Using the cash method of accounting.

Taxpayers using the cash method of accounting, especially construction contractors, should be aware that some IRS districts are making it a high priority to identify potential changes to the accrual method of accounting. A 1992 Tax Court memorandum case gave the IRS a preliminary victory in this area. That victory became more significant this year when the taxpayer did not appeal the decision.

In J. P. Sheahan Associates, TC Memo 1992-239, the taxpayer was a roofing contractor. The company was 100% owned by its founder, and did just over $1 million in gross sales each year. Believing it was eligible to do so, the company used the cash receipts and disbursements method of accounting for Federal income tax purposes. The company ordered roofing materials only as it needed them, and returned excess materials to the supplier for credit. It had no year-end inventory and did not hold merchandise for sale. The company did, however, charge a 25% markup on the cost of materials used on a job.

On examination, the Service challenged Sheahan's use of the cash method. Because of the company's markup on the cost of the materials, the Tax Court agreed with the IRS and concluded the company was required to use the accrual method of accounting for purchases and sales of roofing materials.

In determining whether Sheahan had to use the accrual method of accounting overall, the court compared the taxable income resulting from the cash method with that resulting from the accrual method. As taxable income would have been higher had it been determined on the accrual method (the company did have receivables at year-end), the court sustained the Service in forcing the company's change to the accrual method of accounting.

Significantly, the Tax Court not only sustained the IRS's change of the taxpayer's overall method of accounting from the cash to the accrual method, but also the Service's imposition of a substantial understatement penalty on the difference in tax resulting from determining taxable income on the cash instead of on the accrual method. The substantial understatement penalty is imposed at a rate of 20% of the amount of the understatement.

This Tax Court decision is significant because it reduces any optimism practitioners might have about a cash-method taxpayer prevailing in the Tax Court against an IRS-forced change to the accrual method. Such a victory is still possible, of course, to the extent the taxpayer has more favorable facts than did Sheahan. But Sheahan's were fairly favorable. It is also possible that a taxpayer might succeed in judicial forums other than Tax Court; however, this involves paying the tax before contesting it.

Cash-basis taxpayers concerned about a possible IRS challenge to their use of the cash method can beat an examining agent to the punch by making a voluntary accounting method change before being notified of a pending examination. Rev. Proc. 92-75 permits the taxpayer to make the change by attaching the application to a timely filed return for the current year. Filing an advance copy of the application with the IRS National Office as soon as possible may preclude an examining agent from making the change for an earlier year. It can also avoid any interest or penalties the agent might impose.

From Eileen J. O'Connor, CPA, J.D., Washington, D.C.