The Internal Revenue Service's increasing power with the clear reflection of income standard.

AuthorCarnes, Gregory A.

Many corporate tax professionals are discovering to their chagrin that the selection of accounting methods for reporting taxable income that meet the requirements of generally accepted accounting principles (GAAP), or that have been previously accepted by the Internal Revenue Service, may no longer be acceptable. The IRS has recently denied the taxpayer's choice of inventory valuation method in three different circumstances by claiming that the taxpayer's method did not clearly reflect income. In all instances, the inventory valuation method was acceptable under GAAP, and in some instances, the inventory valuation method had bee recognized by the Securities and Exchange Commission (SEC) or by the Treasury Regulations. This article documents that the IRS's power with the clear reflection of income standard has increased in recent years, and that the IRS has instituted policies to increase their power even more unless the judiciary or legislature takes steps to limit this authority.

The implications of these decisions for corporate tax professionals are immense. As the disparity between acceptable inventory valuation methods for financial and tax reporting grows, it will become much more costly for firms to correctly report both financial and taxable income. Additionally, as the complexity and ambiguity of meeting federal income tax requirements increases, a decline in the compliance level of firms may result. Noncompliance could flow from mistakes and errors, or from willful noncompliance because of the unreasonableness of the standards. Given the judiciary's willingness to accede to the IRS's aggressive use of the clear reflection of income standard, tax professionals may well have to appeal to legislators to reverse, or at least slow down, this proliferation of increasingly complex rules.

This article reviews the various judicial and legislative directives concerning the clear reflection of income standard. It then delineates the critical elements of the definition of this standard and analyzes the manner in which the courts have been increasing the power of the IRS concerning this standard. Finally, it describes the implications of these decisions for corporate tax professionals.

  1. The Clear Reflection of Income Standard

    Section 446(a) of the Internal Revenue Code addresses the choice of accounting methods for reporting taxable income, as follows:

    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.

    Consequently, it appears that corporations should be able to use GAAP for reporting taxable income since GAAP is the standard most corporations adhere to in keeping their books. Nonetheless, section 446(b) provides an exception to this rule if the method used by the taxpayer does not clearly reflect income. In such a case, the IRS has the power to require the taxpayer to use a method which does clearly reflect income.

    The phrase "clearly reflect income" means that income should be determined with as much accuracy as the standard methods of accounting permit.(1) Treas. Reg. [section] 1.446-1 elaborates that a method will ordinarily be regarded as clearly reflecting income if two conditions are met: first, the method must reflect the consistent application of GAAP in a particular trade or business in accordance with accepted conditions or practices in that trade or business; and second, all items of income and expense must be treated consistently from year to year.

    If the taxpayer's accounting method does not clearly reflect income, the IRS has broad power to reconstruct the income by whatever method seems appropriate, and the taxpayer has the burden of proving that its method does clearly reflect income if it does not wish to accept the IRS's reconstruction.(2) The regulations do not state that accounting methods meeting the requirements of GAAP will always meet the clear reflection of income standard; rather, the regulations aver only that consistently applied GAAP-approved methods will ordinarily" meet the statutory standard.

    The specific tax accounting rules for inventories are

    provided in section 471(a) of the Code:

    Whenever in the opinion of the Secretary the use of

    inventories is necessary in order clearly to determine

    the income of any taxpayer, inventories shall

    be taken by such taxpayer on such basis as the

    Secretary may prescribe as conforming as nearly as

    may be to the best accounting practice in the trade

    or business and as most clearly reflecting the income. Treas. Reg. [section] 1.471-2 elaborates that trade customs within an industry should be considered when identifying best accounting practices, and that consistency of application should be given greater weight than any particular method of valuing inventory as long as the method is consistent with the regulations.

    Therefore, the method by which inventories are to be valued for determining taxable income must withstand scrutiny at two levels. First, the method must conform to the best accounting practice in the trade or business. Although the phrase "best accounting practice in the trade or business" has not been defined by Congress, the Supreme Court in Thor Power Tool suggested it is a surrogate or proxy for GAAP.(3) Second, the method must clearly reflect income. Most accountants are likely to view these two requirements as one and the same, because the purpose of GAAP is to clearly reflect income. Nevertheless, the IRS has claimed in many circumstances that GAAP does not clearly reflect income, and the courts seem willing to support the IRS in these positions. The result of these decisions has been to increase substantially the power that the IRS wields under section 446(b).

    Il. Tog Shop and Thor Power Tool

    1. The Tog Shop, Inc.

      In 1989, a U.S. District Court in The Tog Shop, Inc. v. United States(4) determined that the inventory accounting method used by Tog to value excess discontinued goods did not clearly reflect income even though the method met the requirements of GAAP. This decision was recently upheld by the U.S. Court of Appeals for the Eleventh Circuit. Tog was a mail-order company that sells ladies fashions. After each selling season, Tog had excess merchandise on hand that was not suitable for inclusion in next year's catalogue. To dispose of this merchandise, Tog opened retail outlet stores. On average, the company sent about 100,000 items a year to these stores. Because of shop wear and changes in style, the merchandise could not be sold at normal selling prices.

      For its 1980 and 1981 tax years, Tog elected to use the "lower of cost or market method" and valued the excess inventory at net realizable value, which is the replacement cost of inventory less the direct cost of disposing of it. Tog did not compare cost and market for each individual item in its inventory. Instead, Tog applied a percentage formula to the total inventory, which was classified by age, to determine the value of the merchandise.

      Although this inventory valuation method met the provisions of GAAP and was consistently applied as required by Treas. Reg. [section] 1.471-2, the IRS argued that the method did not clearly reflect income. Even though GAAP would allow the valuation of classes of items, the court agreed with the IRS. The only case cited as precedent in Tog was the Thor Power Tool case. To understand the reasons for and implications of the court's decision in Tog, therefore, it is necessary to review and analyze Thor.

    2. The Thor Power Tool Co. Decision

      Thor was a tool manufacturing company that wrote down what it considered to be excess inventory to its estimate of the inventory's net realizable value in accordance with GAAP; it did this even though the inventory continued to be held for sale at regular retail prices. The excess inventory consisted of spare parts for machines that were no longer being manufactured, but that customers continued to use. All the spare parts that Thor estimated it would need...

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