule is that such an apportionment must
be upon the comparative values as of the date of the
sale.
We think that the reasoning of the U.S. Court of Appeals
for the D.C. Circuit in the Keneipp case is equally applicable
in the case at hand. We do not think there is any legitimate
basis for the method imposed upon petitioner. In this case,
the facts clearly show that the method of accounting employed
by respondent was not authorized or warranted by any provision
of the Internal Revenue Code or the regulations. Merely
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invoking the accrual method without a serious attempt to comply
with the rules and regulations governing that method is simply
not sufficient. Respondent has no unilateral power to value
inventory and allocate amounts to accounts receivable and
payable as he pleases in complete disregard of the Internal
Revenue Code and the regulations. To do so is an abuse of
respondent's discretion.
Respondent contends that petitioner must show a
substantial identity of results between the cash method and the
method of accounting respondent imposed in order to show an
abuse of discretion. We disagree.
The substantial identity of results test is applicable
when the taxpayer is required to maintain inventories and the
Commissioner has required the taxpayer to compute its income on
a proper accrual method of accounting as provided in the
regulations. We think it would be an abuse of the Court's
discretion to require petitioner to show that the cash method
it has consistently used produces substantially the same
results as the arbitrary and erroneous method respondent
imposed.
Respondent's adjustments based on the improper method
increased petitioner's income by $36,002 for the taxable year
ending May 31, 1991, but decreased petitioner's income by
$113,875 for the taxable year ending May 31, 1992, and created
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a net operating loss of $37,636 for the taxable year ending May
31, 1992. Under the circumstances of this case, and given the
inadequacies of respondent's method, we think petitioner's use
of the cash method produces substantially the same results.
Furthermore, respondent's method not only distorts
petitioner's income but will subject petitioner to further
adjustments, including adjustments under section 481, in
subsequent taxable years if petitioner attempts to properly
comply with regulations for accrual method accounting. If, in
respondent's opinion, petitioner's accounting method did not
clearly reflect its income, the remedy was to require a
computation on a basis that would correctly reflect income by
proper application of the accrual method of accounting.
The fact that the Commissioner possesses broad authority
under section 446(b) does not mean that the Commissioner can
change a taxpayer's method of accounting with impunity. See
Prabel v. Commissioner, 91 T.C. 1101, 1112-1113 (1988), affd.
882 F.2d 820 (3d Cir. 1989); Wal-Mart Stores, Inc. v.
Commissioner, T.C. Memo. 1997-1. The Commissioner cannot
require a taxpayer to change his accounting method to one which
is unacceptable or wrong. Harden v. Commissioner, 223 F.2d
418, 421 (10th Cir. 1955), revg. and remanding 21 T.C. 781
(1954); Rotolo v. Commissioner, 88 T.C. at 1514. Courts will
not approve the Commissioner's change of a taxpayer's
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accounting method from an incorrect method to another incorrect
method. Harden v. Commissioner, supra; Prabel v. Commissioner,
supra at 1112; see also Dayton Hudson Corp. & Subs. v.
Commissioner, T.C. Memo. 1997-260. The Commissioner's
authority is limited to substituting a method that will clearly
reflect the taxpayer's income. Harden v. Commissioner, supra
at 421. The Commissioner is required to use reasonable
accounting methods. Helvering v. Taylor, 293 U.S. 507 (1935);
Rubin v. Commissioner, T.C. Memo. 1954-213. The taxpayer has
the burden of showing that the method selected by the
Commissioner is incorrect, and that burden is extremely
difficult to carry. Hamilton Indus., Inc. v. Commissioner,
97 T.C. 120 (1991); Photo-Sonics, Inc. v. Commissioner, 42 T.C.
926, 933 (1964), affd. 357 F.2d 656 (9th Cir. 1966). In this
case, petitioner has carried its burden because the facts
clearly show that the method selected by the Commissioner is
arbitrary, capricious, and without sound basis in fact or law.
In Loftin & Woodard, Inc. v. United States, 577 F.2d 1206,
1229 (5th Cir. 1978), the court stated:
While abuse of this discretion by the
Commissioner must be proven by a clear showing, Wood
v. Commissioner of Internal Revenue, 245 F.2d 888
(5th Cir. 1957), it would seem that such a showing
could be predicated upon a decision to use an
accounting method that is inaccurate under the
circumstances. * * *
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We hold it was an abuse of respondent's discretion to
require petitioner to change from the cash method to
respondent's improper and inaccurate method.
