Source: https://law.justia.com/cases/federal/appellate-courts/F2/796/843/251919/
Timestamp: 2017-10-21 12:23:59
Document Index: 329326023

Matched Legal Cases: ['§ 446', '§ 446', '§ 446', '§ 446', '§ 446', '§ 446']

Asphalt Products Co., Inc., Petitioner-appellant, Cross-appellee, v. Commissioner of Internal Revenue, Respondent-appellee,cross-appellant, 796 F.2d 843 (6th Cir. 1986) :: Justia
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Asphalt Products Co., Inc., Petitioner-appellant, Cross-appellee, v. Commissioner of Internal Revenue, Respondent-appellee,cross-appellant, 796 F.2d 843 (6th Cir. 1986)
U.S. Court of Appeals for the Sixth Circuit - 796 F.2d 843 (6th Cir. 1986)
Argued March 4, 1986. Decided July 17, 1986
Mark H. Westlake (argued), Tune, Entrekin & White, Nashville, Tenn., for petitioner-appellant, cross-appellee.
With respect to methods of accounting, Sec. 446 of the Code, in applicable part, provides:
26 U.S.C. § 446 (1982). Treasury Regulations follow the statute and permit a taxpayer to compute taxable income under either the cash or accrual method and require that taxable income be computed on the basis of the same method of accounting regularly used in keeping the taxpayer's books. 26 C.F.R. Sec. 1.446-1(a). Reflecting the provisions of Code section 446(b), an exception to this general rule appears in 26 C.F.R. Sec. 1.446-1(b) (1):
In addition there is a special rule related to inventories in 26 C.F.R. Sec. 1.446-1(c) (2) (i):
26 C.F.R. Sec. 1.471-1.
From the foregoing code provisions and regulations the Commissioner argues that the use of inventories is necessary in order to reflect the taxpayer's taxable income correctly since the production and sale of merchandise is an income-producing factor. The use of inventories being necessary, the accrual method of accounting must be used. Thus, the Commissioner asserts, he did not abuse his discretion in requiring the taxpayer to adopt the accrual method. In the alternative, the Commissioner contends that the presence of a significant amount of accounts receivable in 1974 and subsequent years resulted in a substantial distortion when the cash method of accounting was used. The failure to match sales with the true costs of goods sold produced a return that did not accurately reflect income. Based on the grant of discretion in Sec. 446 of the Code, the Commissioner maintains that he acted properly in requiring the taxpayer to adopt the method of accounting that would "clearly reflect" its income.
The taxpayer contends that the Commissioner abused his discretion. Since the taxpayer had fairly and consistently reported its income for many years on a cash basis and the increase in inventories and accounts receivable resulted from forces over which it had no control, the taxpayer argues that the Commissioner acted arbitrarily. Inventories became "necessary" only by reason of a temporary and "aberrational" condition, not because the ordinary operation of its business required them. Recognizing the fact that the Commissioner has broad discretion to require a change of accounting methods, the taxpayer argues the authority to do so is limited to cases where "the method used does not clearly reflect income," 26 U.S.C. § 446(b), and this is not such a case. The taxpayer relies on the second "special rule" contained in 26 C.F.R. Sec. 1.446-1(c) (2) (ii):
The Commissioner acts for the Secretary of the Treasury and Sec. 446 of the Code clearly gives the Secretary very broad discretion to require a particular method of accounting. The only limitation on the exercise of this discretion appears to be that the method in use does not clearly reflect income and that a different method is required to do so. However, this preliminary determination is also left to the Commissioner. The Supreme Court has construed Sec. 446 [formerly Sec. 41 of the 1939 Code] as follows:
The Commissioner has broad powers in determining whether accounting methods used by a taxpayer clearly reflect income, Lucas v. American Code Co., 280 U.S. 445, 449 [50 S. Ct. 202, 203, 74 L. Ed. 538]; Automobile Club of Michigan v. Commissioner, 353 U.S. 180, 189-190 [77 S. Ct. 707, 712-13, 1 L. Ed. 2d 746] and under Sec. 41 of the Internal Revenue Code of 1939, 26 U.S.C. (1952 ed.) Sec. 41, the Commissioner, believing that the accounting method employed by a taxpayer "does not clearly reflect the income," may require that "computation shall be made in accordance with such method as in [his] opinion ... does clearly reflect the income."
Commissioner of Internal Revenue v. Hansen, 360 U.S. 446, 467, 79 S. Ct. 1270, 1281, 3 L. Ed. 2d 1360 (1959). Thus, Sec. 446 gives the Commissioner discretion with respect to two determinations. The Commissioner first determines whether the accounting method chosen by a taxpayer clearly reflects income. If the Commissioner concludes that the taxpayer's chosen method does not meet this standard, he has the further discretion to require that computations be made under the method which, in his opinion, does clearly reflect income. It would be difficult to describe administrative discretion in broader terms.
