Is the IRS’s Discretion on Clear Reflection of Income Not So Robust After All?

The Tax Court recently issued a memorandum opinion in the case of Continuing Life Communities Thousand Oaks, LLC v. Comm’r, T.C. Memo. 2022-31, questioning the scope of the IRS’s discretion over whether a taxpayer’s accounting method clearly reflects income. Section 446(a) of the Internal Revenue Code, sets out the general rule that a taxpayer is to compute its taxable income using the same method of accounting it uses to compute its income in keeping its books. As with most areas of the tax law, this general rule is subject to exceptions, which are subject to further exceptions. Section 446(b) sets out the fundamental exception to the general rule, providing that if the taxpayer’s method of accounting does not clearly reflect income the IRS can determine the taxpayer’s taxable income under the method which, “in the opinion of the [Commissioner], does clearly reflect income.” It is the scope of this discretion afforded to the Commissioner that was at the heart of the issue in Continuing Life.

The taxpayer in this case was a continuing care facility providing housing and care to senior citizens as their needs continuously change as they age. The taxpayer followed generally accepted accounting principles in maintaining its books and followed the same accounting methods for income tax accounting purposes, particularly with respect to its deferred revenue. In the taxpayer’s view, this approach was permitted because the Treasury regulations provide that “a method of accounting which reflects the consistent application of generally accepted accounting principles in a particular trade or business in accordance with accepted conditions or practices in that trade or business will ordinarily be regarded as clearly reflecting income . . . .” Treas. Reg. § 1.446-1(a)(2). But, once again, this general rule is qualified by the exception that “no method of accounting is acceptable unless, in the opinion of the Commissioner, it clearly reflects income.” Id. And, it is this exception that formed the basis for the Commissioner’s position that he gets to decide whether a particular method of accounting clearly reflects income, and that, in order to clearly reflect income, Continuing Life should recognize all of its deferred revenue in the year of receipt.

Although only a memorandum opinion of the Tax Court, the opinion is insightful for several reasons. Judge Holmes sets a framework for analyzing whether a method of accounting clearly reflects income that will no doubt be helpful to taxpayers and other courts, and one cannot fully appreciate his conclusion without understanding the history discussed in his opinion. Yet, more importantly, Judge Holmes challenged the scope of the Commissioner’s discretion on this issue. The Commissioner’s position has historically been that he has the final say on whether an accounting method clearly reflects income, and, in our experience, IRS Appeals has not often assigned significant, if any, hazards to this IRS position. Judge Holmes concluded his opinion by stating that, although it is undoubtedly true that the Commissioner has discretion to change accounting methods, “the history of how that discretion came to be weakens its power to overcome text, purpose, and analogy.” Accordingly, taxpayers who once thought their most reasonable option was to concede issues of clear reflection of income because of the broad discretion afforded to the Commissioner may now want to reconsider their position in light of Judge Holmes’s opinion.