Hybrid cash-accrual method found to clearly reflect income.

• Author: Conjura, Carol
• Position: Hospital Corp. of America case

In Hospital Corp. of America (HCA), TC Memo 1996-105, the Tax Court held that a hospital's use of a combination of the cash and accrual methods of accounting (the "hybrid method") "clearly reflected" its income. HCA is the second case in the last 12 months in which the IRS's attempt to force a taxpayer to change from the cash method has failed in court. Last year, the Tax Court held in Ansley-Sheppard-Burgess Co., 104 TC 367 (1995), that the Service had abused its discretion in disallowing the use of the cash method by a construction contractor with no inventories.

In HCA, the taxpayer had applied a hybrid method of accounting, under which the income and expenses attributable to the sale of pharmaceutical products and supplies was reported under the accrual method, and the income and expenses attributable to physician and other hospital services was reported under the cash method of accounting. Relying on its authority under Sec. 446(b) to require the use of an accounting method that clearly reflects income, the IRS disallowed the taxpayer's use of the hybrid method, and attempted to force the taxpayer to report all of its income and expenses on the accrual method.

Before the Tax Court, the Service relied heavily on the substantial identity of results test (a judicially created test applied previously by other courts) to support its contentions. The IRS's position appears to be that the "substantial identity of results" test permits the Service to disallow the use of the cash method (even for a service provider), if the taxpayer's cash method of accounting produces taxable income that deviates too far from the amount of income that would have been reported under the accrual method of accounting preferred by the IRS. In HCA's case, the difference between the taxpayer's hybrid method and the pure accrual method resulted in proposed deficiencies totaling near $700 million. (As a large C corporation, HCA was required to change to the accrual method beginning in 1987; however, as discussed later, a number of exceptions to this requirement still exist for many large businesses.)

In HCA, the Tax Court did not reject the validity of the substantial identity of results test, and it recognized that Sec. 446(b) grants the Service broad discretion and wide latitude to change a taxpayer's method of accounting if, in the IRS's opinion, the taxpayer's method fails to clearly reflect income. However, as in Ansley-Sheppard-Burgess, the Tax Court determined...