The taxpayer also relies on two decisions from this court, both of which are distinguishable. In Morris-Poston Coal Co. v. Commissioner of Internal Revenue, 42 F.2d 620 (6th Cir. 1930), the Commissioner based a deficiency assessment on his finding that a taxpayer had changed its method of accounting without prior approval. The court concluded that the facts did not support this finding and reversed an order of the Board of Tax Appeals upholding the deficiency assessment. The significant difference between the present case and Morris-Poston is that the Commissioner in Morris-Poston failed to make a determination that the accounting method employed by the taxpayer did not clearly reflect income. Rather the Commissioner sought to require the taxpayer to accrue rental income on the erroneous finding that the taxpayer had changed its accounting method without prior approval. As the court pointed out, "... the right of the commissioner to reject the taxpayer's theory of income in this kind of a case stands upon the Commissioner's preliminary finding that the method employed by the taxpayer did not clearly reflect the income." Id. at 621. The authority to require a taxpayer to change its accounting method is not available for enforcement of other Code provisions. It may be used only as provided in Sec. 446, after a determination has been made that the method in use does not clearly reflect income.
Glenn v. Kentucky Color & Chemical Co., 186 F.2d 975 (6th Cir. 1951), may be distinguished on the same basis. The Court in Kentucky Color stated:
Id. at 977 (citation omitted). The same fact distinguishes Magnon Service Electric Corp. v. Commissioner of Internal Revenue, 73 T.C. 980 (1980), a recent decision which cited Osterloh. In Magnon the Commissioner based a deficiency upon a finding that the taxpayer should have used the percentage of completion method rather than the cash receipts and disbursements method of accounting with respect to long-term construction contracts. The Commissioner made no express determination under Sec. 446 that the cash method of accounting did not clearly reflect income.
In each of the cited cases other than Osterloh the courts have concluded that the Commissioner was seeking to exercise a statutory power without making a preliminary determination which the statute establishes as a prerequisite. These cases do not limit the Commissioner's discretion when Sec. 446 is properly applied. Instead, they stand for the proposition that the Commissioner cannot resort to his Sec. 446 authority to require a change in accounting method just because he disagrees with a taxpayer's choice of method. That is not the situation in the present case. Here the Commissioner concluded that the cash method did not clearly reflect the taxpayer's 1974 income because inventories were a necessary element of its income-producing activities and the presence of substantial accounts receivable at the end of the year meant that the cost of goods sold had been deducted while the proceeds from the sales of these goods had not been included in income. This "mismatching" resulted in reporting that did not clearly reflect income.
(a) Negligence or intentional disregard of rules and regulations with respect to income or gift taxes.--If any part of any under payment (as defined in subsection (c) (1)) of any tax imposed by subtitle A or by chapter 12 of subtitle B (relating to income taxes and gift taxes) is due to negligence or intentional disregard of rules and regulations (but without intent to defraud), there shall be added to the tax an amount equal to 5 percent of the underpayment.
There is case law to support the decision of the Tax Court. See Vnuk v. Commissioner of Internal Revenue, 621 F.2d 1318 (8th Cir. 1980); Abrams v. United States, 449 F.2d 662 (2d Cir. 1971). These cases bear no resemblance to the present case. In both there were egregious attempts to avoid the payment of taxes and one is left wondering how the taxpayers avoided the 50% fraud penalty imposed by Sec. 6653(b) of the Code. In Abrams the taxpayer argued that literal application of Sec. 6653(a) would lead to an absurd result where a "comparatively insignificant item of income is negligently omitted." The court responded:
"That case" is now before us. The bulk of the deficiency arose from the taxpayer's consistently following its accounting practices. In contesting the Commissioner's deficiency determinations it relied on decisions of this court that arguably supported its position. The Commissioner did not claim a negligence penalty with respect to the actions of the taxpayer that resulted in all but a few hundred dollars of the $133,000 deficiency assessment. The taxpayer did not concede that it was negligent in claiming the disallowed deduction; it merely conceded that the deduction was erroneously claimed. We will not let the tail wag the dog. "Under all the circumstances of the instant case," Frederick W. Finney, T.C. Memo 1980-23, we conclude that the Sec. 6653(a) penalty should be applied only to that portion of the deficiency attributable to the disallowed deduction.
--26 C.F.R. Sec. 1.471-1 says that "inventories at the beginning and end of each taxable year are necessary in every case in which the production, purchase, or sale of merchandise is an income-producing factor;"
--26 C.F.R. Sec. 1.446-1(c) (2) (i) says that " [i]n any case in which it is necessary to use an inventory the accrual method of accounting must be used...."
