Court Opinion

ID: 9475165
Source: CourtListenerOpinion
Date Created: 2023-08-05 05:18:51.61111+00
Date Added: 2024-06-11T17:44:32.672515
License: Public Domain

DAVID A. NELSON, Circuit Judge,
concurring in part and dissenting in part.
I concur wholeheartedly in Part IV of the court’s opinion. Where the taxpayer is subject to a penalty only because of the negligent omission of a comparatively insignificant item of income, and the Commissioner also asserts that there is a large underpayment not claimed to be due to negligence, I agree with the court that it would be absurd to let the Commissioner calculate the negligence penalty by applying the statutory percentage to the sum of the negligent and non-negligent underpayments. The absurdity is compounded where, as here, it is a close question whether the non-negligent “underpayment” was an underpayment at all. The Tax Court clearly erred in failing to limit the measure of the negligence penalty to the underpayment that was negligent.
With respect to Part III of the court’s opinion, I agree that the temporary and rather insignificant increase in the taxpayer’s raw material inventories was probably not sufficient, in itself, to justify a forced change in accounting methods. I concur in the court's conclusion on this point notwithstanding that the regulations, if they may be enforced in accordance with their terms, would apparently require the use of accrual accounting by anyone engaged in the kind of business in which this taxpayer was engaged.
The Commissioner’s argument, as I understand it, boils down to this:
—26 C.F.R. § 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. § 1.446 — l(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.
The Commissioner’s logic seems unassailable on its face, but if we look beyond the language of the regulations I think we shall see several problems with the Commissioner’s conclusion.
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 recog*851nizes” 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).
Given that statutory right, I do not see how the regulations can be permitted automatically to require this taxpayer to use an accrual method of accounting unless we are prepared to accept the proposition that the Commissioner, by regulation, has made a valid determination that the cash method of accounting “does not clearly reflect income” in any case in which the production, purchase, or sale of merchandise is an income-producing factor. Such a determination would seem overbroad, particularly when we recall it is beyond dispute that the cash method of accounting did clearly reflect the income of this very taxpayer prior to 1973.
In the second place, although the Tax Court may in this instance have accepted the Commissioner’s argument that as a matter of regulatory law the cash method can never clearly reflect any merchant’s income, the Tax Court has frequently refused to construe the regulations in such absolute terms. As the Court of Appeals for the First Circuit pointed out in Wilkinson-Beane, Inc. v. Commissioner of Internal Revenue, 420 F.2d 352 (1st Cir.1970) (a case the holding of which would require affirmance of the Tax Court’s decision here for other reasons):
“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 § 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.
In the third place, the testimony of the only witness offered by the Commissioner in this case flatly contradicts the reading of the regulations for which the Commissioner now contends. Notwithstanding that this taxpayer has always been engaged in the production, purchase, or sale of merchandise, and notwithstanding that it has thus always been “necessary [for this taxpayer] to use an inventory,” the witness testified that “so long as the accounts that affect the difference between the cash receipts and disbursements method and the accrual method do not change materially, they could stay on [the cash] method." (Emphasis supplied.)
Therefore, notwithstanding the seemingly unambiguous language of the regulations, I concur in the judgment that the regulations relating to inventories may not be construed in the absolute terms adopted by the Commissioner and the Tax Court.
This brings me to the question whether we must uphold the Commissioner’s finding that the cash method did not clearly reflect this taxpayer’s post-1973 income because of the presence of significant accounts receivable in 1974 and subsequent years. I would be inclined to answer this question differently than the court has done.
This taxpayer had accounts receivable on its books at the end of the 1974 tax year, to *852be 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 *853Coal 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.
The Commissioner did argue, unsuccessfully, that the taxpayer in Morris-Poston had changed its method of accounting without prior approval, but that fact does not distinguish Morris-Poston from this case if it was also the Commissioner’s position, as it seems to have been, that the taxpayer’s accounting method did not clearly reflect the taxpayer’s income for 1921.
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.
Osterloh, the Ninth Circuit decision applied by this court in Glenn, was a case in which the Commissioner required the taxpayer to continue to adhere to the -cash method of accounting where the use of that method happened to work to the Commissioner’s advantage. The reasons given by the court in upholding the Commissioner are instructive:
“The method of accounting regularly employed by the petitioner [the cash receipts and disbursements method] is a recognized one within the meaning of the act, and should be accepted as controlling unless such method does not clearly reflect the income.
If [the requirement that the method of accounting clearly reflect income] is absolute, it is safe to say that the books kept on the basis of cash received and disbursed will rarely, if ever, reflect the true income, because nearly always at the end of a tax year accounts due the *854taxpayer will remain uncollected and some of his own obligations will remain unpaid. But we do not think that any such literal construction was contemplated. In our opinion, all that is meant is that the books shall be kept fairly and honestly; and when so kept they reflect the true income of the taxpayer within the meaning of the law. In other words, the books are controlling, unless there has been an attempt of some sort to evade the tax. This construction may work to the advantage of the taxpayer or the government at times, but if followed out consistently and honestly year after year the result in the end will approximate equality as nearly as we can hope for in the administration of a revenue law.” 37 F.2d at 278-79. (Emphasis supplied.)
Citing Wilkinson-Beane, Inc. v. Commissioner, ¶ 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.
Accordingly, and with respect, I dissent from the court’s decision to uphold the Commissioner’s determination. I would reverse the decision of the Tax Court insofar as it denies the taxpayer the right to calculate its 1974 income under the method of accounting regularly used in prior years, and I would hold for the Commissioner on his protective cross-appeal from the Tax Court’s decision that the taxpayer overpaid its 1975 and 1976 income taxes.