C O R P O R A T E B U S I N E S S T A X A T I O N M O N T H L Y Tax Accounting BY JAMES E. SALLES ing merchandise in the first place, and therefore need T his month’s column presents the first of a two- not abide by the procedure’s terms. Nevertheless, part discussion of Notice 2001-76, a new IRS many taxpayers will appreciate the increased flexibility initiative which considerably expands small that the Notice offers. business’s access to the cash method. Notice 2001-76 was issued against a complex regu- NOTICE 2001-76 EXPANDS APPLICA- latory and judicial backdrop. Evaluating its terms TION OF CASH METHOD requires an understanding of among other things: The IRS released Notice 2001-76 1 in early December • the different treatment historically accorded sales of as part of an ongoing response to the continued con- services, inventory goods, and other property; troversy about small businesses’ ability to use the cash • the controversy about when sales of merchandise method. The Notice incorporates a revenue procedure are an “income-producing factor” in what is other- relieving certain taxpayers with gross receipts of up to wise a service business; and $10 million from the requirement to accrue income from • the treatment of non-inventory “materials and sup- sales of goods. The procedure is in proposed form, but plies.” pending further guidance taxpayers may rely upon it for taxable years beginning with calendar 2001. This month’s column attempts to summarize the exist- Taxpayers covered by the proposed procedure are ing law and explain the evolution of the IRS’ institutional permitted to elect to report income from routine receiv- position as to when taxpayers sell “merchandise.” Next ables on the cash basis: that is, as payment is received, month’s column will continue the treatment of recent or constructively received. Other transactions would be judicial developments, and discuss the pressures that covered by the rules applicable to non-inventory sales. brought about issuance of the two procedures, their key The cost of the goods themselves would be capitalized terms, and their practical implications for affected tax- but not subjected to formal inventory accounting. The payers. Notice and the proposed procedure represent a very significant step in responding to the outcry about small The Code and Regulations businesses being forced to adopt accrual accounting Code Section 446(a) states the general rule that “tax- because of the IRS’ application of existing rules appli- able income shall be computed under the method of cable to sellers of “merchandise.” accounting on the basis of which the taxpayer regularly Notice 2001-76 does not simplify the law. Indeed, it computes his income in keeping his books,” and Code adds another step to the existing analysis. The pro- Section 446(c) lists both cash and accrual accounting posed revenue procedure does not even supersede among “permissible methods.” Code Section 446(b), Revenue Procedure 2001-10, 2 an earlier, more limited however, adds the proviso that “if the method used relief provision confined to taxpayers with revenues does not clearly reflect income, the computation of tax- under $1 million. Current law will continue to apply if the able income shall be made under such method as, in taxpayer does not elect to change accounting methods the opinion of the Secretary, does clearly reflect under the procedure. Finally, some taxpayers (notably income.” The Supreme Court has repeatedly empha- contractors) will continue to argue that they are not sell- sized the Commissioner’s broad discretion in prescrib- ing tax accounting methods and determining if a tax- Jim Salles is a member of Caplin & Drysdale in Washington, D.C. payer’s chosen method “clearly reflects income.” 3 32 32 F E B R U A R Y 2 0 0 2
C O R P O R A T E B U S I N E S S T A X A T I O N M O N T H L Y The Regulations have long required both that “[i]n all “Substantial Identity of Result” cases in which the production, purchase, or sale of mer- As a practical matter, the question was largely chandise of any kind is an income-producing factor,” resolved by the First Circuit’s holding in Wilkinson- inventories must be kept, 4 and that “in any case in which Beane, Inc. v. Commissioner 17 that a taxpayer using a it is necessary to use an inventory the accrual method of method contrary to the regulations must demonstrate a accounting must be used with regard to purchases and “substantial identity of result.” 18 The widespread adop- sales unless otherwise authorized.” 5 Taxpayers may con- tion of this standard 19 poses an almost impossible bur- tinue to account for other items of income and deduction den for sellers of merchandise seeking to remain on the under the cash method unless otherwise prohibited. 6 cash method. “Substantial identity of result” is generally determined Origins of the Accrual Requirement taking into account not only actual inventories but The requirement that taxpayers accrue purchases accounts receivable and payable as well. Thus, for and sales when inventories are present reflects the fact example, the court in Wilkinson-Beane compared income that, in many cases, the real problem with the use of the under the IRS’ method (employing inventories and accru- cash method by sellers of goods is not with the inven- al accounting) with the taxpayer’s previous cash tories themselves but with the associated receivables method. 20 The Eleventh Circuit’s decision in Knight-Ridder and payables. One court explained: “The use of inven- Newspapers v. United States 21 appeared to break from tories in computing income results in stating the this pattern by framing the issue as whether there were expenses of a year’s operations in terms of the cost of “substantial” balances or annual fluctuations in the inven- the goods actually sold during the year. Thus, the prof- tory accounts. However, the narrower analysis did not it from these operations will be stated accurately only if affect the outcome, and the decision has since been held the income from all sales made during the year is taken not to foreclose the IRS from requiring accrual accounting into consideration.” 7 Income likewise will be distorted if in the absence of actual inventories. 22 purchases on credit are not taken into account. 8 Other courts and the IRS have consistently consid- If a taxpayer maintained inventories, but were ered receivables and payables balances. For example, nonetheless allowed to use the cash method, then its in Asphalt Products Co. v. Commissioner 23 the taxpayer, gross income would be reduced by the cost of goods a seller of emulsified asphalt, had virtually no year-end sold on credit in the year of sale, but the revenue will not inventories because roads cannot be asphalted in low be reported until the year of collection. 9 Thus, the accru- temperatures. While stating that “[i]f the temporary and al requirement has been enforced even in cases where rather insignificant increase in inventories of raw materi- a large portion of the goods were routinely returned 10 or als had been the only basis for the Commissioner’s the prospects for collection were so dubious that the determination, we would have been inclined to find an court approved a bad debt reserve of 50 percent of abuse of discretion,” the court approved the IRS’ impos- receivables. 11 ing accrual accounting because of the taxpayer’s sub- Language in some early cases suggests either that for- stantial receivables. 24 mal inventories might not be required if the balances were Taxpayers have been held subject to the accrual immaterial or else that modest inventories need not nec- requirement even though they had no actual inventories essarily compel accrual accounting. However, the at all. The taxpayer in Epic Metals Corp. v. Commissioner 25 sold custom metal decking that the authorities that actually approved use of the cash method with inventories seem all to involve instances where tax- fabricator shipped directly to Epic’s customers. The Tax payers argued that their own methods were wrong, 12 and Court held that Epic had to use an accrual method in many of them the “inventories” were dubious 13 or because it sold merchandise, even though title to the unnecessary. 14 When the IRS sought to enforce accrual decking passed to the ultimate customer “virtually imme- accounting, the courts tended to apply the regulations as diately” after it passed to Epic. Several other decisions written. 15 A few decisions suggested that the regulations’ reach the same result in similar “custom order” or “drop mandate might not be absolute, but approved the IRS’ shipment” situations where the seller held title only imposing accrual accounting on the facts. 16 momentarily. 26 F E B R U A R Y 2 0 0 2 33
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