Income recognition.

The courts have uniformly held that generally accepted accounting principles (GAAP) are not determinative of tax rules. Whether a taxpayer recognized income for financial statement purposes is irrelevant in deciding whether he or she must report the income on a tax return. The Ninth Circuit Court of Appeals recently analyzed when a taxpayer must report a cash advance volume discount as income.

Westpac, a partnership formed by three grocery store chains to purchase and warehouse inventory, signed four contracts, each specifying a quantity of inventory to be purchased. Each contract also provided Westpac a cash advance and a repayment obligation on a pro rata basis if the partnership failed to purchase the quantity specified. Westpac booked the advances as liabilities, and it reduced the cost of goods sold by a percentage of the advance as goods were purchased. The government reclassified the advances as income when received. The Tax Court sided with the IRS and held that Westpac should have reported the advances as income. The taxpayer appealed the decision.

Result. For the taxpayer. The question before the court was whether a discount received in the form of a cash advance was income in the year received. The court found Indianapolis Power & Light Co. and Automobile Club of Michigan provided the answer, though neither one was exactly on point.

In Indianapolis Power, 493 US 203, the Supreme Court ruled that a deposit was not income because there was an obligation to repay the money when the services ended. In Automobile Club, 353 US 180, the prepaid membership dues were income when received because a pro rata recognition of the dues would not match income with expenses and the taxpayer was entitled to keep the dues even if no services were demanded.

In the Westpac case, the advance had to be repaid if volume requirements were not met. Therefore the case was closer to Indianapolis Power than to Automobile Club. The fact that the amount of the repayment might be less than the total advance did not change the analysis or the outcome.

The decision in Westpac was based on tax accounting principles. The fact that GAAP requires the cash to be reported as income when the volume requirements are met was immaterial. The court also referenced the prior case of Milenbach in order to remind taxpayers the repayment obligation must be real and enforceable or it will be disregarded in reaching the tax outcome.

This decision clarifies the requirements for taxable income. A taxpayer must realize an increase in wealth and have complete control of the cash. An increase in wealth does not exist as long as there is an obligation to return the cash based on future performance or nonperformance.

* Westpac Pacific Food v. Commissioner, 2006-2 USTC 950,369 (CA-9).

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