Consultant Had Accounting Method Change; Reliance on CPA Helps Him Avoid Penalties

(Parker Tax Publishing August 2016)

The Tax Court determined that a consultant's accounting method of waiting to deducting subcontractor expenses until after clients paid their invoices was inconsistent with the cash method of accounting. The court held that the IRS properly adjusted the taxpayer's method, triggering the application of Code Sec. 481, but declined to impose accuracy-related penalties because the taxpayer had reasonably relied on advice from his CPA. Nebeker v. Comm'r, T.C. Memo. 2016-155.

Background

Mark Nebeker formed a successful sole proprietorship, The Project Man, in 1995. It provides project management consulting for aerospace and defense companies through the use of independent contractors.

Nebeker used the cash method of accounting in reporting income The Project Man received. Nebeker would submit itemized invoices with its subcontractors' time and travel expenses to clients approximately every four or five weeks. The clients typically would not pay until at least 60 to 90 days after the invoices were received and, at times, The Project Man would receive portions of the payments from the clients for subcontractor labor and travel expense reimbursements in the following tax year.

The Project Man paid its independent contractors an hourly rate for labor and for expenses incurred for traveling to its client's location. They were paid every two weeks for these expenses, regardless of whether clients had paid the invoices associated with the subcontractors' labor and expenses. Nebeker deducted the subcontractor expenses on his Schedule C as "outside services" for the year in which his client paid the related invoice, regardless of whether The Project Man paid the subcontractor in a prior year. Martin DeKarver, Nebeker's CPA, approved this method of determining the amount of each year's deduction for outside services.

This process of deferring tax deductions for the Project Man's subcontractor labor and subcontractor travel expenses began in 2004 and continued through 2009.

On his tax returns for 2006 and 2009 (the years at issue), Nebeker claimed other expense deductions for outside services of $1,373,309 and $392,210, respectively. After examining these returns, the IRS found that $285,757 and $211,544 were amounts Nebeker paid for outside services for prior years for which he deferred deductions until 2006 and 2009, respectively. The IRS adjusted Nebeker's method of accounting for outside services from the method he was using to the cash method. Thus, the independent contractor expenses were deductible in the year paid. The IRS also determined a 20 percent accuracy-related penalty under Code Sec. 6662(a) for the resulting tax underpayments.

Analysis

The Tax Court determined that the IRS was correct to adjust the method The Project Man used to deduct independent contractor expenses. The court stated that, under Reg. Sec. 1.446-1(c)(1)(iv)(a), use of the cash method in computing gross income from a trade or business necessitates use of the cash method in computing expenses of the trade or business. The court found that Nebeker failed to clearly reflect his sole proprietorship's income because his method of waiting to deduct subcontractor expenses until clients paid the invoices related to the independent contractor's services was inconsistent with the cash method of accounting. However, the court said, the more difficult question was whether the IRS's change required Nebeker to take into account any adjustments to his taxable income pursuant to Code Sec. 481.

The court noted the case's similarity to that of Connors, Inc. v. Comm'r, 71 T.C. 913 (1979), in which a cash basis taxpayer consistently deducted bonuses paid to its president and sole stockholder on the accrual basis. There, the taxpayer accrued a bonus in 1973, claimed the deduction for 1973, and paid the bonus in 1974. In that case, the court held that the IRS'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 Code Sec. 481, the IRS 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., the court concluded that Nebeker's method of deferring deductions for subcontractor expenses was a method of accounting that he consistently used. Because the expenses were a "material item," the court stated, the IRS's adjustment in the notice of deficiency to that material item for tax years 2006 and 2009 constituted a change in Nebeker's accounting method under Reg. Sec. 1.446-1(a), triggering the application of Code Sec. 481. The court held that Code Sec. 481 adjustments were required, but left the application of the adjustments to the parties' agreement.

With regard to the accuracy-related penalties, Nebeker argued that the reasonable cause exception of Code Sec. 6664(c) applied because he reasonably relied on the advice of his return preparer, DeKarver, in determining when to deduct the subcontractor expenses. The court noted that, as a licensed CPA who had been preparing tax returns and providing tax advice for more than 30 years, DeKarver had sufficient training and experience to justify reliance. In addition, the court noted that Nebeker provided DeKarver with all available records and did not withhold information from him. The court found that Nebeker's reliance on his CPA's advice was reasonable because it was based on a plausible theory for a layman such as Nebeker to believe. Accordingly, the court did not sustain the penalties under Code Sec. 6662(a).

For a discussion of accounting method changes, see Parker Tax ¶241,590.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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