Morrissey v. Internal Revenue Service (In Re EWC, Inc.)

F I L E D
United States Court of Appeals
Tenth Circuit
PUBLISH
JUN 9 1997
UNITED STATES COURT OF APPEALS
PATRICK FISHER
Clerk
TENTH CIRCUIT

In re: EWC, INC.,

Debtor,

GARY L. MORRISSEY, Trustee for
EWC, Inc., No. 95-6391

Appellant,
v.

INTERNAL REVENUE SERVICE,

Appellee.

Appeal from the United States District Court
for the Western District of Oklahoma
(D.C. No. CIV-94-652-L)

Gary L. Morrissey of Mahaffey & Gore, P.C., Oklahoma City, Oklahoma, for
Appellant.

Jonathan S. Cohen, Department of Justice, Washington, D.C. (Kenneth W.
Rosenberg with him on the briefs) for Appellee.

Before SEYMOUR, PORFILIO and LUCERO, Circuit Judges.

LUCERO, Circuit Judge.
 This appeal concerns a C corporation’s use of the cash accounting method

to calculate its 1989 taxable income in violation of 26 U.S.C. § 448. Despite

using a prohibited accounting method, the taxpayer’s return clearly reflected

taxable income. At issue is whether § 448 requires the IRS, in its audit of the

taxpayer’s 1989 return, to treat the taxpayer as an accrual method taxpayer,

regardless of the accounting method the taxpayer actually used. The bankruptcy

and district courts held that although § 448 prohibits the taxpayer from using the

cash accounting method to prepare its 1989 return, it does not prohibit the

Commissioner of Internal Revenue from assessing taxes based on a return

prepared under the cash accounting method when that method had always been

used by the taxpayer and clearly reflected income.

The taxpayer in this case, EWC, sold extended service warranty contracts

for electronic products. In 1991, EWC filed a voluntary petition for bankruptcy

under Chapter 11 of the Bankruptcy Code. The IRS, as one of EWC’s creditors,

filed a claim for $2,971,799.02. The claim resulted from the IRS’s pre-petition

audit of EWC’s tax returns for 1987, 1988, and 1989.

The bankruptcy trustee, Morrissey, objected to the IRS’s claim. He argued

that the IRS had incorrectly disallowed numerous deductions to which EWC, as

an accrual method 1 taxpayer, was entitled. The IRS disallowed the deductions

1
Under the accrual method of accounting, income is recognized in the “year when
(continued...)

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because it determined that EWC actually used the cash method 2 of accounting in

the preparation of its tax returns.

To resolve whether EWC used the cash or accrual method of accounting,

the bankruptcy court held two hearings. It heard conflicting evidence. Gordon

Henderson, who maintained EWC’s books and records through 1987 and prepared

EWC’s tax returns from 1985 to 1989, testified that he set up EWC’s initial

accounting system, recommended that EWC adopt the accrual method of

accounting, and, allegedly, used an accrual method of accounting to prepare

EWC’s 1985-89 returns. EWC marked on its first corporate tax return in 1985

and on every return through 1989 that it used the accrual method of accounting.

Randy Webb, who kept EWC’s books and records for 1988 and 1989, testified

that he employed a hybrid method of accounting in maintaining EWC’s internal

books, using the accrual method for the general ledger and the cash method for

the accounts receivable, sales, and warranty claim reserves. The IRS agent who

audited EWC’s returns testified that she determined that EWC had not used the

(...continued)
1

all events have occurred that fix the right to receive the income and the amount of the
income can be determined with reasonable accuracy.” 26 C.F.R. § 1.446-1(c)(ii).
Expenses are deducted in the “year in which all the events have occurred that establish the
fact of the liability, the amount of the liability can be determined with reasonable
accuracy, and economic performance has occurred with respect to the liability.” Id.
2
Under the cash method of accounting, income is recognized in the taxable year in
which it is actually or constructively received, and expenses are deducted in the taxable
year in which they are actually paid. 26 C.F.R. § 1.446-1(c)(i).

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accrual method of accounting for the years in question “because its books and

records were substantially maintained on the cash method; no adjusting entries

were made to [EWC’s] books to convert the accounting to an accrual basis for

reporting purposes; and the numbers in the internal book and records were

mirrored in [EWC’s] tax returns . . . .” Appellant’s App. at 22. It was the

opinion of the IRS agent that both the cash and accrual methods would clearly

reflect EWC’s income.

After considering this and other evidence, the bankruptcy court ruled that

despite the indication on EWC’s tax returns that it used the accrual method of

accounting, it actually used the cash method of accounting for the years in

question. The bankruptcy court rejected the trustee’s argument that § 448

required the IRS to consider EWC to be on the accrual method of accounting for

1989. The trustee did not appeal the bankruptcy court’s factual determination that

EWC actually used the cash method of accounting in preparing its 1987, 1988,

and 1989 tax returns. Rather, the trustee appealed only the bankruptcy court’s

legal conclusion that § 448 did not require the IRS to use the accrual accounting

method to calculate EWC’s tax liability for 1989. The district court affirmed the

bankruptcy court’s order. The trustee appeals.

