Part D. Tax Accounting

• Pages: 311-356
• Author: Marvin A. Chirelstein,Lawrence Zelenak

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Part D

TAX ACCOUNTING

Code § 446(a) provides that “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. ” This provision

reflects the general approach of tax accounting. It indicates, as might

be expected, that tax acco unting largely depends upon and accepts

the principles of ordinary commercial accounting. There are,

however, some important differences, and by and large it is the areas

of divergence, rather than the similarities betwee n the two systems,

which are taken up in this brief Part. In some instances these

differences are the product of administrative and other policy

considerations peculiarly relevant to taxation; in others (the tax

treatment of prepaid income would be an example; see 12 .02) they

appear merely to be the result of doubtful reasoning on the part of

the courts and the Internal Revenue Service.

Although extensive, freedom to choose a method of accounting is

not unlimited. Section 446(b) broadly authorizes the Commissioner

to reject, or at least contest, the taxpayer’s accounting practice if that

practice does not “clearly reflect income.” Much of the litigation

described in Sections 11 and 12 entails an application of that

standard. In general, the courts have tended to regard the subje ct of

accounting as “administrative,” and have shown a considerable

willingness to follow the Commissioner’s lead on close questions.

This, in turn, has prompted Congress, from time to time, to adopt

provisions aimed at relieving particular hardship situations. Overall,

this pattern of judicial caution and congressional liberalization has

led to a steady, bu t also a painfully slow, improvement in the

applicable rules.

In a sense, the precise timing of revenues and expenses is more

important for tax accounting purposes than it is for general

accounting purposes. Allocation of borderline items to one period

rather than another in the company’s financial statements can, if

necessary, be explained to investors and other inter ested persons by

means of footnotes to the income statement or the balance sheet.

When the accounting decision is one that has to be reflected on an

income tax return, howev er, the stake is an increase or reduction in

the taxpayer’s actual cash tax obligations, with mere ex planation

being secondary. Accordingly, the conflicts are likely to be sharper in

a tax setting, particularly when there has been a rise or decline in

rate levels as be tween two taxable years, or when an individual

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TAX ACCOUNTING

PT. D

taxpayer, by reason of a change in her income, faces higher marginal

rates in one taxable period than in another.

This Part is divided into three sections. Section 10 deals with

the annual accounting requirement—the requirement that income be

determined and reported at fixed intervals of a year. Sections 11 and

12 describe the principal accounting methods used by individual and

business taxpayers, namely, the cash and the accrual methods of

accounting. The effort, as usual, is to concentrate on the questions

that have occasioned controversy, and to emphasize major elements

of the tax accounting system rather than details.

10. Annual Accounting

10.01 Loss Carryovers—Burnet v. Sanford & Brooks

Code § 441 provides, in effect, that the taxpayer’s taxable income

shall be computed on the basis of her “annual accounting period.” For

almost all individuals the annual accounting period is simply the

calendar year; corporations and other business taxpayers frequen tly

use fiscal years—say July 1 to June 30—which may conform to the

normal cycle of their manufacturing or marketing activities. In either

case the taxpayer ’s income is determined and re ported at 12-mon th

intervals, and tax is assessed and paid on the basis of events

occurring between the beginning and the end of each such period.

While the taxpayer ’s true income cannot really be ascertained until

the taxpayer’s economic existence is over, it is obvious that no

functioning tax system could afford to wait for its collections until the

end of an individual’s lifetime or until the termination of a business

enterprise. Income and taxes must be reported and paid periodically,

and the 12-month unit is familiar to almost every taxpayer. But even

so, there is something ar tificial about this attempt t o cut the flow of

economic activity into segments for the purpose of making annual tax

payments, and distortions—sometimes serious distortions—

necessarily result.

Roughly speaking, the history of the annual accounting

requirement is one of literal enforcement by the courts, followed in a

few important instances by the enactment of specific relief

legislation. Compared, for example, with the innovative role it played

in the field of income attribution (Part C), the Supreme Court has

been notably cautious and conservative in its approach to accounting

problems. (Put differently, the Court mainly followed the

government’s lead in both areas.) Mindf ul that the Treasury was

required to process and audit millions of tax returns annually, the

Court in its early decisions was plainly reluctant to apply the income

definition under § 61 in ways that might complicate the needs of

SEC. 10

ANNUAL ACCOUNTING

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practical tax administration. As a result, the somewhat delicate task

of balancing more equity against heavier administrative burdens was

largely, and wisely, left to Congress and the Treasury.

In Burnet v. Sanford & Brooks Co.

1

the taxpayer had entered

into a dredging contract with the United States, but ultimately

abandoned the undertaking and sued the government for breach of

warranty. Between 1913 and 1916 the taxpayer incurred expenses of

$176,000 in excess of the payments r eceived under the contract. In

1920, as a result of the l awsuit, the taxpayer recovered the excess

expenses of $176,000, plus $16,000 of interest conceded to be taxable.

The taxpayer apparently had other sources of revenue during the

periods affected because it reported a positive net income for the year

1914. For 1913, 1915 and 1916, however, it reporte d net losses from

business operations after deducting the expenses just mentioned.

The question presented was whether the award received in 1920

was includable in the taxpayer’s gross income for that year. The

taxpayer argued that as the dredging contract had produced no profit

whatever, the amount received in 1920 could not be “income” within

the meaning of the 16th Amendment. Since, however, the

requirement of annual accounting could not simply be dismissed, the

taxpayer proposed three alternative mechanisms by which its prior

losses could be given proper recognition: (i) allow the operating losses

sustained in 1913–15–16 to be carried forward as an offset against

the award received in 1920; or (ii) treat the dredging contract as a

unitary tran saction, with the excess expenses being added back to

the income of the earlier years and the award being ex cluded from

that o f the later;

2

or (iii) treat the earlier outlays as capital

expenditures (or as “loans” to the government) which could later be

charged off against the award. Each of these devices, in the

taxpayer’s view, would succeed in recognizing the absence of gain

under the co ntract, and would do so without detracting from the

integrity of the annual accounting requirement.

Reversing the court of appeals, the Supreme Court sustained the

Commissioner in treating the award as fully taxable in 1920. The

Court held that each acco unting period must be regarde d as a

discrete unit for tax purposes, and found that “income” under the

Constitution could properly be understood to refer to accessions

taking place solely within the taxable year. Annual accounting, said

1

282 U.S. 359 (1931).

2

An election to report on the completed-contract method of accounting actually

was available to the taxpayer, if made in advance. No doubt assuming that its

expenses would be offset annually by adequate progress payments from the

government, the taxpayer did not make the election. In effect, the taxpayer was asking

the Supreme Court to allow it to make the election on a hindsight basis.