Accounting method choice cuts both ways

By Keith Kebodeaux, J.D., LL.M.

Accounting method choice cuts both ways
Photo by krichie/iStock

Although small business taxpayers usually prefer to use the cash method of accounting, some, for whom considerations of accelerating deductions weigh paramount, might prefer to use the accrual method instead. Or they might elect it inadvertently. But they can also regret that choice (or accident) with respect to income, especially, for example, in the case of a business with a limited cash flow that receives a promissory note in payment.

In a recent Tax Court case, King Solarman, Inc., T.C. Memo. 2019-103, a corporate taxpayer elected the accrual basis of reporting in its initial tax return and failed to establish a justification for cash-basis accounting. The taxpayer was required to utilize inventories and the accrual method. Consequently, the deferred proceeds of a bulk sale of inventory were income in the year of delivery and passing of title, and sales of inventory were not eligible for installment-sales treatment. The taxpayer was not liable for an accuracy-related penalty, however.

The taxpayer, King Solarman Inc. (KSI), was a C corporation formed in 2011 to manufacture and sell mobile solar-powered lighting towers used as temporary lighting. On Schedule K, Other Information, of its initial Form 1120, U.S. Corporation Income Tax Return, for the fiscal year ended April 30, 2012, KSI represented that it was an accrual-basis taxpayer and continued to do so for tax years 2013—2015. It did not file a Form 3115, Application for Change in Accounting Method, seeking treatment as a cash-basis taxpayer. The returns for all four tax years reflected various accrued receivables and payables, consistent with the accrual method of accounting.

The IRS examined the return for the fiscal year ended April 30, 2015. In that year, KSI sold 162 solar towers to Solarman Fund I LLC (the Fund), an investment entity organized by the CEO and principal of KSI. Through a series of intermediary entities, the towers were ultimately subleased to end users. The total purchase price to the Fund was $7,938,000, payable in two cash installments totaling $2,143,260 and the execution of a promissory note in the amount of $5,794,740. In fiscal year 2015, the Fund made cash payments of $2,268,814. KSI's 2015 ledger reflected sales of $2,268,814 and "deferred sales" and "accounts receivable/note" of $5,669,186. Title to the towers passed to the Fund upon delivery of the note and the first payment. Approximately 60% of KSI's 2015 sales were to the Fund.

In its 2015 tax return, KSI excluded from its gross receipts $5,669,186, the portion of the purchase price for the bulk tower sale that was not received in the return year. It reported the entire material and labor costs for the towers as cost of goods sold. Its accounting for inventories was incomplete.

Upon audit, the IRS concluded that KSI was required to use an inventory and the accrual method of accounting and to report the entire purchase price on its 2015 return. The notice of deficiency reflected a $5,794,400 adjustment to gross receipts and an accuracy-related penalty under Sec. 6662 of $385,842.

KSI filed a petition in Tax Court contending that it properly used the cash method of accounting and that the IRS improperly changed its accounting method to one that did not clearly reflect its income.

The Tax Court considered whether KSI was required to use an inventory and, therefore, the accrual method, making the entire proceeds of the bulk sale reportable on the 2015 return. As subsidiary issues, the Tax Court considered whether KSI had elected the accrual method, whether it had sought to change to the cash method, and whether, assuming it was an accrual-basis taxpayer, the sale was eligible for installment-sale treatment under Sec. 453. The court also addressed the accuracy-related penalty.

ACCRUAL METHOD ELECTED OR REQUIRED

The court determined that KSI had elected the accrual method in its fiscal-year 2012 return, affirmed it in subsequent returns, and never sought to change to the cash method of accounting pursuant to Sec. 446(e). The court rejected KSI's contention that it had used the accrual method inadvertently, noting that the returns were prepared by a CPA. The court further noted that KSI's general ledger for 2015 included various entries and accounts consistent with accrual accounting, as well as an account that represented inventory.

