When to accrue for inventories

Not all taxpayers are permitted to use the cash method of accounting for income tax purposes. Section 448(a) requires all C corporations, partnerships with a C corporation as a partner and tax shelters, as defined in Section 448(d)(3), to use the accrual method of accounting. Section 448(c)(1) provides an exception to the general rule for nontax shelter corporations and partnerships for any tax year in which the average annual gross receipts for the prior three years are $5 million or less. Even a taxpayer that passes the gross receipts test of Section 448(c)(1) for the cash method and does not use inventories still may be required to use the accrual method for tax purposes. In the American Fletcher Corp. case, the 7th Circuit upheld the IRS's determination that the cash method be disallowed for a credit card business where it produced $1.4 million and $200,000 greater net operating losses in two consecutive years than would have occurred had the accrual method been used. On the other hand, the Tax Court has not accepted the unilateral authority of the IRS to require a taxpayer to change its method of accounting. In the Ansley-Sheppard-Burgess case, the Tax Court stated that the IRS cannot require a taxpayer to change from an accounting method which clearly reflects income to an alternate method of accounting merely because the IRS considers the alternate method to more clearly reflect the taxpayer's income. The Tax Court's decision in the RACMP Enterprises case should prevent the IRS from arguing that the taxpayer's cash method of accounting fails the clear reflection of income standard of Section 446(b). Rather, clear reflection of income using the cash method will be presumed providing that there is no deliberate distortion of income.