When does the cash method clearly reflect income?

• Author: Conjura, Carol

In recent years, the IRS has increasingly challenged the use of the cash receipts and disbursements method of accounting by taxpayers in service businesses. Because they do not purchase and sell merchandise, service providers are not required by the regulations to use the accrual method. Service providers that are C corporations but have average annual gross receipts of not more than $5 million are not prohibited from using the cash method by Sec. 448. In addition, partnerships owned by individuals, S corporations and qualified personal service corporations (such as consultants, engineers, architects, health providers and similar service businesses) are not prohibited from using the cash method, regardless of their size. However, where no other prohibition applies, the Service has asserted that the cash method of accounting fails to clearly reflect income (as required by Sec. 446(b)) to support proposed disallowances of the cash method.

Substantial-identity-of-results

test

The number of recent IRS challenges to the cash method has begun to concern many taxpayers. Along with the accrual method, the cash method of accounting is specifically enumerated in Sec. 446(c) as one of the alternative permissible methods of accounting for tax purposes. Thus, taxpayers not prohibited by the Code from using the cash method or not engaged in the sale of inventory have generally assumed their use of the cash method would satisfy the clear reflection of income test in Sec. 446(b). Based on recent challenges involving service providers, however, the Service has relied on a "substantial identity of results" test to show that the taxpayer's use of the cash method distorts income; see, e.g., Letter Ruling (TAM) 9113003. Under this test, to overcome the IRS's disallowance of the cash method, the taxpayer must show that the results under the cash method are substantially identical to the results under the method of accounting the Service selects as clearly reflective of income. Understandably, taxpayers have objected to the broad application of this test to service providers. Since the IRS would probably not seek to substitute a taxpayer's method with another method unless it made a substantial difference in taxable income, it is difficult to imagine a taxpayer's being able to meet the burden of proof.

In some situations, the use of the cash method might be abusive, such as when a taxpayer is found to be intentionally deferring the collection of revenue while...