Category: Accounting Periods & Methods Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Facts It is assumed that S is expected to be profitable at all times. If that is not the case, it is possible that the so-called syndicate rules could come into play and we should look at this as a separate issue. Issue Answer Discussion You seem to be concerned, and I share your concern to some degree at least, that the closeness of association between Taxpayer and S might allow IRS to somehow view S as an alter ego of Taxpayer or as a sham or as an attempt to end-run Taxpayer's duly elected method of accounting. Assume, arguendo, that these concerns are real. What can be done to minimize them? It seems to me that the relationship between S and Taxpayer must be totally consistent with an arms-length relationship between unrelated parties. If not, the IRS has a number of weapons, principally Section 482, that would allow the transactions between the two entities to be reallocated based on what the IRS views as economic reality. This could have very significant adverse consequences. You have also asked me to speak to the issue of whether Taxpayer was really required to adopt the accrual method of accounting in the first instance. Based on the facts as I understand them, the existence of an "inventory" of spare parts would not require Taxpayer to adopt the accrual method of accounting. The regulations at Section 1.446-1(a)(4)(i) state that inventories must be kept "in all cases in which the production, purchase, or sale of merchandise of any kind is an income-producing factor." "Merchandise" under Regulation Section 1.471-1 includes "all finished or partly finished goods and, in the case of raw materials and supplies . . .those which have been acquired for sale or which will physically become a part of merchandise intended for sale," including containers. By contrast, it is well settled that "incidental materials or supplies" may be expensed as acquired, if this practice results in clear reflection of income. Regulation Section 1.162-3. If materials or supplies are material in amount such that immediate deduction of the costs thereof distorts income, it may be necessary to institute some sort of record of consumption, but such items are not subject to the ordinary principles of inventory accounting. In other words, it may be necessary to "inventory" incidental supplies as opposed to immediately expensing them, but that is not to say that the ordinary inventory rules (particularly those which require the accrual method of accounting) come into play as a result. Perhaps Taxpayer was advised that because of the magnitude of its stock of spare parts, these items had to be inventoried. Someone then over-interpreted the meaning of that term and placed Taxpayer on the accrual method of accounting. It seems clear to me, however, that since these spare parts and supplies are neither sold to customers nor do they become part of anything that is, the parts and supplies could hardly be deemed merchandise. There is a body of case law holding that a variety of items sold in conjunction with what is normally considered a service constitutes sale of merchandise. Examples include eye-glass frames for an optometrist, caskets for a funeral director, asphalt for a paving company, construction materials for a contractor, and a stock of precious metals used by an electroplating operation. It seems to me that the spare parts inventory of a taxicab operation does not fit in with even these rather far-fetched cases. We also discussed the issue of whether taxicabs are including in any kind of IRS Market Segment Specialization Program (MSSP) or Coordinated Issue Program. There is an MSSP for taxicab companies. There is no discussion of accounting method issues in the MSSP. The focus of the document is almost entirely on reconstruction of gross income based on certain formulas concocted by the IRS. As I told you, I feel that it is quite important to be aware of these various IRS programs. Tax Analysts publishes the entire set in a paper bound volume at a cost of approximately $50. They can be reached at 800-955-2444. Finally, there is always exposure to the so-called clear reflection of income rule. Under Section 446(b), the IRS has the authority to force a taxpayer to abandon an existing accounting method in favor of a method deemed by the IRS to clearly reflect income. The phrase "clearly reflects income" is not defined, and many practitioners and taxpayers have been shocked to learn that it does not mean absence of willful manipulation of income. In practice, the method of accounting the IRS deems to clearly reflect income by some remarkable coincidence generally ends up being the method which will produce the greatest increase in taxable income for the years under examination. The taxpayer has the burden of proving that the method in use clearly reflects income, and the IRS's determination is presumed correct unless the taxpayer can show a clear abuse of discretion. In practical terms, the taxpayer is virtually helpless to fight an IRS assertion that the method of accounting in use does not clearly reflect income. In recent years, the IRS has demonstrated great enthusiasm for applying this line of attack to forbid taxpayers from using the cash method of accounting in cases for which the existing statutory and regulatory provisions do not already preclude its use. Accordingly, if it is apparent that S's accrual method income will be substantially higher than its cash basis income, S is exposed to this kind of attack. I know of no effective defense. I suggest that it would be appropriate to apprise your client of this risk at the outset. |
