Asphalt Products Co., Inc., Cross-Appellee v. Commissioner of Internal Revenue, Cross-Appellant

796 F.2d 843, 58 A.F.T.R.2d (RIA) 5453, 1986 U.S. App. LEXIS 27298

• Court: Court of Appeals for the Sixth Circuit
• Decided: July 17, 1986
• Docket: 84-1841, 84-1882
• Status: Published

Opinions

LIVELY, Chief Judge.

This tax case presents issues related to the method of accounting employed by a taxpayer and the application of the negligence penalty provided for in section 6653 of the Internal Revenue Code (the Code), 26 U.S.C. § 6653 (1982). Asphalt Products Co., Inc. (the taxpayer) appeals from a decision of the United States Tax Court upholding an income tax deficiency assessment by the Commissioner of Internal Revenue (the Commissioner) for 1974. The Tax Court also affirmed the addition of a five percent negligence penalty on the total deficiency. The Commissioner has filed a protective cross-appeal with respect to that portion of the decision of the Tax Court which credited the taxpayer with overpayments of its income taxes for 1975 and 1976. If this court should reverse the finding of a deficiency for 1974 based on the conclusion that the Commissioner erred in requiring the taxpayer to change its method of accounting, it would be necessary to recalculate the taxpayer’s income tax liability for 1975 and 1976.

I.

A.

The taxpayer produces and sells emulsified asphalt, a road paving material. Its principal customers are county governments in its general area of Tennessee. The counties share in state gasoline taxes, and these taxes provide the revenues required for road construction and maintenance. The Arab oil embargo of 1973 created a double-barreled problem for the counties. The price of emulsified asphalt, whose principal ingredient is a residue from the refining of oil, rose rapidly, while the consumption of gasoline dropped sharply. Because of this combination of circumstances the taxpayer’s accounts receivable increased from $72,000 on January 1, 1974 to $264,000 on the first day of 1975.

The oil embargo had an additional direct effect on the taxpayer’s operations. Because emulsified asphalt cannot be used in cold weather, until 1973 the taxpayer never carried any inventory of asphalt or raw materials through the winter. Instead, it finished its run in December and closed its operation down completely for several weeks before the end of the year. As a result of the embargo, the suppliers of petroleum residue made allocations to their customers and required each to take its allocation every month or lose the right to receive raw materials in subsequent months. After having only nominal ending inventories through 1973, the taxpayer had inventories on hand of $25,800 at the end of 1974 and $36,000 at the end of 1975. When more normal conditions returned, inventories at the end of 1976 fell to $1,583.

B.

From its inception the taxpayer employed the cash receipts and disbursements method of accounting. The Commissioner determined that the cash method did not accurately reflect the taxpayer’s income, and assessed a deficiency for 1974 by recomputing the taxpayer’s income using the accrual method of accounting. The Commissioner found that the use of inventories was necessary in order to reflect the taxpayer’s income accurately, and applied the rule that a taxpayer must use the accrual method of accounting where inventories are a significant income-producing factor. The Commissioner also found that the fluctuations in accounts receivable made use of the cash method inappropriate because its use resulted in a “mismatching” of receipts from sales and cost of sales.

The taxpayer petitioned the Tax Court for redetermination of the deficiency. The Tax Court found that the Commissioner acted properly in requiring the taxpayer to change to an accrual method of accounting, and upheld the deficiency determinations.

C.

The taxpayer claimed a deduction of $1,103 on its 1974 return for the expenses of transporting personal property of two shareholders from California to Tennessee. The taxpayer took delivery of two new trucks in California and sent its drivers there to bring the trucks to Tennessee. The two principal shareholders of the taxpayer had purchased wastewater treatment plants in California to use in a Tennessee development. The truck drivers hauled the plants to Tennessee, using the new trucks they picked up in California, and the taxpayer deducted the salaries and reimbursed expenditures of the drivers as business expenses.

The taxpayer conceded in the Tax Court that the deduction for salaries and expenses of the drivers was not properly taken. The Commissioner assessed a 5% negligence penalty on the entire deficiency rather than assessing it only on the deficiency resulting from the improper deduction. The penalty exceeded $6,900, though the improperly claimed deduction was only $1,103. The Tax Court affirmed this addition to tax for 1974.

II.

With respect to methods of accounting, § 446 of the Code, in applicable part, provides:

§ 446. General rule for methods of accounting

(a) General Rule. — 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.

(b) Exceptions. — If no method of accounting has been regularly used by the taxpayer, or if the method used does not clearly reflect income, the computation of taxable income shall be made under such method as, in the opinion of the Secretary, does clearly reflect income.