C. For the Taxable Year at Issue, Petitioner Is Not Required
To Change From the Cash Method of Accounting
Courts have recognized that the regulations do not impose
an absolute prohibition of the use of the cash method upon a
taxpayer who is required to maintain inventories. Cf. Asphalt
Prods. Co. v. Commissioner, 796 F.2d at 849 (an insignificant
increase in inventories may be grounds for finding an abuse of
discretion by the Commissioner); Estate of Sperling v.
Commissioner, 341 F.2d 201, 204 (2d Cir. 1965), affg. T.C.
Memo. 1963-260 (courts will not require the Commissioner to
place a taxpayer on the accrual method); Drazen v.
Commissioner, 34 T.C. 1070, 1079 (1960) (where inventories are
so small as to be of no consequence or consist primarily of
labor, the presence of inventories is not necessarily
sufficient to require a change in the taxpayer's method of
accounting).
In Estate of Sperling v. Commissioner, supra, the taxpayer
argued that it was required to account for inventories and,
therefore, the Commissioner should have used the accrual method
in determining the tax deficiency. The court stated:
It is difficult to find any basis in reason for
thus placing the burden on the Commissioner to place
the taxpayer's tax returns on a different accounting
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basis. As this case comes to us, * * * [the
taxpayer's] 1953 and 1954 tax returns show two
defects. The first is that certain alleged credits
for the purchase of metals are not adequately
documented. The second is the use of an improper
accounting method. What the Commissioner has done is
to determine deficiencies attributable to the first
defect but to leave the second alone. We may guess
that this decision was made because it was believed
that the game was not worth the candle: the
additional deficiencies, if any, which use of the
accrual method might reveal would not warrant the
considerable effort which a redetermination would
require. Whatever the reason, however, we cannot see
why the decision should be held improper.
* * * * * * *
Of course, it is possible that the taxpayer's
accounting system may be so inadequate that the
Commissioner has no choice but to redetermine the
liability on the basis of his own system; * * * But
where the taxpayer does have a rational, though
improper, system, we think that the Commissioner may
choose to let it stand and to pursue only specific
deficiencies within it. And so long as the
deficiencies which he determines are not themselves
infected by the system's shortcomings, the taxpayer
may not avoid the deficiencies simply by pointing to
the inadequacy of his own accounting system. [Id. at
204-205; citation omitted.]
In Keneipp v. United States, 184 F.2d at 268, the court
reversed and remanded for further proceedings. In that case,
the court stated:
such proceedings need not be elaborate or extensive.
The Bureau of Internal Revenue has many auditors who
can quickly compute the gain properly taxable to
these appellants upon the facts of this case and the
principles we have referred to.
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By contrast, in this case proper application of the
accrual method and inventory valuation would require a full
audit of petitioner's books and records. The record does
not provide any basis upon which the Court can properly value
petitioner's inventory or accounts receivable and payable or
otherwise discern petitioner's taxable income under a proper
accrual method. In this case, the erroneous items cannot be
discerned with relative clarity and, therefore, cannot be
corrected in a computation under Rule 155. Cf. All-Steel
Equip. Inc. v. Commissioner, 54 T.C. 1749 (1970), affd. in
part, revd. in part and remanded 467 F.2d 1184 (7th Cir. 1972).
The Internal Revenue Code contemplates action by the
Commissioner, not the courts. Harden v. Commissioner, supra at
421.
Since petitioner's cash method is a rational system, we
think that the Court may choose to let it stand. We see no
basis for placing a greater burden on the Court than we place
on the Commissioner. See Estate of Sperling v. Commissioner,
supra at 203. We hold that petitioner is not required to
change from the cash method of accounting for the taxable year
at issue.
II
Whether Respondent's Adjustments Under Section 481 Were Proper
Section 481(a)(1) provides that where in computing a
taxpayer's taxable income the computation is under a method of
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accounting different from the method under which the taxpayer's
income for the preceding taxable year was computed, there shall
be taken into account those adjustments which are determined to
be necessary solely by reason of the change in order to prevent
an amount from being duplicated or omitted. Since we have held
that petitioner is not required to change from the cash method
for the taxable year at issue, petitioner's taxable income is
computed under the same method of accounting as in the previous
taxable year. Therefore, petitioner is not subject to any
adjustments under section 481.
III
Whether Petitioner Is Liable for the Accuracy-Related Penalty
Under Section 6662(a)
In its brief, petitioner addressed the accuracy-related
penalty only with respect to the change in accounting method.
Petitioner concedes that it is not entitled to deduct the loss
on the sale of an automobile. The deficiency to be computed
under Rule 155 is attributable solely to the disallowance of
that loss. Therefore, we hold petitioner is liable for the
accuracy-related penalty under section 6662(a).
To reflect the foregoing and because of the concessions by
the parties,
Decision will be entered
under Rule 155.