--The production, purchase, or sale of merchandise is unquestionably an income-producing factor in the case at bar, so this taxpayer is automatically required to use the accrual method of accounting.
In the first place, the result produced here by a strict application of the regulations is hard to reconcile with the statute. 26 U.S.C. § 446(a) provides, subject to only two exceptions, that taxable income "shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books." The law thus "plainly recognizes" that, as this court has repeatedly declared, "the selection of the system or method of keeping his books is primarily for the taxpayer." Morris-Poston Coal Co. v. Commissioner of Internal Revenue, 42 F.2d 620, 621 (6th Cir. 1930); Glenn v. Kentucky Color & Chemical Co., 186 F.2d 975, 977 (6th Cir. 1951). The Secretary of the Treasury, and the Commissioner as his designee, have discretion to require the use of a particular method of accounting only where "no method of accounting has been regularly used by the taxpayer" (a situation that does not obtain here) or where "the method used [by the taxpayer] does not clearly reflect income." 26 U.S.C. § 446(b). Except where one of those two conditions has been shown to exist, the taxpayer enjoys an express statutory right to elect to "compute taxable income under ... the cash receipts and disbursements method." 26 U.S.C. § 446(c).
"The Tax Court, in a variety of contexts, has recognized that the presence of inventories does not necessarily mean that the cash basis does not clearly reflect income. See, e.g., Ezo Products, Co., 37 T.C. 385, 393 (1961); Estate of Howard T. Roe, 36 T.C. 939, 952 (1961); Michael Drazen, [34 T.C. 1070] at 1079 [ (1960) ]; Stanford R. Brookshire, 31 T.C. 1157, 1166 (1959), aff'd, 273 F.2d 638 (4th Cir.), cert. denied, 363 U.S. 827, 80 S. Ct. 1597, 4 L. Ed. 2d 1523 (1960); Theodore H. Beckman, 8 B.T.A. 830, 831 (1927); 2 J. Mertens, Law of Federal Income Taxation Sec. 16.03, at 6 (Malone rev. ed. 1967); contra Harry Hartley, 23 T.C. 353, 358 (1954)." 420 F.2d at 355-56, n. 9.
This taxpayer had accounts receivable on its books at the end of the 1974 tax year, to be sure, but that was true of tax years before 1974 as well. Unless all its sales were made C.O.D., the business could always be expected to have accounts receivable at year end, with the result that its income in any given year, computed on a cash basis, could always be expected to differ from the income that would be reflected for that year under an accrual method of accounting. The differences ought to wash out over the life of the business, of course, and the mere existence of a difference, in a particular year, could not mean that either method failed clearly to reflect income. If Congress had intended otherwise it almost certainly would not have required taxable income to be computed under the accounting method regularly employed by the taxpayer, as opposed to requiring anyone engaged in the production, purchase or sale of merchandise to use an accrual accounting method. Neither would Congress have said, as it did say in 26 U.S.C. § 446(c), that a taxpayer "may" use "any" of a list of accounting methods headed, rather conspicuously, by the cash method. As the Tax Court has reminded us in this very case, the Commissioner "has no authority to force a taxpayer to change from a method which does clearly reflect income to another method which in his opinion more clearly reflects income;" and the statute, as this court declared in Glenn v. Kentucky Color & Chemical Co., 186 F.2d 975, 977, supra, does not require of the taxpayer's accounting method "absolute precision."
It is true that because of the cash crunch experienced by the taxpayer's customers as a result of the Arab oil embargo, the taxpayer's accounts receivable--which, as the court acknowledges, were not negligible before 1974--had increased greatly by the end of 1974, and had not shrunk even to their former size by the end of 1976. Under the taxpayer's cash accounting method, however, the decline in the taxpayer's income was less than it otherwise would have been because of a partially offsetting increase in the taxpayer's accounts payable. Just as the taxpayer's customers were taking longer to pay their bills, so the taxpayer was taking longer to pay its own bills--and under the cash method of accounting, the latter circumstance obviously worked to the advantage of the tax collector.
As the following chart shows, there was roughly a threefold increase in both the taxpayer's accounts receivable and its accounts payable between the beginning of 1974 and the end of 1976:
1/1/74 12/31/76 ------ -------- Accounts Receivable $72,304.59 $238,689.53 Accounts Payable 28,700.82 84,215.35
At the end of 1976, the gap between the taxpayer's accounts receivable and its accounts payable had increased by only $110,870.41; yet the accounting change imposed by the Commissioner caused a $258,075.63 jump in the taxpayer's 1974 income. The change in accounting methods thus boosted the taxpayer's income for that one year by more than 230% of the increase in the taxpayer's accounts receivable, net of accounts payable, over the entire three year period.