(c) Permissible methods. — Subject to the provisions of subsections (a) and (b), a taxpayer may compute taxable income under any of the following methods of accounting—

(1) the cash receipts and disbursements method;

(2) an accrual method;

(3) any other method permitted by this chapter; or

(4) any combination of the foregoing methods permitted under regulations prescribed by the Secretary.

26 U.S.C. § 446 (1982). Treasury Regulations follow the statute and permit a taxpayer to compute taxable income under either the cash or accrual method and require that taxable income be computed on the basis of the same method of accounting regularly used in keeping the taxpayer’s books. 26 C.F.R. § 1.446-1(a). Reflecting the provisions of Code section 446(b), an exception to this general rule appears in 26 C.F.R. § 1.446-1(b)(1):

(b) Exceptions. (1) If the taxpayer does not regularly employ a method of accounting which clearly reflects his income, the computation of taxable income shall be made in a manner which, in the opinion of the Commissioner, does clearly reflect income.

In addition there is a special rule related to inventories in 26 C.F.R. § 1.446-1(c)(2)(i):

(2) Special Rules, (i) In any case in which it is necessary to use an inventory the accrual method of accounting must be used with regard to purchases and sales unless otherwise authorized under subdivision (ii) of this subparagraph.

A related regulation describes the conditions under which the use of inventories is necessary:

In order to reflect taxable income correctly, inventories at the beginning and end of each taxable year are necessary in every case in which the production, purchase, or sale of merchandise is an income-producing factor.

26 C.F.R. § 1.471-1.

From the foregoing code provisions and regulations the Commissioner argues that the use of inventories is necessary in order to reflect the taxpayer’s taxable income correctly since the production and sale of merchandise is an income-producing factor. The use of inventories being necessary, the accrual method of accounting must be used. Thus, the Commissioner asserts, he did not abuse his discretion in requiring the taxpayer to adopt the accrual method. In the alternative, the Commissioner contends that the presence of a significant amount of accounts receivable in 1974 and subsequent years resulted in a substantial distortion when the cash method of accounting was used. The failure to match sales with the true costs of goods sold produced a return that did not accurately reflect income. Based on the grant of discretion in § 446 of the Code, the Commissioner maintains that he acted properly in requiring the taxpayer to adopt the method of accounting that would “clearly reflect” its income.

The taxpayer contends that the Commissioner abused his discretion. Since the taxpayer had fairly and consistently reported its income for many years on a cash basis and the increase in inventories and accounts receivable resulted from forces over which it had no control, the taxpayer argues that the Commissioner acted arbitrarily. Inventories became “necessary” only by reason of a temporary and “aberrational” condition, not because the ordinary operation of its business required them. Recognizing the fact that the Commissioner has broad discretion to require a change of accounting methods, the taxpayer argues the authority to do so is limited to cases where “the method used does not clearly reflect income,” 26 U.S.C. § 446(b), and this is not such a case. The taxpayer relies on the second “special rule” contained in 26 C.F.R. § 1.446-1(c)(2)(ii):

No method of accounting will be regarded as clearly reflecting income unless all items of gross profit and deductions are treated with consistency from year to year.

The taxpayer’s argument turns the negative statement of the regulation into a positive rule that if all items of gross profit and deductions are treated with consistency from year to year, the method of accounting must be regarded as clearly reflecting income.

III.

The Commissioner acts for the Secretary of the Treasury and § 446 of the Code clearly gives the Secretary very broad discretion to require a particular method of accounting. The only limitation on the exercise of this discretion appears to be that the method in use does not clearly reflect income and that a different method is required to do so. However, this preliminary determination is also left to the Commissioner. The Supreme Court has construed § 446 [formerly § 41 of the 1939 Code] as follows:

The Commissioner has broad powers in determining whether accounting methods used by a taxpayer clearly reflect income, Lucas v. American Code Co., 280 U.S. 445, 449 [50 S.Ct. 202, 203, 74 L.Ed. 538]; Automobile Club of Michigan v. Commissioner, 353 U.S. 180, 189-190 [77 S.Ct. 707, 712-13, 1 L.Ed.2d 746] and under § 41 of the Internal Revenue Code of 1939, 26 U.S.C. (1952 ed.) § 41, the Commissioner, believing that the accounting method employed by a taxpayer “does not clearly reflect the income,” may require that “computation shall be made in accordance with such method as in [his] opinion ... does clearly reflect the income.”

