Cash method found to reflect income.

In Ansloheppard-Burgess Co., 104 TC 367 (1995), the taxpayer was a C corporation in the construction business. It had always been on the cash method of accounting. It had no inventories and its gross receipts were less than $5 million per year. It seemed to satisfy all of the requirements for being on the cash method, and Sec. 448 did not require a change to the accrual method.

The taxpayer's construction contracts generally lasted between six and nine months, with the longest project lasting years. On audit, the IRS conceded that the taxpayer was not subject to either Sec. 448 or 460. The Service concluded, however, that the use of the cash method by the taxpayers did not clearly reflect income, and it required the taxpayer to use the percentage-of-completion method. The total cumulative Sec. 481 (a) adjustment from the forced change was approximately $55,000.

The IRS argued that Wilkinson-Beane, 420 F2d 352 (1st Cir. 1970), held that a taxpayer that uses the cash method must be able to show that the cash method produces substantial identity of results with the method required by the Service in order to retain the cash method. The IRS also relied on its broad discretion to determine if a method of accounting clearly reflects income. Because the taxpayer did not recognize income from its contracts until the income was received, the results would not be identical to those arising if the taxpayer was required to recognize income on the percentage-of-completion method.

The Tax Court held that the substantial identity of results test applies only in cases in which the taxpayer has inventories. All of the cases using that test had been inventory cases. Further, the court stated that if the Service's arguments were taken to their logical conclusion, the cash method would be totally prohibited. Congress had not intended this result because it provided exceptions to both Secs. 448 and 460 for small businesses. Therefore, the court held that the IRS had abused its discretion in requiring the taxpayer to change its method of accounting.

This case is important in several contexts. The Service has been very active in attempting to force as many businesses as possible off the cash method, especially construction companies and health care providers (although the same analysis can seemingly apply to almost any service business). By restricting the "substantial identity of results" doctrine to inventory cases, this case gives taxpayers an additional weapon to help retain the cash method for construction or service businesses. Further, the Tax Court seemed to be influenced by the fact that Congress had exempted businesses like the taxpayer from Secs. 448 and 460. Despite IRS attempts in the regulations to state that the "clear reflection of income" analysis could force taxpayers exempt from Sec. 448 off the cash method, the Tax Court did not seem convinced.

It is, still nearly impossible to receive permission from the Service to change from the accrual method to cash on a change of accounting method request. Generally, the IRS will not grant permission to change if there is a significant amount of receivables at the end of the tax year. We do not believe that this case will change the Service's view of these requests.

From Glenn F. Mackles, Esq., Washington, D.C.