Is the cash method dead?

• Author: Larson, Neil E.

Is the cash method dead? Although the Tax Court thinks not ("The cash method of accounting has been widely used throughout the contracting industry and accepted by the [IRS] since time immemorial" (Magnon, 73 TC 980 (1980)), the IRS does, and has attacked this time-honored system in two Tax Court cases.

Ansley-Sheppard-Burgess Co., 104 TC No. 17 (1995), and J.P. Sheahan Associates, Inc., TC Memo 1992-239, illustrate the lines currently drawn by the Service and the courts over the cash method of accounting. In both cases the IRS argued that the use of the cash method of accounting was inappropriate because it did not clearly reflect income. In Ansley, the Tax Court found the taxpayer could use the cash method; in Sheahan, it found the taxpayer could not.

Ansley was a general contractor that did work for a variety of owners; its construction projects typically were for six to nine months, though one project lasted 1 1/2 years. Ansley had used the cash method for internal reporting purposes and the percentage of completion method for external reporting purposes.

Sheahan was a roofing repair contractor that obtained 80% of its annual volume from Dow Chemical on a time and materials basis. Sheahan had negotiated a 25% markup on its labor and materials and, accordingly, separately stated those items on the invoices it submitted to Dow for payment. Sheahan had always used the cash method of accounting for internal and external reporting purposes.

Both companies had annual sales of less than $5 million, thus qualifying for the small company exception to the requirement to use the accrual method under Sec. 448(b)(3), and the small contractor exception to the requirement to use the percentage of completion method under Sec. 460(e).

In Ansley, the IRS agreed that no inventory was maintained. It appears that the Tax Court used the historical understanding of the use of inventories in the construction industry. Generally, materials purchased by a prime contractor and delivered to the job site are not owned by the contractor; rather, title to the materials vests in the property owner. Therefore, Regs. Sec. 1.471-1 concludes such materials can never be included in the inventory of the contractor.

However, in Sheahan, the Service successfully asserted that the...