the cash receipts and disbursements method §5.01...

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5 THE CASH RECEIPTS AND DISBURSEMENTS METHOD §5.01 GENERALLY The cash receipts and disbursements method of accounting ("the cash method") is based on the theory of actual receipts and actual disbursements. Accordingly, under the cash method, income is recognized generally in the year of actual or constructive receipt. Expenses are deductible generally in the year of actual payment. 1 There are many advantages to the cash method of accounting. For one thing, it is simple to use and audit. It provides for the payment of taxes when the taxpayer has the funds with which to make payment. Other advantages include: • The potential for an indefinite deferral of time as to when income must be reported; • Control over the timing of deductions; and • The simplification of the accounting process for determining the amount of income taxable. Issues often raised in connection with the cash method include whether the method is available to the taxpayer; whether it clearly reflects income; whether an item of income has been received; and whether the form of income should be taxed upon receipt. 2 The use of cash method can result in the deferral of income and the acceleration of deductions, such as through the build-up of receivables or pre-paying expenses. Under the cash method, there is no need to maintain inventories. 3 As a result, the IRS views the cash method as not clearly reflecting income whenever its results differ materially from the accrual method. 4 The cash method is predominantly used by service providers who are not engaged in the sale of merchandise. 5 §5.02 INCOME RECOGNITION An item of gross income is recognized in the year in which it is actually or constructively received. 6 1 Reg. §1.446-1(c)(1)(i). 2 At all times in the study of the cash method, or in the study of any accounting system for that matter, one must keep in mind the power of the IRS to change a taxpayer's method. Section 446(b) of the Code allows the IRS to require the taxpayer to change his method of accounting if, in its opinion, the taxpayer's method does not clearly reflect income. Thor Power Tool Co. v. Commissioner, 43 AFTR 2d 79-362, 99 S. Ct. 773 (1979). 3 Except for supply inventories. 4 See Austin v. Commissioner, T.C. Memo 1997-157. 5 Service providers include lawyers, doctors, engineers, plumbers, banks, hospitals, and contractors. 6 Section.446. 47

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5

THE CASH RECEIPTS AND DISBURSEMENTS METHOD

§5.01 GENERALLY

The cash receipts and disbursements method of accounting ("the cash method") is based on the theory of actual receipts and actual disbursements. Accordingly, under the cash method, income is recognized generally in the year of actual or constructive receipt. Expenses are deductible generally in the year of actual payment.1 There are many advantages to the cash method of accounting. For one thing, it is simple to use and audit. It provides for the payment of taxes when the taxpayer has the funds with which to make payment. Other advantages include: • The potential for an indefinite deferral of time as to when income must be reported; • Control over the timing of deductions; and • The simplification of the accounting process for determining the amount of income taxable.

Issues often raised in connection with the cash method include whether the method is available to the taxpayer; whether it clearly reflects income; whether an item of income has been received; and whether the form of income should be taxed upon receipt.2 The use of cash method can result in the deferral of income and the acceleration of deductions, such as through the build-up of receivables or pre-paying expenses. Under the cash method, there is no need to maintain inventories.3 As a result, the IRS views the cash method as not clearly reflecting income whenever its results differ materially from the accrual method.4 The cash method is predominantly used by service providers who are not engaged in the sale of merchandise.5

§5.02 INCOME RECOGNITION

An item of gross income is recognized in the year in which it is actually or constructively received.6

1 Reg. §1.446-1(c)(1)(i). 2 At all times in the study of the cash method, or in the study of any accounting system for that matter, one must keep in mind the power of the IRS to change a taxpayer's method. Section 446(b) of the Code allows the IRS to require the taxpayer to change his method of accounting if, in its opinion, the taxpayer's method does not clearly reflect income. Thor Power Tool Co. v. Commissioner, 43 AFTR 2d 79-362, 99 S. Ct. 773 (1979). 3 Except for supply inventories. 4 See Austin v. Commissioner, T.C. Memo 1997-157. 5 Service providers include lawyers, doctors, engineers, plumbers, banks, hospitals, and contractors. 6 Section.446.

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Actual receipt occurs upon the occurrence of one of the following events: • A transfer of money, property, or services to the taxpayer; • A transfer to a third party at the taxpayer’s direction or for the taxpayer’s benefit;7 • An obligation of the taxpayer is cancelled or offset;8 or • Receipt by the taxpayer’s agent of money or property on the taxpayer’s behalf.9 On the other hand, income is not recognized where the taxpayer loans another party money that, in turn, is utilized to pay the taxpayer.10 Income recognition under the cash method involves the application of a couple of important tax accounting doctrines. The first of these doctrines is the cash equivalency doctrine;11 the second, the constructive receipt doctrine.12

