In the case of King Solarman, Inc. v. Commissioner, TC Memo 2019-103[1] the key issue was whether the taxpayer was reporting on the cash or accrual overall method of accounting and, even if the business was on the cash method of accounting, it was nevertheless required to use the overall accrual method of accounting for tax purposes.

Taxpayers are generally eligible to use the overall cash or accrual method of accounting or another method permitted under the Code or regulations.[2]  However, once a taxpayer has chosen an overall method of accounting, the taxpayer must obtain the IRS’s permission to change that method.[3]

The taxpayer selects its overall method of accounting generally on the taxpayer’s initial tax return.[4] A method of accounting is established based on the consistent use of the method by the taxpayer on the taxpayer’s tax returns.[5]  Thus, if a taxpayer makes an error in single year in how an item is treated, that is generally not considered a selection of a method[6]  But if the taxpayer continues to make that same error (such as using the wrong depreciable life for a class of assets), the consistency makes the treatment the taxpayer’s method of accounting.

However, taxpayers do not have unfettered discretion in how items are treated—the method chosen must be one that clearly reflects income or in other cases mandated by the IRC.[7]  For instance, if a taxpayer is required to use an inventory under IRC §471, the taxpayer is required to use the overall accrual method of accounting unless the IRS has otherwise authorized.[8]  IRC §471 mandates the use of inventories by a taxpayer whenever the production, purchase or sale of merchandise is a material income producing factor.[9]

The case before the Tax Court involved a business that manufactured solar equipment.  The company had accepted an order for 162 towers.  While the towers could accept various accessories, the buyer did not have any of those optional items installed on these towers.[10]

The transaction is described by the Court as follows:

The total purchase price was $7,938,000, payable in two cash installments totaling $2,143,260 and a promissory note for the $5,794,740 balance. The note was secured by the solar towers and called for 240 monthly payments of $31,388.50. During FYE 2015 the Fund paid the two cash installments and made four monthly payments on the note, yielding total cash payments of $2,268,814 ($2,143,260 + (4 × $31,388.50)). At the close of FYE 2015, KSI's general ledger showed “net sales” to the Fund of $2,268,814, “deferred sales” of $5,669,186, and “accounts receivable/note” of $5,669,186.[11]

The Court continues to describe how this transaction was reported by the taxpayer on the tax return for the year in question:

KSI included in its reported COGS — as “purchases” or “purchases/agent” — 100% of the material costs attributable to the 162 solar towers it sold to the Fund. And it included among its deductions — either as “salaries and wages” or as “other deductions” — 100% of the labor costs attributable to the 162 solar towers. But it excluded from its gross receipts $5,669,186, the portion of the purchase price that it did not receive in cash during FYE 2015.[12]

The IRS objected that the taxpayer was either on the accrual method of accounting for tax purposes or was required to be on that method, thus requiring all of the revenue from the contract to be included in income for the year of the sale.  The taxpayer objected that it was properly reporting on the cash basis.[13]

The Court first looked at whether the taxpayer had ever actually been on the cash basis of accounting, or rather had adopted to use the accrual basis of accounting on its prior returns.  The taxpayer had checked the box to indicate it was using the accrual method of accounting on all of its tax returns.[14]

The taxpayer suggested that this box had been checked in error, but the Court found nothing to support that assertion.  The Court noted that each of its returns had been prepared by a CPA and that CPA had not advised the taxpayer to seek permission to change its method of accounting.  The CPA was not asked to give testimony at trial by the taxpayer to support the view that this had been a mistake despite having the box checked on multiple returns and no request to change methods had been filed—thus, the Court found it did not seem a “mistake” had been made.[15]

Nor did the returns and books of the taxpayer suggest that the taxpayer was reporting on any method of accounting other than accrual.  In response to the taxpayer’s claim that its books really were kept on the[16] accrual basis, the Court noted:

In a related vein petitioner contends that, despite its election of the accrual method, it actually used the cash method in keeping its books. We find little if any factual support for this counterintuitive proposition. Petitioner did not introduce into evidence its general ledger (or any other bookkeeping records) for FYE 2012, 2013, or 2014. There is thus no record evidence regarding petitioner’s internal bookkeeping practices for the first three years of its existence. For FYE 2015, petitioner’s general ledger includes various entries that are consistent with its use of the accrual method, e.g., accounts captioned “accrued salaries,” “accounts payable,” “payroll taxes payable (Federal),” “payroll taxes payable (State),” “payroll taxes payable (FUTA),” and “income tax payable.” Many of these same items, as well as “credit card payables,” appeared on the Schedules L and attached statements included in petitioner’s tax returns for FYE 2015 and prior years.4