Commissioner of Internal Revenue v. Hansen, 360 U.S. 446, 467, 79 S.Ct. 1270, 1281, 3 L.Ed.2d 1360 (1959). Thus, § 446 gives the Commissioner discretion with respect to two determinations. The Commissioner first determines whether the accounting method chosen by a taxpayer clearly reflects income. If the Commissioner concludes that the taxpayer’s chosen method does not meet this standard, he has the further discretion to require that computations be made under the method which, in his opinion, does clearly reflect income. It would be difficult to describe administrative discretion in broader terms.

It is the taxpayer’s position that the requirement that a method of accounting clearly reflect income is not absolute, in that it does not require an exact matching of receipts from the sale of products with the costs of goods sold. If the requirement were absolute, it contends, the cash receipts and disbursements method of accounting would never be permitted because that method admittedly is inexact. Yet the Code and regulations do recognize and permit use of the cash method. The taxpayer urges us to follow cases which have held that the requirement is not absolute and that the Commissioner exceeds his authority when he insists that a taxpayer change from a method that has been fairly and consistently employed unless there has been some attempt to manipulate records or evade the payment of taxes. In Osterloh v. Lucas, 37 F.2d 277, 278-79 (9th Cir.1930), the court stated:

In our opinion, all that is meant [by the requirement that the method of accounting shall clearly reflect the income] is that the books shall be kept fairly and honestly; and when so kept they reflect the true income of the taxpayer within the meaning of the law. In other words, the books are controlling, unless there has been an attempt of some sort to evade the tax.

Osterloh has been cited by the Tax Court as stating a general principle, though we have found no case where it has been followed in circumstances like those of the present case.

The taxpayer also relies on two decisions from this court, both of which are distinguishable. In Morris-Poston Coal Co. v. Commissioner of Internal Revenue, 42 (6th Cir.1930), the Commissioner based a deficiency assessment on his finding that a taxpayer had changed its method of accounting without prior approval. The court concluded that the facts did not support this finding and reversed an order of the Board of Tax Appeals upholding the deficiency assessment. The significant difference between the present case and Morris-Poston is that the Commissioner in Morris-Poston failed to make a determination that the accounting method employed by the taxpayer did not clearly reflect income. Rather the Commissioner sought to require the taxpayer to accrue rental income on the erroneous finding that the taxpayer had changed its accounting method without prior approval. As the court pointed out, “... the right of the commissioner to reject the taxpayer’s theory of income in this kind of a case stands upon the Commissioner’s preliminary finding that the method employed by the taxpayer did not clearly reflect the income.” Id. at 621. The authority to require a taxpayer to change its accounting method is not available for enforcement of other Code provisions. It may be used only as provided in § 446, after a determination has been made that the method in use does not clearly reflect income.

Glenn v. Kentucky Color & Chemical Co., 186 F.2d 975 (6th Cir.1951), may be distinguished on the same basis. The Court in Kentucky Color stated:

The Commissioner does not here assert, and so far as this record shows has never asserted that the taxpayer’s method of accounting and reporting its taxes did not clearly reflect its income. He asserts that the method used is the accrual method and that therefore the Commissioner was authorized to order the accrual of the items involved. But the Commissioner’s authority to order a change in accounting methods when the taxpayer has regularly employed a consistent method depends upon his finding that the taxpayer’s method does not clearly reflect the income.

Id. at 977 (citation omitted). The same fact distinguishes Magnon Service Electric Corp. v. Commissioner of Internal Revenue, 73 T.C. 980 (1980), a recent decision which cited Osterloh. In Magnon the Commissioner based a deficiency upon a finding that the taxpayer should have used the percentage of completion method rather than the cash receipts and disbursements method of accounting with respect to long-term construction contracts. The Commissioner made no express determination under § 446 that the cash method of accounting did not clearly reflect income.

In each of the cited cases other than Osterloh the courts have concluded that the Commissioner was seeking to exercise a statutory power without making a preliminary determination which the statute establishes as a prerequisite. These cases do not limit the Commissioner’s discretion when § 446 is properly applied. Instead, they stand for the proposition that the Commissioner cannot resort to his § 446 authority to require a change in accounting method just because he disagrees with a taxpayer’s choice of method. That is not the situation in the present case. Here the Commissioner concluded that the cash method did not clearly reflect the taxpayer’s 1974 income because inventories were a necessary element of its income-producing activities and the presence of substantial accounts receivable at the end of the year meant that the cost of goods sold had been deducted while the proceeds from the sales of these goods had not been included in income. This “mismatching” resulted in reporting that did not clearly reflect income.