§5.03 CASH EQUIVALENCY DOCTRINE

§5.03(a) Generally The cash equivalency doctrine basically provides that a taxpayer is in receipt of income for tax purposes when he is in receipt of a cash equivalent. Not all items of income under the cash method are recognized as a cash equivalent on receipt. Uncertainty and confusion in the case law and rulings stem from a lack of clarity and uniformity in their application. The concept of “cash equivalency” was considered in the case of Cowden v. Commissioner.13 In Cowden, the taxpayer received a bonus payment under an oil, gas, and mineral lease in the amount of $511,192.50. The bonus was paid partly in cash in 1951, and the remainder (over $500,000.00 of the bonus) was not due to be paid until January of 1952, and then again, in January of 1953. Upon the receipt of the "initial bonus payment" in 1951, the taxpayer had “in hand” a small amount of cash and a contractual obligation requiring the payor to make future payments of cash over a two-year period. The taxpayer sought to delay reporting the entire bonus as income until the contractual obligation was paid. The IRS assessed a deficiency against the taxpayer claiming that he had received income in the initial year of the contract. On appeal to the Fifth Circuit, the Court made it clear that the substance and not the form of the transaction should control. The Court considered the following factors in determining the cash equivalency status of the bonus: • Whether the instrument itself was a negotiable promissory note; • Whether the debtor was solvent; • Whether the agreement was unconditional and transferable; 7 See, e.g., Henritze v. Commissioner., 41 B.T.A. 505 (1940). 8 See, e.g., Shuster v. Helvering, 121 F.2d 643 (2d Cir. 1941). 9 See, e.g., Diescher v. Commissioner., 36 B.T.A. 732 (1937). 10 See, e.g., Helvering v. Martin-Stubblefield, 71 F.2d 944 (8th Cir. 1934). 11 See §5.03, below. 12 See §5.04, below. 13 289 F.2d. 20 (5th Cir. 1961).

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• Whether there was a market for the obligation; • Whether the obligation could be sold; and • Whether the obligation could be sold at a small or reasonable discount. The Court’s primary focus was whether the bonus obligation received by the taxpayer was readily convertible into cash. In its analysis, the Court stated that negotiability is not the test of taxability. The fact that an obligation is not a promissory note, in negotiable form, does not prevent it necessarily from being a cash equivalent. Moreover, the Court concluded that the mere fact that the bonus had a fair market value14 did not necessarily mean that it was the equivalent of cash.15

In J.A. Williams,16 a taxpayer received an unsecured, non-interest bearing promissory note in 1951 for services rendered. The taxpayer understood that the maker of the note was unable to pay anything on the note, until such time as the maker acquired and sold at least part of some timber property. The taxpayer attempted on ten to fifteen occasions to sell the note without success. Finally, in 1954, he collected some money from the maker and discharged the note. He did not receive full payment. The Tax Court held that the note had no fair market value in 1951 and could not be considered to be the equivalent of cash in the year of receipt.17 A hypothetical application of the cash equivalency doctrine is illustrated in the following example.

Woodrow Call is a cash basis individual taxpayer who is a shareholder in a C corporation that manufactures bicycles. In 2007, Mr. Call received a dividend distribution from the corporation in the form of a promissory note which was payable either (1) upon receipt in exchange for a bicycle at any of its stores up to the retail value of $175 or (2) on June 1, 2008 for $200 in cash. If the note were transferable, and if there was a market for the note for a reasonable discount, Woodrow Call will recognize income in 2007 in the amount of $175 under the cash equivalency doctrine, even if he waits until 2008 to receive $200 in cash If Mr. Call waits until June 1, 2008 to receive cash, he will recognize an additional $25 in income in 2008.

The cash equivalency doctrine has not been accepted by the IRS. The difficulty with the doctrine is that even though an obligation has a fair market value, it still may not rise to the level of being a cash equivalent. If so, it need not be reported as income until it is paid or becomes a cash

14 See §5.03(c), below, for a discussion of fair market value. 15 Stating it another way, if the obligation had a face amount of $100 but could only be sold for $20, the obligation would likely not be a cash equivalent. 16 28 T.C. 1000 (1958) 17See also Barnsley v. Commissioner, 31 T.C. 1260 (1959); Andrews v. Commissioner, 135 F.2d 314 (2nd Cir. 1943) and Ennis v. Commissioner, 17 T.C. 465 (1951). See also, Weeden’s Estate v. Commissioner, 685 F.2d 1160 (9th Cir. 1982) where the court said: “If a promise to pay in the future is contingent on unknown facts or circumstances, or if the right to receive payment is speculative, then the obligation may have no ascertainable fair market value. In this situation, a cash basis taxpayer realizes no income as a result of the contract until payment is made.”

