## F I L E D United States Court of Appeals Tenth Circuit 

### JUN 9 1997 

### PATRICK FISHER Clerk PUBLISH
UNITED STATES COURT OF APPEALS

TENTH CIRCUIT

In re: EWC, INC., Debtor,

GARY L. MORRISSEY, Trustee for EWC, Inc., Appellant, v. INTERNAL REVENUE SERVICE, Appellee. No. 95-6391

Appeal from the United States District Court for the Western District of Oklahoma (D.C. No. CIV-94-652-L)
Gary L. Morrissey of Mahaffey & Gore, P.C., Oklahom a City, Oklahoma, for Appellant. Jonathan S. Cohen, Department of Justice, Washingto n, D.C. (Kenneth W. Rosenberg with him on the briefs) for Appellee.

Before SEYMOUR , PORFILIO and LUCERO , Circuit Judges.

LUCERO , Circuit Judge.1 Under the accrual method of accounting, income is recognized in the “year when (continued...) - 2 - This appeal concerns a C corporation’s use of the c ash accounting method to calculate its 1989 taxable income in violation o f 26 U.S.C. § 448. Despite using a prohibited accounting method, the taxpayer’ s return clearly reflected taxable income. At issue is whether § 448 requires the IRS, in its audit of the taxpayer’s 1989 return, to treat the taxpayer as an accrual method taxpayer, regardless of the accounting method the taxpayer ac tually used. The bankruptcy and district courts held that although § 448 prohib its the taxpayer from using the cash accounting method to prepare its 1989 return, it does not prohibit the Commissioner of Internal Revenue from assessing tax es based on a return prepared under the cash accounting method when thatmethod had always been used by the taxpayer and clearly reflected income. The taxpayer in this case, EWC, sold extended servi ce warranty contracts for electronic products. In 1991, EWC filed a volu ntary petition for bankruptcy under Chapter 11 of the Bankruptcy Code. The IRS, as one of EWC’s creditors, filed a claim for $2,971,799.02. The claim resulte d from the IRS’s pre-petition audit of EWC’s tax returns for 1987, 1988, and 1989

. The bankruptcy trustee, Morrissey, objected to the IRS’s claim. He argued that the IRS had incorrectly disallowed numerous de ductions to which EWC, as an accrual method 1 taxpayer, was entitled. The IRS disallowed the de ductions1 (...continued)

all events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy.” 26 C.F.R. § 1.446-1(c)(ii). Expenses are deducted in the “year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.” Id.

2Under the cash method of accounting, income is recognized in the taxable year in which it is actually or constructively received, and expenses are deducted in the taxable year in which they are actually paid. 26 C.F.R. § 1.446-1(c)(i). - 3 - because it determined that EWC actually used the ca sh method 2 of accounting in the preparation of its tax returns. To resolve whether EWC used the cash or accrual met hod of accounting, the bankruptcy court held two hearings. It heard c onflicting evidence. Gordon Henderson, who maintained EWC’s books and records through 1987 and prepared EWC’s tax returns from 1985 to 1989, testified thathe set up EWC’s initial accounting system, recommended that EWC adopt the a ccrual method of accounting, and, allegedly, used an accrual method of accounting to prepare EWC’s 1985-89 returns. EWC marked on its first corporate tax return in 1985 and on every return through 1989 that it used the a ccrual method of accounting. Randy Webb, who kept EWC’s books and records for 19 88 and 1989, testified that he employed a hybrid method of accounting in m aintaining EWC’s internal books, using the accrual method for the general led ger and the cash method for the accounts receivable, sales, and warranty claim reserves. The IRS agent who audited EWC’s returns testified that she determined that EWC had not used the- 4 -

accrual method of accounting for the years in quest ion “because its books and records were substantially maintained on the cash m ethod; no adjusting entries were made to [EWC’s] books to convert the accountin g to an accrual basis for reporting purposes; and the numbers in the internal book and records were mirrored in [EWC’s] tax returns . . . .” Appellant ’s App. at 22. It was the opinion of the IRS agent that both the cash and acc rual methods would clearly reflect EWC’s income. After considering this and other evidence, the bank ruptcy court ruled that despite the indication on EWC’s tax returns that itused the accrual method of accounting, it actually used the cash method of acc ounting for the years in question. The bankruptcy court rejected the truste e’s argument that § 448 required the IRS to consider EWC to be on the accru al method of accounting for 1989. The trustee did not appeal the bankruptcy co urt’s factual determination that EWC actually used the cash method of accounting in preparing its 1987, 1988, and 1989 tax returns. Rather, the trustee appealed only the bankruptcy court’s legal conclusion that § 448 did not require the IRS to use the accrual accounting method to calculate EWC’s tax liability for 1989. The district court affirmed the bankruptcy court’s order. The trustee appeals. We review the legal decisions of the bankruptcy and district court de novo. Phillips v. White (In re White) , 25 F.3d 931, 933 (10th Cir. 1994). We note,- 5 -

