CCA 1027052: Advice on limits for hybrid accounting methods

Plain-English summary

Chief Counsel Advice compiles authorities on whether taxpayers may use hybrid accounting methods that combine cash and accrual treatment. The cited authorities state that a hybrid method must be used consistently and clearly reflect income, and that a taxpayer generally cannot use the cash method for expenses while using the accrual method for income from the same business. The advice also discusses the IRS's authority to require an accrual method for businesses with inventory and to reject deductions when the taxpayer's accounting method does not clearly reflect income. The examples cover business expenses, pension contributions, repairs, and real estate taxes.

Ruling snapshot

• Question: When may a taxpayer use a hybrid cash and accrual accounting method?
• Outcome: advice given
• Key authorities: IRC §§ 446, 404(a), and 461; Treas. Reg. §§ 1.446-1(a)(2), 1.446-1(c)(1)(iv), and 1.461-1(a)(1)

Full text (IRS public release)

ID: CCA-123231-10 Number: 201027052
Release Date: 7/9/2010
Office: ----------------
UILC: 446.03-00

From: ----------------------
Sent: Saturday, January 23, 2010 11:14 PM
To: ---------------------------------------------------------------------------------------------------------------------------

Cc: -------------------
Subject: RE: Conference call to discuss comments on ----------rebuttal draft

-------- -- My plane arrives at 11:45, so I should be at my desk sometime after 1:00; I am also available
any time Tuesday. Here are some potentially interesting quotes/cites:

1. “Petitioner's next argument is that he is using a hybrid method of accounting. Hybrids
   are permissible if they are used consistently and clearly reflect Income. Section 1.446-
   1(c)(2)(ii), Income Tax Regs. However, a hybrid method which uses the cash method to
   report expenses must also use the cash method to report income. It is well settled that
   taxpayers may not accrue receipts and treat expenditures on a cash basis, or vice
   versa. Mass. Mutual Life Ins. Co. v. United States [3 USTC ¶ 1045], 288 U.S. 269, 274
   (1933). Petitioner has used the cash method to report his expenses and, therefore,
   cannot use anything other than the cash method to report his income. Otherwise,
   petitioner would be able to currently deduct expenses while deferring income.”
   Gustafson v. Commissioner, T.C.Memo. 1988-82.

2. “Petitioner concedes that, absent the prior examination and approval of petitioner's
   method of accounting, this case would be controlled by Connors, Inc. v. Commissioner,
   71 T.C. 913 (1979). In Connors, this Court held that section 446(c)(4) and section
   1.446-1(c)(1)(iv)(a), Income Tax Regs., require a taxpayer, who uses the cash method
   of accounting for reporting items of gross income for his trade or business, to use also
   the cash method for reporting items of expenses even though he uses a hybrid method
   of accounting with respect to other items.” Pierce Ditching Co. v. Commissioner, 73
   T.C. 301, 304-5 (1979).

3. “The issues in this case concern taxpayer's method of accounting during the tax
   years in question. Characterizing this method as a hybrid of cash and accrual methods,
   the tax court found that Record Wide reduced its inventory when items were shipped to
   its customers, but recorded sales upon actual receipt of payment.2 The Commissioner
   concluded that this hybrid method did not clearly reflect taxpayer's income,3 see 26
   U.S.C. § 446(b), and recalculated tax liability for the years 1972, 1973 and 1974, on an
   accrual basis, resulting in the assessment of deficiencies in the amounts of $92,056.99,
   $34,444.54 and $21,232.29, respectively.4

“Record Wide defends its accounting method as consistent with its unique business
practices. It is established, however, that the Commissioner has broad discretion to
evaluate and modify a taxpayer's accounting method in order to insure the clear
reflection of income, and that the taxpayer has the heavy burden of proving that the
Commissioner's determination is plainly arbitrary. Thor Power Tool Co. v. Comm'r, 439
U.S. 522, 532-33, 99 S.Ct. 773, 780-81, 58 L.Ed.2d 785 (1979); Clement v. United
States, 580 F.2d 422, 430 (Ct.Cl.1978), cert. denied, 440 U.S. 907, 99 S.Ct. 1214, 59
L.Ed.2d 455 (1979). The regulations clearly mandate the use of an accrual accounting
method for businesses that maintain inventories, unless the Commissioner, in his
discretion, authorizes an alternate method. Treas. Reg. § 1.1446-1(c)(2). The tax court
concluded, and we agree, that Record Wide failed to establish that the Commissioner
abused his discretion by requiring the use of an accrual method to compute Record
Wide's tax liability.” Record Wide Distributors, Inc. v. Commissioner, 682 F.2d 204
(1982).

4. “The petitioner argues that he is entitled to use a hybrid method of accounting, under
   the authority of section 1.446-1(a)(2), Income Tax Regs. His theory is, apparently, that
   he should be permitted to accrue currently, as a liability, amounts owed by him to
   himself on account of his labors, but include the value of such labor in income only
   when (754) and if such labor gives rise to cash income in the future. This argument is
   totally without merit. For one thing, we have found that the petitioner incurred no liability,
   in favor of himself or anyone else, to pay for the value of his services. For another, the
   regulations specifically provide:

“a taxpayer who uses the cash method of accounting in computing gross income from
his trade or business shall use the cash method in computing expenses of such trade or
business. Similarly, a taxpayer who uses an accrual method * * * in computing business
expenses shall use an accrual method in computing items affecting gross income from
his trade or business. [Sec. 1.446-1(c)(1)(iv), Income Tax Regs.]

