## United States Court of Appeals FOR THE EIGHTH CIRCUIT

___________ No. 96-3828

___________ Horace R. Walter; Donna L. Walter, * * Plaintiffs - Appellants, * * Appeal from the United States
v. * District Court for the * District of South Dakota. United States of America, * * Defendant - Appellee. *

___________ Submitted: February 9, 1998 Filed: July 8, 1998

___________ Before WOLLMAN, LOKEN, and HANSEN, Circuit Judges.

___________ LOKEN, Circuit Judge.
Horac e and Donna Walter farm and feed cattle in rural Clark County, South Dak ota. By 1985 and 1986, the tax years in question, they were feeding and sellin g over 8,000 cattle per year and farming ab out 2,000 acres. In their joint federal income tax returns for those years, the Walters reported taxable income of $195,353 in 1985 and $204,5 13 in 1986. In 1988, the Commissioner of Internal Revenue audited th e returns , increasing the Walters’ taxable income to $393,817 in 1985 and $529,159 in 1986, and assessing negligence and substantial understatement penalties. See 2 6 U.S.C. (hereafter cited as “I.R.C.”) §§ 6653, 6661 . The Walters paid the amounts due-2-

and filed this refund lawsuit. Following trial, the district court entered judgmen t parti ally in favor of the Walters and partially in favor of the Commissioner. Th e Walters appeal, raising two issues: whether income received by check was taxable in 1986, the year a

check was initially received and lost, and whether the Commissioner abused her discretion by refusing to waive part of the substantial understatemen t penalty. We affirm.

I. The Lost Check Issue.

Du ring the 1988 audit, the IRS auditor discovered a document from a cattl e buying cust omer in the Walters’ business records. The document reported that th e Walters sold 115 steers to IBP, Inc., in March 1986 f or a net price of $77,441.83. The document appeared to be a “tear slip” -- the t op half of an IBP document that normally includes a business check which the recip ient detaches for negotiation or deposit. The Walters’ bank record s for 1986 showed no such deposit. The Walters then contacted their customer. IBP advised that its March 1986 check for $77,441.83 had never been cashed and issued a new check in January 1988. The Walters included that amount in th eir 1988 taxable income. Some months later, the Commissioner issued an audi t report contendin g that this income was taxable in 1986 under a theory of constructive receipt. The jury found that the first check was received in 1986 and then los t (presumably when the Walters mailed it to their ban k for deposit), and that the Walters negligently failed to include the IBP payment in their 1986 income. On appeal, they argue the district court erred in not granting them judgment as a matter of law on their claim that the $77,441.83 was not taxable income until 1988.

For c ash basis taxpayers like the Walters, an item of gross income “shall b e included in the gross income for the taxable year in which received.” I.R.C. § 451(a). Because t he timing of income receipt may have great tax significance, and becaus e taxpayers are ingenious at devising ways to minimize taxes, the Commissioner has-3-

devel oped the concept of “constructive receipt,” which the courts have uniforml y endorsed. This concept is defined in the Commissioner’s current regulations:

Income although not actually reduced to a taxpayer’s possession i s constru ctively received by him in the taxable year during which it i s credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so t hat he could have drawn upon it during the taxable year if notice of intention to withd raw had been given. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions. Treas. Reg. (26 C.F.R.) § 1.451-2(a).

A check in the hands of a taxpayer ordinarily means that funds are immediately avai lable. Therefore, the general rule is that a check constitutes taxable income to a cash-ba sis taxpayer when received

. See Avery v. Commissioner , 292 U.S. 210, 21 5 (19 34); Kahler v. Commissioner , 18 T.C. 31 (1952). There are some common sens e except ions to this rule, such as when the payor may be insolvent, see Lavery v

. Com missioner , 158 F.2d 859, 860 (7th Cir. 1946), or has imposed substantia l restr ictions or conditions that prevent the taxpayer from receiving funds, see Bright v. United States , 926 F.2d 383, 386-87 (5th Cir. 1991).
Relying on a reference to negotiable instruments law in Kahler , 18 T.C. at 34, the Walters argue tha

t only if presentment is made and a check is honored should the date of payment relate back to its delivery. Therefore, a check tha t is lost and never honored should not be taxable income in the year the check was received. We agree that the law of negot iable instruments provides a useful backdrop, but it cannot trump the doctrine of constructive receipt as developed in the Internal Revenue Code and its implementing Treasury Regulations. The Walters receiv ed the check in 1986. IBP was not insolvent and placed no conditions or restrictions on its payment. Losing the check was a restricti on on collection imposed by the Walters, the payees. No tax case ha s recognized an exception to the rule that receipt of a check is constructive receipt of the-4-

income when the restrictions on “the disposition of the proceeds were the pa yees’ own.” Estate of Kamm v. Commissioner , 349 F.2d 953, 955 (3d Cir. 1965); accord B right , 926 F.2d at 386-87; United States v. Hancock Bank , 400 F.2 d 975, 979 (5th Cir. 1968). As we said in Loose v. United States , 74 F.2d 147, 150 (8th Cir. 1934):
the strongest reason for holding constructive receipt of income to be within the statute is that for taxation purposes income is received or realize d when it is made subject to the will and control of the taxpayer and can be,
exce pt for his own action or inaction, reduced to actual possession. S o viewed, it makes no difference why the taxpayer did not reduce to actual poss ession. The matter is in no wise dependent upon what he does o r up on what he fails to do. It depends solely upon the existence of a situation where the income is fully available to him.