however, that the Commissioner of Internal Revenue has broad discretion to determine the propriety of a taxpayer’s method of a ccounting. The Commissioner’s allowance of a particular method of accounting will not be disturbed unless it is plainly arbitrary. See Thor Power Tool Co. v. Commissioner of Internal Revenue , 439 U.S. 522, 532-33 (1979). The trustee argues on appeal that § 448 requires th e IRS to treat EWC as an accrual method taxpayer for 1989. “In interpreting the meaning of the words in a revenue act, we look to the ordinary, everyday sens es of the words.” Commissioner of Internal Revenue v. Soliman , 113 S. Ct. 701, 705 (1993) (quotations omitted). Section 448 states: “Except as otherwise provided in this section, in the case of a—(1) C corporation, (2) pa rtnership which has a C corporation as a partner, or (3) tax shelter, taxab le income shall not be computed under the cash receipts and disbursements method of accounting.” 26 U.S.C. § 448(a). This rule does not apply to farming busine sses, qualified personal service corporations, and corporations or partnerships withaverage gross receipts of less than $5,000,000. 26 U.S.C. § 448(b)(3). Absent on e of these exceptions, the plain language of § 448 bars a C corporation from u sing the cash accounting method to compute its taxable income. Yet, this is precisely what EWC did. 1989 was the first year in which EWC’s gross receip ts exceeded $5,000,000. Section 448(a) clearly prohibited EWC from using the cash3 Other than EWC’s assertion that the cash method of accounting is improper, the

record does not indicate that EWC has demonstrated “that there would be no deficiency, or a smaller deficiency, if its tax liability were redetermined using the accrual method.” In re Sperling , 341 F.2d 201, 204 (2d Cir. 1965). Thus, we need not decide whether such a redetermination by the taxpayer would have been an appropriate response to the Commissioner’s deficiency notice. - 6 - accounting method to calculate its 1989 taxable inc ome. EWC tells us it believed that it had always used the accrual method of accou nting and that § 448(a), therefore, did not require a change in its method o f accounting. The bankruptcy court ruled, however, that EWC had used the cash ac counting method to calculate its 1989 taxable income, in violation of § 448—a ru ling that has been not appealed. At no point has EWC attempted to correct its improp er use of the cash method, either by filing an amended return or by ot herwise adopting another accounting method. 3 Given EWC’s violation of § 448 and its failure to correct its error, we find disingenuous the trustee’s arguments on appeal that the IRS has “imposed” a prohibited accounting method on EWC, an d “ordered” EWC to use an illegal accounting method in preparing its 1989 tax return. In reality, the IRS has done no more than accede to EWC’s use of the ca sh method and compute the tax deficiency pursuant to that method. The trustee does not dispute that the cash method o f accounting clearly reflected EWC’s 1989 taxable income. We agree with the district court that the4 We assume for purposes of this appeal that EWC consistently used the cash

method, because the trustee has not appealed the bankruptcy court’s factual determination that EWC used the cash method on its 1987, 1988, and 1989 tax returns. - 7 - IRS appropriately exercised its discretion to auditEWC using the cash method, because that method clearly reflected EWC’s 1989 ta xable income and had been consistently used by EWC. 4 See 26 C.F.R. Part 1, § 1.446-1(c)(2)(ii) (allowing Commissioner to “authorize a taxpayer to continue t he use of a method of accounting consistently used by the taxpayer, even though not specifically authorized by the regulations in this part, if, in the opinion of the Commissioner, income is clearly reflected by the use of such meth od”); see also In re Sperling , 341 F.2d 201, 204 (2d Cir. 1965) (holding that wher e the taxpayer used a rational but improper accounting method, IRS “may choose to let it stand and pursue only specific deficiencies within it”). Contrary to the trustee’s argument, § 448 does not require the IRS to place EWC on the accrual method. Section 448 only prohib its taxpayer use of the cash accounting method; it does not mandate use of the a ccrual method. Moreover, § 448(d)(7) contemplates that the taxpayer, not the I RS, is responsible for making necessary changes in accounting methods. See 28 U.S.C. § 448(d)(7) (“In the case of any taxpayer required by this section to ch ange its method of accounting . . .”). We need not resolve whether IRS consent wou ld be necessary for EWC to- 8 -

change to the accrual method, because the IRS has n ot withheld its consent, and EWC has not attempted to change accounting methods without consent.
AFFIRMED.