Clear reflection of income.

As a general rule taxpayers have the right to select their method of accounting--but this right is restricted by the requirement that the selected method clearly reflect income. Recently, the Seventh Circuit Court of Appeals remanded a case to the Tax Court to redetermine the method the taxpayer selected.

JP Morgan Chase, successor to First National Bank of Chicago, engaged in interest rate swaps. These are complex financial transactions that require two parties to pay each other interest based on various factors. Chase reported the income from these swaps based on its financial accounting method. The IRS objected and assessed a deficiency based on its own method. The Tax Court rejected both methods and imposed a third. JP Morgan Chase appealed.

Result. JP Morgan Chase's method was incorrect. The case was remanded for the Tax Court to reconsider the IRS method.

IRC section 446(a) requires taxpayers to compute their taxable income based on the accounting methods used in their books and records. Under section 446(b), the IRS can impose a different method if a taxpayer's selected method does not clearly reflect income. The fact that the taxpayer's method is based on GAAP does not mean it clearly reflects income. These general rules concerning selection of accounting methods give way to specifically designated methods in the tax code.

One such designated method is the mark-to-market method, which must be used by dealers in financial instruments. Since interest rate swaps are financial instruments, JP Morgan Chase was required to use this special method. If the taxpayer's computation under a mandated method is incorrect, it is treated as a method that does not clearly reflect income and the IRS has the right to mandate the computation under section 446(b).

When the IRS imposes a method under section 446(b), it is entitled to significant deference in fact, according to the Court of Appeals, taxpayers must follow the IRS's method unless it is "clearly unlawful" or "plainly arbitrary." The fact that the imposed method may not be the most accurate method to calculate income is not sufficient for rejecting it.

In this case, the method used by JP Morgan Chase was unacceptable since the IRS showed that it did not clearly reflect income. It is up to the taxpayer to prove that the IRS method was unlawful or arbitrary. The court has the power to impose a different method only if the taxpayer meets this burden. Given this very high hurdle, it is likely the IRS's method will be imposed.

* JP Morgan Chase & Co. v. Commissioner, 2006 US App Lexis 20430 CA-7.

Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.