We review the legal decisions of the bankruptcy and district court de novo.

Phillips v. White (In re White), 25 F.3d 931, 933 (10th Cir. 1994). We note,

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however, that the Commissioner of Internal Revenue has broad discretion to

determine the propriety of a taxpayer’s method of accounting. The

Commissioner’s allowance of a particular method of accounting will not be

disturbed unless it is plainly arbitrary. See Thor Power Tool Co. v. Commissioner

of Internal Revenue, 439 U.S. 522, 532-33 (1979).

The trustee argues on appeal that § 448 requires the IRS to treat EWC as an

accrual method taxpayer for 1989. “In interpreting the meaning of the words in a

revenue act, we look to the ordinary, everyday senses of the words.”

Commissioner of Internal Revenue v. Soliman, 113 S. Ct. 701, 705 (1993)

(quotations omitted). Section 448 states: “Except as otherwise provided in this

section, in the case of a—(1) C corporation, (2) partnership which has a C

corporation as a partner, or (3) tax shelter, taxable income shall not be computed

under the cash receipts and disbursements method of accounting.” 26 U.S.C. §

448(a). This rule does not apply to farming businesses, qualified personal service

corporations, and corporations or partnerships with average gross receipts of less

than $5,000,000. 26 U.S.C. § 448(b)(3). Absent one of these exceptions, the

plain language of § 448 bars a C corporation from using the cash accounting

method to compute its taxable income. Yet, this is precisely what EWC did.

1989 was the first year in which EWC’s gross receipts exceeded

$5,000,000. Section 448(a) clearly prohibited EWC from using the cash

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accounting method to calculate its 1989 taxable income. EWC tells us it believed

that it had always used the accrual method of accounting and that § 448(a),

therefore, did not require a change in its method of accounting. The bankruptcy

court ruled, however, that EWC had used the cash accounting method to calculate

its 1989 taxable income, in violation of § 448—a ruling that has been not

appealed.

At no point has EWC attempted to correct its improper use of the cash

method, either by filing an amended return or by otherwise adopting another

accounting method. 3 Given EWC’s violation of § 448 and its failure to correct its

error, we find disingenuous the trustee’s arguments on appeal that the IRS has

“imposed” a prohibited accounting method on EWC, and “ordered” EWC to use

an illegal accounting method in preparing its 1989 tax return. In reality, the IRS

has done no more than accede to EWC’s use of the cash method and compute the

tax deficiency pursuant to that method.

The trustee does not dispute that the cash method of accounting clearly

reflected EWC’s 1989 taxable income. We agree with the district court that the

3
Other than EWC’s assertion that the cash method of accounting is improper, the
record does not indicate that EWC has demonstrated “that there would be no deficiency,
or a smaller deficiency, if its tax liability were redetermined using the accrual method.”
In re Sperling, 341 F.2d 201, 204 (2d Cir. 1965). Thus, we need not decide whether such
a redetermination by the taxpayer would have been an appropriate response to the
Commissioner’s deficiency notice.

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IRS appropriately exercised its discretion to audit EWC using the cash method,

because that method clearly reflected EWC’s 1989 taxable income and had been

consistently used by EWC. 4 See 26 C.F.R. Part 1, § 1.446-1(c)(2)(ii) (allowing

Commissioner to “authorize a taxpayer to continue the use of a method of

accounting consistently used by the taxpayer, even though not specifically

authorized by the regulations in this part, if, in the opinion of the Commissioner,

income is clearly reflected by the use of such method”); see also In re Sperling,

341 F.2d 201, 204 (2d Cir. 1965) (holding that where the taxpayer used a rational

but improper accounting method, IRS “may choose to let it stand and pursue only

specific deficiencies within it”).

Contrary to the trustee’s argument, § 448 does not require the IRS to place

EWC on the accrual method. Section 448 only prohibits taxpayer use of the cash

accounting method; it does not mandate use of the accrual method. Moreover, §

448(d)(7) contemplates that the taxpayer, not the IRS, is responsible for making

necessary changes in accounting methods. See 28 U.S.C. § 448(d)(7) (“In the

case of any taxpayer required by this section to change its method of accounting .

. .”). We need not resolve whether IRS consent would be necessary for EWC to

4
We assume for purposes of this appeal that EWC consistently used the cash
method, because the trustee has not appealed the bankruptcy court’s factual determination
that EWC used the cash method on its 1987, 1988, and 1989 tax returns.

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change to the accrual method, because the IRS has not withheld its consent, and

EWC has not attempted to change accounting methods without consent.

AFFIRMED.

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