IRS Building
Tax & AccountingMay 05, 2022

Tax Court takes an excursion through tax accounting history

By: CCH AnswerConnect Editorial

If a taxpayer uses an accounting method that does not clearly reflect income, the IRS may require the taxpayer to change its method of accounting. In Continuing Life Communities Thousand Oaks,  the Tax Court held that the taxpayer's accounting method clearly reflected income and the IRS abused its discretion in requiring a change. In doing so, the Tax Court provided an extensive discussion of law and rulings regarding IRS authority and its own history.

Thor Power Tool

In Thor Power Tool, the U.S. Supreme Court found that generally accepted accounting principles (GAAP) and tax accounting have different purposes.  It decided a taxpayer cannot simply argue that because it follows GAAP it should presumptively win. The Court also held that "the Commissioner has an unusually broad power of discretion to set aside a taxpayer's method of accounting 'if, in [his] opinion, it does not reflect income clearly.'"

Conflict between statute and regulation

The Thor Court, in reaching its decision, cited Reg. §1.446-1(a)(2). This regulation includes the sentence: “However, no method of accounting is acceptable unless, in the opinion of the Commissioner, it clearly reflects income.” The Tax Court noted that like the regulation, Code Sec. 446 requires deference to the opinion of the Commissioner. However the Code Section "makes that deference conditional: '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.'"

Standards for determining abuse of discretion

The Tax Court looked into the interpretation of the word "opinion." It found that there is "some good authority" to read “opinion” to mean something similar to “discretion.” According to the Tax Court, Congress routinely delegates functions to executive agencies, and those agencies exercise discretion in performing those functions. Disgruntled persons may seek judicial review, and that review is aimed at  uncovering “abuses of discretion.” 

The Tax Court noted that a court asked to decide if an agency has abused its discretion must usually review how the agency exercised its discretion on the basis of the administrative record compiled by the agency. The court then reviews "only the rationale that the agency uses," and "doesn't come up with one of its own or let the Commissioner's attorneys come up with one of their own," according to the Tax Court.

The Tax Court reviews whistleblower awards in this manner, and, in cases appealable to certain circuits, notices of determination in collection-due-process cases. However, the Tax Court stated that this is not how it has reviewed exercises of the Commissioner's discretion in contesting or changing a taxpayer's method of accounting. According to the Tax Court, over the decades that its has been reviewing the Commissioner's work, the Court does not ask for an administrative record, does not confine itself to the rationale given by the IRS at the end of an audit, and does not ask whether there's some particular clearly erroneous factfinding or mistake of law or irrational application of law to facts. Instead, the Tax Court does "not interfere unless the Commissioner's determination is arbitrary, capricious, clearly unlawful, or without sound basis in fact or law."

Pre-tax court

The Thor Court quoted 1930s cases in noting that that deference to a taxpayer's choice of accounting method is limited to cases “where the Commissioner believes that the accounts clearly reflect the net income” and that a taxpayer who wants to overcome the Commissioner's rejection of his accounting method must show that the rejection was “plainly arbitrary."

The Tax Court stated that cases from that era did not say that the Commissioner had this discretion, but rather that “much latitude for discretion is thus given to the administrative board charged with the duty of enforcing the act." And it noted that the "administrative board" was the Tax Court's predecessor, the Board of Tax Appeals. 

Clear reflection of income

The Tax Court found that the taxpayer's accounting for deferred fees, the issue challenged by the IRS, clearly reflected income.

The taxpayer, a California nursing home, argued that its residence agreement provides that residents pay deferred fees only when they die or move out. Because it has an obligation to provide care for their entire lives, the taxpayer contended that its performance ends only when a resident dies or moves out. Therefore, its right to the deferred fee also becomes fixed and definite only when a resident dies or moves out.

The IRS argued that the residence agreement's schedule fixing the amount of deferred fees that the nursing home earns each year is what really fixes its right to those fees. 

The Tax Court determined that the residence agreement was drafted to comply with California law to win approval of the Department of Social Services. The residence agreement contains a promise to provide care for the duration of the resident's life. If the taxpayer abandons this obligation, it opens itself to fines, and its managers to prison, and it would not receive any deferred fees.

The Tax Court found the deferred fee schedule fixes only the deferred fee amount; and that that there was no way in which the taxpayer's reporting of its income from deferred fees contradicts the purpose of tax accounting's treatment of income recognition.

Abuse of discretion

The Tax Court, following its extensive discussion regarding tax accounting, the text of the Code and regulations, the purpose of distinctions between tax and financial accounting, the exercise of common-law reasoning by analogy to treat similar cases similarly, and finally deference in some fashion to the determination of the Commissioner, found in favor of the taxpayer's summary judgment motion. After holding that the taxpayer's accounting for its deferred fees clearly reflected income, the Tax Court found that the IRS attempt to change that method was an abuse of discretion. According to the Tax Court, "although the IRS Commissioner has discretion to change accounting methods, the history of how that discretion came to be weakens its power to overcome text, purpose, and analogy."

Get More News with CCH AnswerConnect®
CCH AnswerConnect Editorial

Comprising of industry’s most trusted experts, the Wolters Kluwer CCH AnswerConnect Editorial Staff are knowledgeable and highly qualified to analyze and offer guidance on the latest, important tax topics. They ensure every topic is thoroughly researched and meticulously broken down so you receive the most up to date and accurate information available. Read more of their insights on CCH AnswerConnect.

Back To Top