IRS focuses on accounting methods.


The IRS recently stepped up its review of accounting methods in various types of businesses and professions, requiring some to change methods -- usually from the cash method to the accrual method. The IRS may require such a change if it finds the current method does not clearly reflect the entity's income or if it finds the business is holding "inventory" and, therefore, must use the accrual method even though the business does not primarily hold merchandise for sale. For example, a veterinarian who sells prescriptions or other products may be considered to have inventory even though he or she is primarily engaged in a service profession.

Two recent cases may help clients whose accounting methods are being reviewed by the IRS. In both, the Tax Court found for the taxpayers and did not require them to change accounting methods despite the IRS's findings.

Case no. 1: The taxpayer, an S corporation service business, provided nurses to hospitals and other health care facilities. The corporation generated less than $5 million a year in gross receipts and had always used the cash method of accounting. The corporation paid the nurses directly and billed the client within 30 days. The IRS argued that the cash method did not clearly reflect the corporation's income because it resulted in a mismatch of income and deductions. The corporation took an immediate deduction for the wages it paid but did not recognize the payments from the clients as income until they were received.

Result: For the taxpayer. While the Tax Court agreed with the IRS that a mismatch occurred When the cash method was used, it said mismatching was inherent in the cash method. As long as the taxpayer used the method consistently, a clear reflection of income would result. The court viewed the IRS action as "clearly unlawful, plainly arbitrary and not substantially justified" in holding for the taxpayer. The court ordered the IRS to reimburse the taxpayer for attorney's fees and other costs incurred in the case.

* Austin v. Commissioner (TC memo 1997-157).

Case no. 2: Galedrige, an asphalt-paving contractor, picked up asphalt directly from its supplier daily. The asphalt had to be used within two to five hours from the time it was picked up or it became too hard. Because asphalt cannot be melted, reused or returned for credit, the company discarded any unused asphalt at the end of the day. It deducted the asphalt as a supplies expense in the years in which it was purchased. The...

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