Hybrid cash-accrual method found to clearly reflect income.

In Hospital Corp. of America (HCA), TC Memo 1996-105, the Tax Court held that a hospital's use of a combination of the cash and accrual methods of accounting (the "hybrid method") "clearly reflected" its income. HCA is the second case in the last 12 months in which the IRS's attempt to force a taxpayer to change from the cash method has failed in court. Last year, the Tax Court held in Ansley-Sheppard-Burgess Co., 104 TC 367 (1995), that the Service had abused its discretion in disallowing the use of the cash method by a construction contractor with no inventories.

In HCA, the taxpayer had applied a hybrid method of accounting, under which the income and expenses attributable to the sale of pharmaceutical products and supplies was reported under the accrual method, and the income and expenses attributable to physician and other hospital services was reported under the cash method of accounting. Relying on its authority under Sec. 446(b) to require the use of an accounting method that clearly reflects income, the IRS disallowed the taxpayer's use of the hybrid method, and attempted to force the taxpayer to report all of its income and expenses on the accrual method.

Before the Tax Court, the Service relied heavily on the substantial identity of results test (a judicially created test applied previously by other courts) to support its contentions. The IRS's position appears to be that the "substantial identity of results" test permits the Service to disallow the use of the cash method (even for a service provider), if the taxpayer's cash method of accounting produces taxable income that deviates too far from the amount of income that would have been reported under the accrual method of accounting preferred by the IRS. In HCA's case, the difference between the taxpayer's hybrid method and the pure accrual method resulted in proposed deficiencies totaling near $700 million. (As a large C corporation, HCA was required to change to the accrual method beginning in 1987; however, as discussed later, a number of exceptions to this requirement still exist for many large businesses.)

In HCA, the Tax Court did not reject the validity of the substantial identity of results test, and it recognized that Sec. 446(b) grants the Service broad discretion and wide latitude to change a taxpayer's method of accounting if, in the IRS's opinion, the taxpayer's method fails to clearly reflect income. However, as in Ansley-Sheppard-Burgess, the Tax Court determined that the substantial identity of results test is not an appropriate yard stick for determining whether income and expenses from services are clearly reflected under the cash method. The substantial identity of results test is an appropriate test when the taxpayer is attempting to support the cash method for reporting income and expenses from the sale of goods. (This is evidenced by the Tax Court's decision in Hudson, TC Memo 1996-106, which was released on the same date as HCA, and which upheld the Service's action to require a diamond seller to use the accrual method of accounting for purchases and sales of inventories.) With respect to the sale of goods, the regulations expressly require the accrual method and thus make it an appropriate baseline for whether income is clearly reflected.

The decision in HCA is important in further defining the boundaries of the IRS's discretion under Sec. 446(b) and in articulating the appropriate standards for determining whether the cash method clearly reflects income. First, the decision held that the Service exceeded its discretion when it attempted to disallow the cash method merely because of an inherent preference for the accrual method of accounting. The mere fact that the cash and the accrual methods produced a difference in taxable income, even a monumental difference, is not enough for the IRS to disallow the cash method.

In addition, the Service could not change a method merely because the existing method caused some distortion of income. The Tax Court decision in HCA thus reflects the view that taxpayers should not be held up to the impossible standard of using an accounting method that perfectly matches all income and all expenses Further, the decision means that the clear reflection of income test must be applied to a large sophisticated taxpayer in the same way it is applied to a small less-sophisticated taxpayer (and, thus, without regard to the size of the difference between the cash and accrual methods). Absent evidence of attempts by the taxpayer to unreasonably prepay expenses or delay billings and collections, a taxpayer's use of the cash method should be found to clearly reflect income.

Although Sec. 448 specifically prohibits large C corporations, tax shelters, and partnerships with C corporation partners from using the cash method, it does not prohibit the method for C corporations with average gross receipts of not more than $5 million, and (without regard to size) S corporations, partnerships and personal service corporations. However, the regulations require the accrual method to be used for purchases and sales of inventories. Based on HCA, it would also appear that a hybrid method may be permitted for taxpayers that provide mixed services and merchandise, provided the taxpayer can appropriately segregate its revenues and expenses attributable to services and merchandise. The decision would appear to permit this application of the hybrid method even when the activities arise from the same trade or business.

Although HCA will help taxpayers to defend their existing use of the cash method in IRS examinations, taxpayers who seek to change from the accrual method to the cash method face a more difficult hurdle. The Service cannot disallow a method that clearly reflects income, but it does have more latitude to deny a taxpayer's request to change from an existing method of accounting that clearly reflects income. Thus, taxpayers who have adopted the accrual method to their detriment, and must now obtain permission from the IRS National Office to change, have generally been disappointed. Through experience, it has become generally understood in the tax community that accrual to cash (or hybrid) method change requests are routinely denied. However, at the Federal Bar Association Tax Section's Annual Conference on Mar 7, 1996, an IRS official said that "contrary to popular perception in the tax accounting community, the Service does not routinely deny requests for a change to the cash method and actually grants 35 percent of such requests." Coupled with the HCA case, this statement should give the tax community more reason to be optimistic in requesting a change in a taxpayer's accounting method from accrual to cash or a hybrid.

FROM CAROL CONJURA, CPA, J.D., WASHINGTON, D.C.