When does the cash method clearly reflect income?

In recent years, the IRS has increasingly challenged the use of the cash receipts and disbursements method of accounting by taxpayers in service businesses. Because they do not purchase and sell merchandise, service providers are not required by the regulations to use the accrual method. Service providers that are C corporations but have average annual gross receipts of not more than $5 million are not prohibited from using the cash method by Sec. 448. In addition, partnerships owned by individuals, S corporations and qualified personal service corporations (such as consultants, engineers, architects, health providers and similar service businesses) are not prohibited from using the cash method, regardless of their size. However, where no other prohibition applies, the Service has asserted that the cash method of accounting fails to clearly reflect income (as required by Sec. 446(b)) to support proposed disallowances of the cash method.

Substantial-identity-of-results

test

The number of recent IRS challenges to the cash method has begun to concern many taxpayers. Along with the accrual method, the cash method of accounting is specifically enumerated in Sec. 446(c) as one of the alternative permissible methods of accounting for tax purposes. Thus, taxpayers not prohibited by the Code from using the cash method or not engaged in the sale of inventory have generally assumed their use of the cash method would satisfy the clear reflection of income test in Sec. 446(b). Based on recent challenges involving service providers, however, the Service has relied on a "substantial identity of results" test to show that the taxpayer's use of the cash method distorts income; see, e.g., Letter Ruling (TAM) 9113003. Under this test, to overcome the IRS's disallowance of the cash method, the taxpayer must show that the results under the cash method are substantially identical to the results under the method of accounting the Service selects as clearly reflective of income. Understandably, taxpayers have objected to the broad application of this test to service providers. Since the IRS would probably not seek to substitute a taxpayer's method with another method unless it made a substantial difference in taxable income, it is difficult to imagine a taxpayer's being able to meet the burden of proof.

In some situations, the use of the cash method might be abusive, such as when a taxpayer is found to be intentionally deferring the collection of revenue while quickly paying its vendors. Thus far, however, the Service has not appeared to focus on such a distinction in disallowing the use of the cash method.

IRS clear-reflection-of-income

test rejected

In a recent Tax Court decision, a service provider succeeded, not in overcoming the Service's application of the substantial-identity-of-results test (which would have been impossible), but in persuading the court to scrap the test altogether under the taxpayer's facts. In Ansley-Sheppard-Burgess Co., 104 TC No. 17 (1995), the taxpayer was engaged in the construction business as a contractor. Although the taxpayer did not maintain inventories, the majority of its contracts lasted from six to nine months, with some as long as 1 1/2 years. Since incorporation, the taxpayer had always used the cash method of accounting for tax purposes, and was not prohibited by Sec. 448 from using the cash method. The taxpayer's banks, however, required it to maintain financial statements on the percentage of completion method.

On audit, the IRS disallowed the taxpayer's use of the cash method and required it to change to the percentage of completion method. The Tax Court noted that Sec. 446(b) vests the Service with broad discretion in determining whether a method of accounting clearly reflects income, that the IRS'S determination is entitled to more than the usual presumption of correctness, and that the Service's determination is not to be set aside unless shown to be clearly unlawful. However, the court found that the taxpayer had met this heavy burden of proof and held that the Service's determination was an abuse of discretion. In support of its conclusion, the Tax Court noted the following:

* The cash method has been widely used and accepted throughout the contracting industry and Congress did not intend to change this preexisting law for businesses such as the taxpayer.

* The taxpayer had used the cash method since its incorporation and had made no unreasonable attempt to prepay expenses or defer recognition of income.

* The substantial-identity-of-results test has no application to a taxpayer that does not maintain inventories.

With respect to the third point, the Tax Court reasoned that the substantial-identity-of-results test should be limited to determinations of when a taxpayer with inventories should nevertheless be permitted to use the cash method, because the results would not substantially differ. it can be argued that applying the test beyond these circumstances would be unreasonable, because it would allow the IRS to substitute almost any permissible method of accounting with another method that is more preferable to the Service without regard to actual distortion, but merely on the basis of a difference in results.

Clear reflection determinations

distinguishable

The court noted that there was no support in the case law for applying the substantial-identity-of-results test outside of the inventory context. However, in American Fletcher Corp., 832 F2d 436 (7th Cir. 1987), aff'g DC Ind., 1986, the Seventh Circuit affirmed a decision in which the substantial-identity-of-results test was cited as a basis for disallowing the cash method with respect to a credit card service business that did not sell any merchandise. In American Fletcher, there was evidence that the taxpayer relied on estimates to reconcile its accrual method financial records with its cash method taxable income. This factor alone would seem to render the taxpayer's method an impermissible version of the cash method.

In another recent case, Independent Contracts, DC Ala., 1994, aff'd per curiam, 11th Cir., 1994, the court upheld the IRS's determination that an HVAC contractor's use of the cash method did not clearly reflect income. In Independent Contracts, the taxpayer derived its revenue from installing and servicing HVAC systems and, in addition, was paid for the cost of the system by a general contractor. However, the taxpayer ordered the systems on an "as needed" basis, and the systems were delivered directly to the site.

The court confined its analysis to the Eleventh Circuit's decision in Knight-Ridder Newspapers, Inc., 743 F2d 781 (1984), in which a newspaper publisher's use of the cash method was found not to clearly reflect income. In Knight-Ridder, the taxpayer's inventory of newsprint and ink was found to be a material income-producing factor because the taxpayer derived 20% of its revenue from the sale of newspapers. In Independent Contracts, the court concluded that the decision in Knight-Ridder did not resolve the issue, because it had turned on the existence and fluctuation of on-site inventory, of which the taxpayer in Independent Contracts had none. Nevertheless, the court concluded that it was within the Service's discretion to require the accrual method. The decision in Independent Contracts is not inconsistent with that in Ansley-Sheppard-Burgess; the court found that the taxpayer, in effect, was earning revenue from the sale of merchandise even though it had no on-site inventory.

Conclusion

The decision in Ansley-Sheppard-Burgess confirms that use of the cash method by service providers can clearly reflect income, even though the results may differ from the accrual method. As a favorable precedent, it may help to forestall and resolve some of the recent challenges taxpayers have faced on examination. In addition, it should provide a basis for the IRS National Office to approve requests by service providers to change to the cash method if they are not prohibited from doing so by statute. If a service provider currently using the accrual method could have adopted the cash method as a new taxpayer, a change from the accrual method to the cash method, based on the clear reflection of income analysis expressed by the Tax Court, should be allowable.