Ac cord Sainte Claire Corp. v. Commissioner , 73 T.C.M. 2540 (1997). Accordingly , the face amount of the check was income to the Walters when they received the check.

II. The Substantial Understatement Penalty Issue.

Because the Walters’ b usiness includes purchasing, fattening, and selling cattle, I. R.C. § 471 requires them to determine cattle inventories at the beginning and end of each tax year, “conforming as nearly as may be to the best accounting practice in the trad e or business.” See also Treas. Reg. § 1.471-1. Inventory values are used t o compute gross profit, because gross profit equals total sales revenue minus cost o f goods sold, a

nd cost of goods sold “equals Opening Inventory, plus Cost of Inventory Acquired, minus Closing Inventory.” Thor Power To ol Co. v. Commissioner , 439 U.S. 522, 530 n. 9 (1979); see generally 4 B. Bittker and L. Lokken, Federal Taxation o f Income, Estates and Gifts , ¶ 105.8 (2d ed. 1992).
In 1988, the IRS auditor f

ound that the Walters had no ledger accounts showing cattle purchased and sold, no actual head counts of cattle, and no recognizable methodThe FIFO inventory method (an acronym for “first in, first out”) assumes that 1 the oldest goods are sold out of inventory first. The LIFO method (an acronym fo r “l astin, first out”) assumes that the most recently acquired goods are sold out o f inventory first. In times of rising prices, the LIFO method incr eases cost of goods sold, thereby deferring taxes. Taxpayers are required to file an election to adopt the LIFO method. See I.R.C. § 472. The Walters never filed that election. -5- for d etermining and valuing inventories. To redetermine cost of goods sold for 198 5 and 1986, she began with a figure the Walters did have, cost of inventory as of January 1, 1985. She d ivided that figure by the average cost of cattle purchased in 1985 t o determine openi ng inventory, that is, the number of cattle on hand that day. Using the Walters’ purchase and sale invoices for 1985 and 1986, she then calculated the other components of gross profit, applying “FIFO” rules in making her calculations. Th e 1 audit r esulted in an increase to the Walters’ reported gross profit of $147,888 in 1985 and $225,529 in 1986.
On appeal, the Walters do not challenge the redetermination of their gross profit calculations. Instead, they argue the Commissioner should have waived the substantial unders tatement

penalty attributable to the resulting increase in taxable income. Th e penalty equals twenty-five percent of the amount of any underpayment attributable to
a s ubstantial understatement. See I.R.C. § 6661(a). An understatement is substantial if it exceeds the greater of ten percent of the tax required to be shown on the return, or $5 ,000. See I.R.C. § 6661(b)(1). The Commissioner may waive an understatemen t penalty if the taxpayer shows good faith and establishes reasonable cause for th e understatement. SeeI.R.C. § 6661(c ). We review the Commissioner’s decision not to waive the penalty for abuse of discretion and the district court’s determination of that issue de novo

. See Caulfi eld v. Commissioner , 33 F.3d 991, 994 (8th Cir. 1994), cert. denied , 514 U.S. 1016 (1995).

The Walters argue that the Commissioner abused her discretion in declining to waive the pena

lty because their substantial understatement was based on the auditor’s-6-

un reasonable use of the FIFO inventory accounting method. We disagree for tw o independent reasons. First, at trial, the Walters were unable or unw illing to explain how they determined cost of goods sold. Horace Walter said they used “a combination of LIFO and some FIFO,” but the closest he came to explaining the figures on their ta x returns was to say they used a method the Commissioner found acceptable when they were audited in the early 1970's. That is plainlyinadequate. The most important factor in determining whether there was reasonable cause for an understatement is “the extent of the taxpa yer’s effort to assess the taxpayer’s proper tax liability.” Treas. Reg. § 1.6661-6(b). The Walters’ failed to prove that they made any effort to adopt a n app ropriate inventory method, to maintain proper inventory records, and to determine cost of goods sold in accordance with recognized accounting principles.
Second, the Walters failed to prove that the inventory accounting method used by the IRS auditor had an unreasonable impact on the rede termination of their 1985 and 1986 taxable incomes. The auditor determined opening in ventory for 1985 by using the
aver age cost of cattle purchased in 1985. This means there was relatively littl e difference in the cost of the first- and l ast-purchased cattle and thus the choice between the FIFO and L IFO methods had little impact on gross profit. Moreover, the cost o f catt le declined in 1986, so use of the FIFO method was favorable to the Walters tha t year. On this record, we think it apparent that the audit resulted in a large increase in taxable inc ome, not because the auditor used the FIFO inventory method, but because the cost of goods sold figures used by the Walters were grossly inflated.
The judgment of the district court is affirmed.
A true copy.

Attest:
CLERK, U.S. COURT OF APPEALS, EIGHTH CIRCUIT.