Judicial resistance to the IRS's growing power with the clear reflection standard.

• Author: Maples, Larry

In the November-December 1992 issue of The Tax Executive, Gregory A. Carnes and Ted D. Englebrecht wrote about "The Internal Revenue Service's Increasing Power with the Clear Reflection of Income Standard." This thoughtful article stimulated my thinking because it documented the IRS's increasingly bold campaign in this area as well as the ambiguity and complexity that accompany increased emphasis on income timing rules. Carnes and Englebrecht suggest that resort to the legislature may be necessary to retard the IRS's movement away from generally accepted accounting principles (GAAP).

Carnes and Englebrecht focused on recent inventory valuation cases. The IRS, however, has attempted to use the clear reflection standard to attempt to override a tax accounting rule in a variety of other situations, including long-term contract. Moreover, although the cases analyzed by Carnes and Englebrecht definitely mark a trend, the courts have generally resisted IRS efforts to override a statutory or regulatory accounting rule even where the IRS concludes that the taxpayer's method does not clearly reflect income. In the past several years, the courts (particularly the Tax Court) have applied this common sense limit in a variety of situations. This article focuses on the circumstances in which taxpayers have successfully argued that the IRS has erred in not following a statutory or regulatory accounting rule.

1. All-Events Test-Expense

   In a 1992 case, the IRS attempted to override the all-events test of Treas. Reg. SS 1.446-1(c)(ii) in pursuit of its goal of "clearly reflecting income." In Fidelity Associates, Inc. v. Commissioner, T.C.M. 1992-142, the taxpayer used the accrual method of accounting for both tax and financial statement purposes. Book sale income was accrued as the books were shipped. The taxpayer, however, reported the related book sale commission expense differently for tax and financial accounting purposes. For financial accounting purposes, commissions paid were recorded as expenses at the same time as the book sale income - as the books were shipped; for tax purposes, the commissions were deducted when the orders were approved. The excess of paid commissions over the accrued commissions was shown as "prepaid" or "deferred" commissions on the company's financial statements.

   The IRS conceded that the all-events test of the regulations had been met. (This concession is not surprising inasmuch as the commissions were not refundable even where the taxpayer could not collect the total contract price from the customer.) Nevertheless, the IRS challenged the deductibility of the commissions, advancing two arguments for its position. First, the IRS argued that section 446(a) of the Internal Revenue Code requires absolute conformity between taxable income and book income. Second, the IRS argued that the clear reflection of income standard of section 446(b) was violated because income and expenses were mismatched.

   1. The Conformity Requirement

      Section 446(a) provides that "[t]axable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books." If these words require absolute conformity, taxpayers would simply have to use the same method of accounting for tax and financial accounting purposes unless the IRS requires otherwise. According to Judge Gerber in Fidelity, this absolute conformity argument was "anomalous" because the IRS usually finds itself in a position of arguing that the taxpayer should be required to use a different method of accounting for tax purposes from the method used for book purposes.

      Furthermore, the Tax Court observed that the IRS's proffered interpretation of "books" was inconsistent with Treas. Reg. [section] 1.446-1(a)(4), which states:

      Accounting records include the taxpayer's regular

      books of account and such other records and data as

      may be necessary to support the entries on his books

      of account and on his return, as for example, a

      reconciliation of any differences between such books

      and his return.

      Such language, the court said, clearly implies the potential for variations between financial and tax reporting.

      Finally, even the most widely cited case for the proposition of the IRS's discretion over accounting methods - Thor Power Tool Co. v. United States, 439 U.S. 522 (1979) - emphasizes the different objectives of tax and financial accounting. Indeed, the holding of Thor depends on the differentiation of such objectives.

      In sum, the Tax Court held that a taxpayer can choose among accounting methods as long as three conditions are satisfied: the other requirements of the Code are met; the taxpayer's overall method is in conformity; and the taxpayer's method clearly reflects income.

   2. "Clearly Reflects Income"

      Since the basic requirements of accrual accounting under the all-events test were clearly met in Fidelity, the Tax Court was faced with the question whether the IRS should be permitted to override the test in order to clearly reflect income. After carefully considering the IRS's argument that the matching concept was violated by the taxpayer's treatment, the court held that the IRS had abused its discretion in attempting to upset the taxpayer's method of accounting.

      In Fidelty, the IRS argued that an obvious mismatching occurred because income from book sales was accrued when the books were shipped but commissions were paid when the orders were received. The Tax Court agreed that some mismatching occurred, but rejected the idea that exact matching is required.(1) Thus, the court held that even though matching is a desired goal, it will not override an established tax accounting rule unless the distortion is more substantial than occurred in this case.(2) Although the Tax Court accorded the taxpayer considerable latitude in its choice of expense timing, the amounts at issue in Fidelity had in fact been paid and economic performance had occurred.(3) Citing Prabel v. Commissioner, 91 T.C. 1101, 1118 (1988), aff'd, 882 F.2d 820 (3d Cir. 1989), the court thus said this was not a case where accrued expenses "significantly exceed[ed]" the taxpayer's cash payment obligations and where the obligation to make payments consistent with the accrual was under the taxpayer's unilateral control.

2. All-Events...