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equivalent. This doctrine naturally is one, which injects uncertainty into a tax accounting system. The cash equivalency doctrine has been rejected in several circuits.18 §5.03(b) Receipt of Property §5.03(b)(1) Generally While cash can be recognized easily as an item of income, the receipt of property is not as clear. Items that are generally regarded as a cash equivalent include: • Automobile usage, • Bargain purchases, • Barter transactions, • Insurance, • Interest-free loans, • Lodging, • Meals, and • Vacation. These items are tangible and provide a recognizable benefit upon receipt. Though they are not cash, they are the equivalent of cash because they have an ascertainable value, and are therefore, income to the recipient. §5.03(b)(2) Intangible Property Problems arise when a taxpayer receives a debtor's promise or obligation that is neither cash nor readily convertible into cash. The receipt of intangible property often raises the question whether the taxpayer is in receipt of a cash equivalent.19 Intangible property includes • Choses in action, i.e., a legally enforceable claims or rights, • Contract rights, and • Promissory notes. §5.03(c) Fair Market Value In Warren Jones Co. v. Commissioner,20 a cash basis taxpayer sold an apartment building and received, in return, cash plus the buyer's promise to pay the balance of the purchase price. The promise was not in the form of a note but was part of a standard real estate contract. There was a market for such contracts at a price that reflected a substantial discount from the price at which contracts of this nature were normally sold.

18 See, Heller Trust v. Commissioner, 382 F.2d 675 (9th Cir, 1967), where deferred payment contracts with a fair market value of 50% of face value were taxable although not negotiable. See also Barnsley v. Commissioner, 31 T.C. 1260 (1959); Andrews v. Commissioner, 135 F.2d 314 (2nd Cir. 1943). In TAM 8952061, the IRS ruled that receipt of a mortgage as payment was income on receipt. In Bright v. U.S., 91-1 USTC ¶50,142, 926 F.2d 383, (5th Cir. 1991), the taxpayer received a large check prior to year end and argued that it was not a cash equivalent because it was not readily marketable and convertible into cash. The Court noted that cash was available to the taxpayer the same day. The Court added that the large amount of the check did not affect its marketability. 19 Under Section 61 of the Code gross income is from “whatever source derived”; the regulations add that income may be “realized” in any form, whether in money, property or services. See Reg. §§ 1.61-1(a), 1.446-1(c)(1)(i). 20 524 F.2d 788 (9th Cir. 1975), rev’g. 60 T.C. 663 (1973).

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The Tax Court held that the contract was not income because it was not the equivalent of cash. In overruling the Tax Court, the Court of Appeals applied Section 1001(b) of the Code, holding that, except in "no market" cases, such as in Burnet v. Logan,21 the fair market value of the property received in the exchange must be included in the amount realized.22 The salient point made was that where income is derived from the sale or disposition of property the amount received must be reported as income in the year of receipt regardless of the value of the note. The Warren Jones decision was a victory for the Internal Revenue Service. By requiring the taxpayer to report the value of an intangible when a transaction occurs, the IRS had successfully blocked the taxpayer's attempt to defer the recognition of income based on the cash equivalency doctrine.23 A factor which differentiates Warren Jones from Cowden is that Warren Jones involved the sale of property while Cowden was not a sale or exchange case.24 Under Warren Jones, if an obligation has an ascertainable fair market value, the year of actual or constructive receipt determines income recognition. Consider the following hypothetical, for example.

Alan sells a parcel of undeveloped real property to Bill for $100,000. Alan receives a promissory note with a face amount of $100,000 bearing adequate interest. However, due to Bill’s near insolvency the note cannot be sold and has a value at the time of receipt of only $60,000. When must Alan recognize income? Following the Warren Jones decision, the fair market value of the property received in the exchange must be reported as the amount realized in the year of receipt.

Reg. §1.61-2(d)(4) also addresses the recognition of the fair market value of a debt as

income. The regulation provides that

Notes or other evidences of indebtedness received in payment for services constitute income in the amount of their fair market value at the time of the transfer. A taxpayer receiving as compensation a note regarded as good for its face value at maturity, but not bearing interest, shall treat as income as of the time of receipt its fair discounted value computed at the prevailing rate. As payments are received on such a note, there shall be included in income that portion of each payment, which represents the proportionate part of the discount originally taken

21 283 U.S. 404 (1931). 13 Subsequent cases have delineated a separation of the two doctrines. In Watson v. Commissioner, 613 F.2d 594 (5th Cir. 1980), the Court of Appeals for the 5th Circuit applied the Cowden standard. In Campbell v. U.S., 661 F.2d 209 (Ct. Cl. 1981), the Court cited Warren Jones for the proposition that where the fair market value of an obligation can be ascertained, that amount must be included in the amount realized under Section 1001(b) of the Code. For the distinction between notes taken as payment for services and notes taken as evidence of the underlying claim, see Dial v. Commissioner, 24 T.C. 117, 122-123 (1955) ( cash method taxpayers not taxed on the value of mortgage bonds evidencing claim for unpaid salaries), relying on Reg. §1.61-(2)(a); and Rev. Rul. 76-135, 1976-1 C.B. 114 (cash method lawyer received and discounted client’s note in 1973, when accepted as payment for services). 23 With respect to sales of real property and casual sales of personal property, the IRS has taken the position that the doctrine of cash equivalence is neither applicable nor relevant. It would seem that Section 1001(b) of the Code provides substantial support. 24 Indeed, in Footnote 9 of the Warren Jones opinion, the Court said its decision did not conflict with the Cowden decision.

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