Cash Basis Taxpayer Never Received Permission to Change Method to Defer Deduction for Paying Independent Contractors

In the case of Nebeker v. Commissioner, TC Memo 2016-155 a taxpayer had changed its method of reporting payments for independent contractors in 2004.  That sets up a case where the IRS would prevail—but perhaps in the end it might end up with a result that reduced the taxpayer’s tax for the year in question.

The taxpayer had operated a business since 1995.  In his business he would bill clients (often governments) for his work and various expenses incurred, including the expenses related to payments to independent contractors.

Although the taxpayer operated on the cash basis of accounting, with the approval of a CPA who prepared his tax returns, the taxpayer began to delay the deduction for payments made to those contractors until he received the related payment from the customer.  The customers would generally not pay the amounts until at least 60 days after the invoice was received by the customer.  However, there were many cases where payments were not made until 90 days after invoicing and in some cases the delay was up to six months.

The taxpayer had to account for the expenses in detail, which meant he was tracking these expenses very carefully.  He preferred to match up the expenses with the payments even though he operated on the cash basis.

The IRS, however, objected that this treatment was not allowed on the cash basis of accounting.  But the IRS did not argue that this was a method of accounting, a position that presumably would have caused the taxpayer to “lose” the amounts he deducted in the year under exam permanently, presuming the prior tax year was closed for adjustment—and, in any event, eventually even with amendments the taxpayer would hit a year closed to claims for refunds.

The taxpayer, while arguing the method was permissible, also argued that since the IRS did not treat this as an accounting method adjustment they were prohibited from making any adjustment for this item.

The Tax Court decided neither party had the completely correct answer.  The Court agreed that this way of accounting for the payments for contractors was impermissible—if income is reported on cash basis, then deductions must be claimed on the same basis.  The Court notes: 

…under section 1.466-1(c)(1)(iv)(a), Income Tax Regs., a taxpayer who uses the cash method in computing gross income from a trade or business shall use the cash method in computing expenses of such trade or business.

While the petitioner argued that any method that reasonably reflects income is allowable, the Court pointed out that the taxpayer had never taken the required step of asking for permission to change his method of accounting.

Petitioner never filed an application to change the method of accounting, nor did he follow the procedure for automatic consent laid out in Rev. Proc. 97-27, 1997-1 C.B. 680. Under section 446(e) respondent can require the Project Man to abandon the new method of accounting and to report taxable income using the old method of accounting. See, e.g., Commissioner v. O. Liquidating Corp., 292 F.2d 225, 231 (3d Cir. 1961), rev'g T.C. Memo. 1960-29. … The Project Man is therefore precluded from changing its method of accounting under section 446(e) and the regulations thereunder, regardless of whether the method proposed is proper.

But, as the Court notes, this is a change of accounting method regardless of what the IRS may have called it on exam.  As the Court notes, while the taxpayer must change how he was deducting the payments to contractors “[t]he more difficult question is whether respondent's change requires the application of section 481.”

The Court looked to a 1979 case to resolve the matter:

In Connors, Inc. v. Commissioner, 71 T.C. 913 (1979), a cash basis taxpayer consistently deducted bonuses paid to its president and sole stockholder on the accrual basis. The taxpayer accrued a bonus in 1973, claimed the deduction for 1973, and paid the bonus in 914-915. In Connors, Inc., this Court held that the Commissioner's requirement that the taxpayer report this material item in the year paid was a change in the taxpayer's method of accounting and under section 481 the Commissioner was authorized to include in the taxpayer's income for 1974 the amount of the bonus the taxpayer erroneously deducted for 1973.

Following Connors, Inc., we conclude that petitioner's method of deferring his deduction is a method of accounting that he consistently used. Thus, respondent's adjustment in the notice of deficiency to that material item for tax years 2006 and 2009 constitutes a change in his accounting method, which triggers the application of section 481.

And what happens when §481 is triggered?  The cumulative overstatement/understatement of income must be taken into account.  In this case that would mean the taxpayer would not “lose” the amounts deducted in the year under exam but paid in the prior year.  Rather, that difference in cumulative deductions would become a §481(a) adjustment.

The Court notes:

Section 1.481-1(a)(1), Income Tax Regs., provides that

[i]n computing taxable income for the taxable year of the change, there shall be taken into account those adjustments which are determined to be necessary solely by reason of such change in order to prevent amounts from being duplicated or omitted. The 'year of the change' is the taxable year for which the taxable income of the taxpayer is computed under a method of accounting different from that used for the preceding taxable year.

Therefore, the change in the method of accounting took place in 2006. We hold that section 481 adjustments are required, and we leave the application of section 481 in these cases to the parties’ agreement or a Rule 155 computation.

To the author it seems likely this is a case where the IRS’s victory is a bit hollow for the agency.  Since the taxpayer’s method had delayed deductions, the new method will allow the taxpayer to deduct payments made in 2006 he would not otherwise have deducted.  While he would not initially deduct the amounts paid in 2005 for invoices that were eventually paid by customers in 2006 on the 2006 return, the §481(a) adjustment will serve to bring those deductions back onto the return.

We do not know why the CPA advised the taxpayer that this change of treatment was permissible.  It is possible the CPA believed that since under some contracts it appeared the taxpayer was being reimbursed that such a delay was required, or that the CPA knew that methods were acceptable that did not misstate income and figured the IRS would not object to delayed deductions even if that wasn’t a true cash basis treatment.

But regardless of the reason, advisers must remember that a taxpayer must always obtain permission to change his/her method of accounting, even if that method is not permitted under the IRC.