This result, as the court suggests, seems harsh. It seems especially so when we recall that the reason the taxpayer is being required to pay substantially more in taxes for 1974 is that it received substantially less in actual cash revenues that year. Recognizing, as we must, that the way in which this taxpayer was applying its regular accounting method was unquestionably correct (a circumstance that sharply distinguishes this case from Commissioner of Internal Revenue v. Hansen, 360 U.S. 446, 79 S. Ct. 1270, 3 L. Ed. 2d 1360 (1959), where accrual basis taxpayers were using accrual accounting in a way which was highly questionable under the statute and which "might well [have afforded] opportunities to accrual basis taxpayers to allocate income to years deemed most advantageous" (360 U.S. at 467, 79 S. Ct. at 1281)), it is hard to avoid the conclusion that the curbstone equities favor the taxpayer here.
This taxpayer is also aided, I believe, by the holding of this court in Morris-Poston Coal Co. v. Commissioner of Internal Revenue, 42 F.2d 620 (6th Cir. 1930), a case which is closely analogous to this case on its facts. There, as here, the taxpayer was on a cash accounting basis. At the end of the year 1921 the taxpayer had on its books a $108,000 receivable that would have been included in 1921 income had it been paid when due; because of a business depression, however, there was some delay in payment and the taxpayer did not actually receive the money until 1922. The Commissioner insisted that the account owed the taxpayer at the end of 1921 should have been accrued as 1921 income, just as he insisted that the money owed the taxpayer in this case at the end of 1974 should have been accrued as 1974 income. This court pointed out, in Morris-Poston, that the Commissioner's right to compel the taxpayer to account for the $108,000 as 1921 income, even though the money was not actually received in that year, "stands upon the Commissioner's preliminary finding that the method employed by the taxpayer did not clearly reflect the income." The Commissioner did not deny that the taxpayer's 1921 tax return clearly reflected its 1921 income, said the court, "unless for the fact that it contemplated assigning to the year 1922 this [$108,000] income, which was in fact received in that year." 42 F.2d at 621. (Emphasis supplied.) "The only question," the court concluded, "is whether the [return] truly reflected the taxpayer's income for 1921; and we think it did." 42 F.2d at 623.
This court did not, in Morris-Poston, explicitly follow the decision handed down earlier that year in Osterloh v. Lucas, 37 F.2d 277 (9th Cir. 1930). In Glenn v. Kentucky Color & Chemical Co., 186 F.2d 975, supra, however, (a per curiam opinion by Chief Judge Hicks and Circuit Judges Simons and Allen), this court did cite Osterloh in support of the proposition that " [t]he statute requires only that the taxpayer's books shall be kept fairly and honestly, without any attempt to evade the tax." 186 F.2d at 977. (Emphasis supplied.) There may be much to be said for the position, advanced in Caldwell v. Commissioner of Internal Revenue, 202 F.2d 112 (2d Cir. 1953), and Wilkinson-Beane, Inc. v. Commissioner of Internal Revenue, 420 F.2d 352, supra, that the statute does not require "only" that the books be kept fairly and honestly, but also requires, as the Wilkinson-Beane court put it, that the taxpayer's accounting method reflect his income "with as much accuracy as standard methods of accounting permit." 420 F.2d at 356. That position is contrary to the one taken by this court in Glenn, however, as Wilkinson-Beane noted (see 420 F.2d at 356, n. 12), and I am not sure we ought to follow Wilkinson-Beane without explicitly overruling our decisions in Glenn and Morris-Poston.
Citing Wilkinson-Beane, Inc. v. Commissioner, p 69,079 P-H Memo T.C. (1969), aff'd. 420 F.2d 352 (1st Cir. 1970), the opinion of the Tax Court in the instant case says that " [t]he test in Osterloh v. Lucas has been narrowed by code changes and by new regulations and does not apply where the production, purchase, or sale of merchandise is an income-producing factor and where it has been determined that income is not clearly reflected in petitioner's method." I do not think this will wash in a circuit in which Morris-Poston and Glenn still constitute binding precedent. As to the "code changes" of which the Tax Court speaks, I know of none that is relevant. As to the regulations on the taxation of businesses in which the production, purchase or sale of merchandise is an income-producing factor, we have seen that these regulations are not controlling here. And as to the Commissioner's determination that "income is not clearly reflected in petitioner's method," the validity of that determination is precisely what we are to decide--and the logic of Osterloh v. Lucas, like the logic of Morris-Poston and Glenn, says that this determination must not be permitted to stand.