PICPA - When IRS Audits Meet the Cash Method of Accounting

When IRS Audits Meet the Cash Method of Accounting

Spring 2011

By Edward R. Jenkins Jr., CPA

It was a pleasant day. That is until your client, an Eddie’s Sub Shack franchisee, received a 2205 letter from the IRS that notified him of selection for examination and explained his rights during an examination. Eddie’s Sub Shack is a national sandwich chain, and your client owns the local franchise. 

The IRS agent wants to meet the client and tour the store. One of the first things the agent does is count the seats, which allows him to apply a metric to compute expected revenue per seat for the year. Then, the agent takes a quick tour. The IRS agent checks how often the proprietor orders goods from his suppliers, requests a couple of invoices from major suppliers, and observes the type and quantities of inventory on hand. The agent notes that the seating metric and supplier interviews are being used to determine if there is a probability of underreported cash receipts.

The agent observes that there isn’t much inventory and that the shop gets two shipments of foodstuffs each week. You note that is why the franchise has always used the cash receipts and disbursements (cash) method, and doesn’t track inventory for tax purposes. This is met with silence.

So, is the cash method of accounting for this kind of restaurant still permitted? This column reviews the difficult area where IRC Section 471, General Rule for Inventories, butts heads with IRC Section 446, General Rule for Methods of Accounting. This column assumes the Eddie’s franchise meets the requirements for an exception from the general rule of IRC Section 448 that limits the use of the cash method. 

IRC Section 471(a) says the IRS gets to determine if the use of inventory is required to clearly reflect income of a taxpayer. That premise is further explained in Treas. Reg. 1.471-1. That regulation states, “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.” That statement sounds pretty straightforward. If Eddie’s Sub Shack uses inventory, and that inventory is an income-producing factor, then, “in every case,” beginning and ending inventories are necessary to clearly reflect income.

That rule of law is plain. Then why is this column being written? Let’s take a look at the framework for accounting methods. First of all, IRC Section 446(a) states the 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.” IRC Section 446(c) goes on to identify 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. …”

Treasury Regulation 1.446-1(c)(1)(i) elaborates: “Generally, under the cash receipts and disbursements method in the computation of taxable income, all items which constitute gross income (whether in the form of cash, property, or services) are to be included for the taxable year in which actually or constructively received. Expenditures are to be deducted for the taxable year in which actually made.” 

That regulation goes on to explain a special rule in (c)(2)(ii) that says, “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 Commissioner may authorize a taxpayer to adopt or change to a method of accounting permitted by this chapter although the method is not specifically described in the regulations in this part if, in the opinion of the Commissioner, income is clearly reflected by the use of such method. Further, the Commissioner may authorize a taxpayer to continue the use of a method of accounting consistently used by the taxpayer, even though not specifically authorized by the regulations in this part, if, in the opinion of the Commissioner, income is clearly reflected by the use of such method.”

The theme in the regulation seems to be “consistently used method” and “clearly reflecting income.” The IRS agent is pretty convinced that your client is required to track inventory for tax purposes. 

You ask, “How much difference do you think exists between beginning and ending inventory if Eddie’s gets shipments twice a week and only keeps a nominal amount of inventory on hand?”

The auditor says, “Well, the IRC Section 481 adjustment is clearly immaterial.” Isn’t that statement another way of saying “the consistently used cash method clearly reflects income?”  

Edward R. Jenkins Jr., CPA, is managing member of Jenkins & Co. LLC in Spring Grove, an instructor of business at Pennsylvania State University – York, and a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at erj2@psu.edu.