Because KSI was engaged in a trade or business "in which the production, purchase, or sale of merchandise" was "an income-producing factor" (Regs. Sec. 1.471-1), it was required to maintain inventories and use the accrual method pursuant to Secs. 471(a) and 446, the court held.

KSI creatively argued that it qualified for discretionary relief for small business taxpayers from the requirement to use the accrual method and to account for inventories under Rev. Proc. 2002-28 (now obsolete). The court agreed that the IRS had provided for such relief for "qualifying small business taxpayers" in the revenue procedure. KSI, though, did not meet any of its three alternative tests for relief, so the court found that it was not entitled to discretionary relief under the revenue procedure.

THE ALL-EVENTS TEST

Having concluded that KSI elected the accrual method and was not eligible for discretionary relief, the court applied the all-events test of revenue recognition under Regs. Secs. 1.446-1(c)(1)(ii)(A) and 1.451-1(a) to determine if the income from the sale was recognized in 2015. Under the all-events test, income is recognized when all events have occurred that fix the right to receive the income and the amount can be determined with reasonable accuracy. The court determined this test was met in 2015 because performance occurred (the towers were delivered and legal title passed to the purchaser) and the amount of income could be determined with reasonable accuracy because it was specified in the contract and fixed by the promissory note.

KSI had argued that the all-events test was not satisfied because it could possibly "lose the ability to compel payments on the Note" if it failed to satisfy its future warranty obligations under its sale contract for the towers. KSI had warranted that the solar towers would remain "in good working order" for 10 years, and the buyer could withhold payments on the note if KSI could not repair a malfunctioning tower as required under the warranty. The court rejected this idea, finding that hypothetical future events that could cause the buyer to withhold note payments were conditions subsequent that did not negate the fact that KSI had earned the full amount of the sale proceeds by its performance during 2015.

KSI alternatively contended that, under the accrual method, it should be allowed a current deduction of approximately the unpaid loan proceeds, for future possible expenses under its warranty obligation. The court, citing General Dynamics Corp., 481 U.S. 239 (1987), stated that a corporation cannot deduct an anticipated estimated expense based on events that have not occurred by the close of the tax year, noting that KSI did not claim that it received any warranty claims during 2015.

INSTALLMENT METHOD

KSI also argued that it should be able to report the sale using the installment method. Although installment sales treatment may in some circumstances be available to accrual taxpayers, the court found KSI could not use it with respect to the sale of the towers because they were inventory, and the installment method is expressly precluded for sales of inventory under Sec. 453(b)(2)(B).

ACCURACY-RELATED PENALTY

The court found that KSI reasonably and in good faith relied upon the advice of its CPA tax preparer because its CEO had limited knowledge of tax law and spoke English as a second language, and the accounting issues in question presented "technical questions of the sort a reasonable businessperson would refer to his accountant," to whom the CEO fully disclosed all relevant facts. Thus, the court held that KSI was not liable for the accuracy-related penalty.

DIFFERENT OUTCOME POSSIBLE

Under current law, KSI might have been entitled to use the cash method if it had properly adopted it. Under the law known as the Tax Cuts and Jobs Act, P.L. 115-97, for tax years beginning after Dec. 31, 2017, a taxpayer (other than a tax shelter) with a three-year rolling average of gross receipts not exceeding $25 million may use the cash method and may account for inventories as nonincidental materials and supplies or by a method that conforms to the taxpayer's method of accounting reflected in an applicable financial statement or, absent such a statement, books and records prepared in accordance with the taxpayer's accounting procedures (see Secs. 471(c) and 448(c)).

Keith Kebodeaux, J.D., LL.M., MSA, is a clinical assistant professor of accounting at the McCoy College of Business at Texas State University in San Marcos, Texas, and a partner in Kebodeaux, Hargroder & Associates LLP in Beaumont, Texas.

To comment on this article or to suggest an idea for another article, contact Paul Bonner, a JofA senior editor, at Paul.Bonner@aicpa-cima.com or 919-402-4434.

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