Cash Basis Taxpayer's Accidental Switch to Reporting Revenue When Billed Rather than Collected Did Not Create Bad Debt Deduction

The taxpayer discussed in Chief Counsel Memorandum 201515018 got a bit confused about this whole accrual vs. cash basis issue when reporting for tax purposes.  The partnership kept its books on the accrual basis but reported on the cash basis for tax purposes.

At some point the partnership accidentally began reporting income from accounts receivable when the accounts were billed and not when cash was collected.  Eventually a partner, after purchasing the outstanding interests of all other partners, discovered the error and filed a claim for refund to correct his outside basis in the partnership due to the excess income he had reported in prior years. 

Unfortunately the problem began more than three years in the past—so the question arose on whether this represented a bad debt under IRC §166 for which §6511(d)(1) allows a seven-year, rather than three-year, limitation on filing a claim for refund.

The National Office decided, not surprisingly, that the answer was no. 

One problem (though, in the view of this author, not the only one) is that in order to have a bad debt deduction under §166 the taxpayer must first have a debt for tax purposes. 

As the memo notes:

Unlike an accrual-basis taxpayer who maintains an accounts-receivable account for income it has accrued under the all-events test but has not yet received, a cash-basis taxpayer does not maintain accounts receivable because cash-basis taxpayers recognize gross income when the income is actually or constructively received. See Treas. Reg. §1.446-1(c)(1)(i).  Thus, a cash-basis taxpayer should not be reporting uncollected income or maintaining an accounts-receivable account on its tax books for which a bad-debt deduction under §166 would subsequently be allowable.

Astute readers almost certainly have been thinking—well, yes, but since this would affect timing it is a method of accounting.  And, as we know (or certainly learned if we did not following the tangible property regulations panic in early 2015), accounting method corrections “reach back” into the past.  Thus the taxpayer, you might argue, should be able to simply ask for a change in accounting method and would, with the §481(a) adjustment, be able to recover the income erroneously reported in the past as a deduction in the year of change.

If, in fact, the partnership had reported receivables as income when billed from the start that would be true.  But in this case the partnership originally reported properly on the cash basis and only accidentally ended up swapping over to reporting receivables (but nothing else) on the accrual basis.

So, in this case the problem is simple—the partnership never had permission from the IRS to switch its method of reporting receivables in this manner.  And, as the memo notes:

The taxpayer must consistently apply the method of accounting for income and deductions that the taxpayer is following and cannot benefit from mistakenly employing another method of accounting for a particular tax item.  W.L. Moody Cotton Co., 143 F.2d at 713–15.

Thus, as the memo notes, not only can the taxpayer not claim a bad debt loss—the taxpayer’s basis in his interest actually doesn’t include the “extra” income he had previously recognized.

Although not discussed in the memo, the result would have been different had the partnership reported using this method from day one.  In that case the taxpayer would have been employing a method of accounting.  Although the IRS could argue that was a hybrid method of accounting (and thus not improper), if the entity qualified under the tax basis revenue procedures  (Rev. Proc 2000-22 as modified by Rev. Procs. 2001-10 and 2002-10, and Rev. Proc. 2002-28) it could have automatically changed to the cash basis.

But, in this case, the entity was already (based on reporting in the years before the error) on the cash basis—thus there was nothing to change, and the use of another method without IRS permission was simply an error.