When the Commissioner concludes that a taxpayer’s method of accounting does not clearly reflect income, the taxpayer has a heavy burden to show that the Commissioner has abused his discretion. A taxpayer does not overcome that burden by merely showing that it has “fairly and consistently” reported its income in the past. As in the present case, a change in conditions might render the past method of accounting inaccurate. Though the temporary increase in inventory in the present case was not significant, the large increase in accounts receivable created a situation where only use of the accrual method of accounting would avoid a serious distortion. Under these circumstances, the Commissioner’s finding that the cash method no longer clearly reflected the taxpayer’s income was fully supported by the record and the requirement that the taxpayer adopt the accrual method for 1974 and subsequent years was not an abuse of discretion.

We agree with the court in Caldwell v. Commissioner of Internal Revenue, 202 F.2d 112, 114-15 (2d Cir.1953), where it stated that the requirement that books reflect income “clearly” means “accurately,” not just “fairly and honestly.” Where the Commissioner has determined that the accounting method used by a taxpayer does not clearly reflect income, in order to prevail, “the taxpayer must demonstrate substantial identity of results between his method and the method selected by the Commissioner.” Wilkinson-Beane, Inc. v. Commissioner of Internal Revenue, 420 F.2d 352, 356 (1st Cir.1970).

We realize that the result seems harsh in this case. If the temporary and rather insignificant increase in inventories of raw materials had been the only basis for the Commissioner’s determination, we would have been inclined to find an abuse of discretion. We do not construe the Code provisions and regulations relating to inventories in the absolute terms adopted by the Commissioner and the Tax Court. However, the taxpayer’s method of accounting did not produce an accurate picture of its 1974 income. The income tax is structured on an annual basis. Using the cash method, the cost of materials sold in 1974 was deducted on the 1974 return, yet the proceeds from that portion of the same sales represented by the accounts receivable were not included in the taxpayer’s gross receipts as reported on its return. Unlike the inventory item, the accounts receivable were not negligible before 1974 and did not shrink even to their former size at the end of the oil emergency. The taxpayer had accounts receivable of $238,000 at the end of 1976. These facts supported the Commissioner’s determination that the cash receipts and disbursements method did not clearly reflect the taxpayer’s income.

IV.

Section 6653(a) of the Code, in its entirety, provided:

(a) Negligence or intentional disregard of rules and regulations with respect to income or gift taxes. — If any part of any under payment (as defined in subsection (c)(1)) of any tax imposed by subtitle A or by chapter 12 of subtitle B (relating to income taxes and gift taxes) is due to negligence or intentional disregard of rules and regulations (but without intent to defraud), there shall be added to the tax an amount equal to 5 percent of the underpayment.

The Commissioner found that the taxpayer acted negligently in claiming a deduction for the cost of transporting the wastewater treatment plants to Tennessee. On the basis of this finding, the Commissioner added a 5% penalty to the entire deficiency assessment. Since the total deficiency assessment was more than $133,000, this resulted in a penalty of $6,943, though the deficiency attributable to the deduction was only the portion of the whole representing the tax on $1,103. The Tax Court upheld the Commissioner, concluding that the Code requires an addition of 5% to the entire underpayment.

There is case law to support the decision of the Tax Court. See Vnuk v. Commissioner of Internal Revenue, 621 F.2d 1318 (8th Cir.1980); Abrams v. United States, 449 F.2d 662 (2d Cir.1971). These cases bear no resemblance to the present case. In both there were egregious attempts to avoid the payment of taxes and one is left wondering how the taxpayers avoided the 50% fraud penalty imposed by § 6653(b) of the Code. In Abrams the taxpayer argued that literal application of § 6653(a) would lead to an absurd result where a “comparatively insignificant item of income is negligently omitted.” The court responded:

That case is not before us on this appeal and we therefore express no opinion whatever as to its proper disposition if it should ever arise.

449 F.2d at 664.

“That case” is now before us. The bulk of the deficiency arose from the taxpayer’s consistently following its accounting practices. In contesting the Commissioner’s deficiency determinations it relied on decisions of this court that arguably supported its position. The Commissioner did not claim a negligence penalty with respect to the actions of the taxpayer that resulted in all but a few hundred dollars of the $133,-000 deficiency assessment. The taxpayer did not concede that it was negligent in claiming the disallowed deduction; it merely conceded that the deduction was erroneously claimed. We will not let the tail wag the dog. “Under all the circumstances of the instant case,” Frederick W. Finney, T.C. Memo 1980-23, we conclude that the § 6653(a) penalty should be applied only to that portion of the deficiency attributable to the disallowed deduction.

The decision of the Tax Court is affirmed in part, reversed in part, and remanded for further proceedings consistent with this opinion. The cross-appeal is dismissed. No costs are allowed.