General ledger account 154, captioned “Equipment-Solar Light Tower,” appears to capture inventory because it has no matching subaccount for accumulated depreciation. Its entries include “solar light tower,” “solar trailer,” and “solar panel.” That general ledger account balance, $1,062,241, was zeroed out in December 2014 (shortly after the sale of the 162 solar towers) and “reclassif[ied] to cost.” This treatment in substance reflects the inclusion of inventory in COGS.[17]

The Court notes that it’s clear that the taxpayer’s return had errors in applying the accrual method, for instance showing no opening or closing inventory or cost of labor on Form 1125-A.  But the existence of errors in applying the method does not constitute evidence that it was truly using the cash method of accounting.[18]

The Court also found that, regardless of what method the taxpayer had been using, it was required to use the accrual method of accounting because the production, purchase and sale of merchandise was an income producing factor.[19] 

The taxpayer objected that it did not keep inventories on its books or its tax returns—but the Court noted that neither issue is relevant, noting:

The dispositive question is not whether petitioner actually maintained inventories but whether “it [wa]s necessary to use an inventory.” Sec. 1.446-1(c)(2)(i), Income Tax Regs. As explained above, it was necessary for petitioner to use an inventory because “the production, purchase, or sale of merchandise [wa]s an income-producing factor.” See sec. 1.471-1, Income Tax Regs. Indeed, the production, purchase, and sale of merchandise were the sole income-producing factors for petitioner's business.[20]

Similarly, the fact that the taxpayer had no inventory on hand at the end of the year also is not a relevant issue—and, again, that fact itself is not relevant.  As the Court noted:

…[I]n determining whether petitioner was required to use the accrual method, the question is not whether it actually had inventory on hand at year end. See J.P. Sheahan Assocs., Inc. v. Commissioner, T.C. Memo. 1992-239, 63 T.C.M (CCH) 2842, 2844 (“[T]he fact that * * * use [of inventory] may produce a zero or minimal year-end inventory is irrelevant.”). The dispositive question is whether the material that produced petitioner’s income was susceptible to being inventoried. See Jim Turin & Sons, Inc., 219 F.3d at 1109 (distinguishing J.P. Sheahan where taxpayer’s asphalt supplies could not be stored and were thus “not susceptible to being inventoried”). It is obvious that petitioner’s solar towers, as well as their component parts, were readily susceptible to being inventoried.[21]

Some issues are important to note in this case.  First, under revisions to §448(c), §471 and §263A enacted as part of the Tax Cuts and Jobs Act it is possible that this business might now qualify to use the cash basis of accounting and treat inventory as supplies—the Court noted that it did not qualify or pre-TCJA relief under Revenue Procedure 2002-28 since it wasn’t a type of business that qualified for relief, a rule not included in the codified version of this relief enacted by Congress. 

But even in that case, the taxpayer would have to file a Form 3115 to obtain permission to change its accounting method since the taxpayer was already using the accrual method.  The fact that the IRS has to allow the change under the law does not relieve the taxpayer from the requirement to request permission to change under IRC §446(e).

Another significant fact to note is that the Court’s discussion of the checked box for accrual method may be a bit misleading. As is suggested later in this case, that likely would not matter if, in fact, the taxpayer had actually been reporting on the cash basis.  The consistent use of the cash method in all prior returns would, per the regulations, have been the taxpayer’s method regardless of what the taxpayer called it.

But when the evidence was, at best, ambiguous regarding the actual use of the cash receipts and disbursements method by the taxpayer on the taxpayer’s books and returns, the fact that the returns consistently stated the accrual basis was being used served to bar the taxpayer from now claiming that the cash method had been the one actually used.

[1] https://www.ustaxcourt.gov/USTCInOP/OpinionViewer.aspx?ID=12019, August 19, 2019, retrieved August 24, 2019

[2] IRC §446(c)

[3] IRC §446(e)

[4] Reg. §1.446-1(a)

[5] Reg. §1.446-1(e)(2)(ii)

[6] Reg. §1.446-1(b)

[7] IRC §446(b)

[8] Reg. §1.446-1(c)(2)(ii)

[9] Reg. §1.471-1

[10] https://www.ustaxcourt.gov/USTCInOP/OpinionViewer.aspx?ID=12019, August 19, 2019, retrieved August 24, 2019, p. 8

[11] Ibid, p. 9

[12] Ibid, p. 11

[13] Ibid, pp. 12-13

[14] Ibid, pp. 18-19

[15] Ibid, p. 19

[16]

[17] Ibid, pp. 20-21

[18] Ibid, p. 21

[19] Ibid, p. 23

[20] Ibid, p. 24

[21] Ibid, pp. 24-25