“There is no evidence that the petitioner contemplated using anything but a cash
method of accounting for any income which might be derived from his mineral
operations. Finally, we cannot see how the method used by the petitioner would clearly
reflect income. See sec. 446(b); sec. 1.446-1(a)(2), Income Tax Regs. For all the
foregoing reasons, we hold that the petitioner may not account for his labors in the
manner claimed.

“Accordingly, the respondent properly disallowed the deductions for the research work,
and for the work to maintain the mining claims, performed by the petitioner. Our
conclusion avoids the necessity of passing on the correctness of the petitioner's
valuation of such labor.” Rink v. Commissioner, 51 T.C. 746 (1969).

5. “The first issue for decision is whether petitioners may deduct more than $51,203 for
   repairs expenses for 1994. Petitioners contend that they may deduct $114,823 for
   repairs expenses for 1994. Petitioners did not report income until they received it, but
   they deducted some expenses before they paid them. Petitioners contend that this is a
   proper hybrid method of accounting which they have consistently and properly used to
   compute and report petitioner's income and expenses from his logging business.

Petitioners also contend that respondent's determination was an abuse of discretion
because the cash method of accounting does not clearly reflect petitioner's income from
the logging business.

“We disagree. First, petitioners did not explain why the cash method would not clearly
reflect their income. Second, petitioners did not use a valid hybrid method of
accounting. Petitioners improperly reported income on the cash method and related
expenses on an accrual method. See sec. 1.446-1(c)(1)(iv), Income Tax Regs. A
taxpayer's method of accounting that is plainly contrary to the regulations does not
clearly reflect income. See Thor Power Tool Co. v. Commissioner [79-1 USTC ¶ 9139],
439 U.S. 522, 523, 533 (1979).” Grider v. Commissioner, T.C.Memo. 1999-417.

6. “In the present case, petitioner contends that it employs a "hybrid" system of
   accounting as authorized by regulation section 1.446-1(a) (2). Under its system,
   petitioner accounts for most of its transactions on a cash receipts and disbursements
   basis. However, deductions for its contributions to its pension and profit-sharing plans
   are accounted for under the accrual method.[6]

“Because it accounts for its contributions on an accrual basis, and because for each of the
years in issue it actually paid such contributions prior to the due date of its returns,
pursuant to section 404(a)(6), petitioner maintains that it is entitled to a deduction for the
year of accrual. We disagree.

“Generally section 446(c) allows a taxpayer to compute its taxable income under either a
cash or an accrual method of accounting. Subsection (4) of section 446(c) authorizes the
use of a hybrid system of accounting if it is "permitted under regulations prescribed by the
Secretary." In this regard, the regulations permit the use of a combination of a cash and
accrual system of accounting if such system clearly reflects income and is consistently
used. See section 1.446-1(c)(1)(iv), Income Tax Regs. However, the regulations restrict
the use of a hybrid system in certain cases. In particular, regulation
section 1.446-1(c) (1) (iv) (a) provides in pertinent part:

a taxpayer who uses the cash method of accounting in computing gross income from
his trade or business shall use the cash method in computing expenses of such trade or
business.

“Here petitioner utilizes the cash method of accounting in computing gross income from
its trade or business, and so it must also use the cash method in accounting for any
expenses, such as compensation, which relate to such business. Included within the
term "compensation" are any payments to a pension or profit-sharing plan. See section
404(a). Accordingly, petitioner must use the cash method to account for any expenses
relating to its contributions, and is therefore not entitled to rely on section 404(a)(6) in
determining the proper year for deducting such contributions.” Cain-White & Co.,
T.C.Memo. 1978-438.

4

7. “The facts of this case fall squarely within section 1.446-1(c)(1)(iv)(a), Income Tax
   Regs., which provides, in pertinent part, as follows:

• • • a taxpayer who uses the cash method of accounting in computing gross income
      from his trade or business shall use the cash method in computing expenses of such
      trade or business.

“In the instant case, petitioners have not only used the cash method of accounting in
computing gross income from the rental of the property, but they have used the cash
method in computing all of the expenses therefrom, except real estate taxes.
Consequently, petitioners must also account for real estate taxes on the cash basis.
See also, Massachusetts Mutual Life Insurance Co.v. United States [3 USTC ¶ 1045],
288 U.S. 269, 273-274 (1933); Miele v. Commissioner [Dec. 36,055], 72 T.C. 284, 291
(1979); Connors, Inc. v. Commissioner [Dec. 35,900], 71 T.C. 913, 916 (1979). Since
petitioners did not pay the real estate taxes attributable to the property during the years
in issue, respondent properly disallowed their claimed deductions for those years. Secs.
1.446-1(c) (1)(i) and 1.461-1(a)(1), Income Tax Regs.” Brunton v. Commissioner,
T.C.Memo. 1982-166.