Nemetschek North America, Inc. v. Commissioner
| Decision Date | 29 October 2001 |
| Docket Number | Docket No. 7829-99. |
| Citation | 82 T.C.M. 827 |
| Parties | Nemetschek North America, Inc. v. Commissioner. |
| Court | U.S. Tax Court |
Joseph Schmelzle (an officer), for the petitioner. William J. Gregg, for the respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
Petitioner's predecessor, Diehl Graphsoft, Inc. (Diehl), petitioned the Court to redetermine respondent's determination of a $142,986 deficiency in its Federal income tax for its taxable year ended May 31, 1995 (1995 taxable year).1 We must decide whether respondent abused his discretion under section 446 when he determined that Diehl must change its overall method of accounting from a hybrid method to an accrual method. We hold he did not. Unless otherwise indicated, section references are to the Internal Revenue Code in effect for the subject year.
Some facts were stipulated and are so found. The stipulated facts and the exhibits submitted therewith are incorporated herein by this reference. Diehl is a publicly traded corporation whose principal place of business was in Columbia, Maryland, when its petition was filed.
Diehl designs, develops, manufactures, and sells unmodified software that allows sophisticated design and engineering projects to be performed on computer hardware. Diehl also develops and sells to its software users, usually as part of the software sale, three manuals which are an integral part of the software. The manuals, which are printed and bound by outside vendors, consist of a: (1) Programming language manual, (2) technical reference manual, and (3) tutorial manual. Diehl also sells to its customers software produced by third parties. (We hereinafter refer collectively to all of the products sold by Diehl as products.) In addition to its products, Diehl provides to its customers free of charge access to its customer support services.
Diehl sells some of its products within the United States through its employees, dealers, and distributors. It sells the remainder of its products outside the United States through foreign distributors and resellers. Most of Diehl's sales (approximately 85 percent of them by revenue) are of a single product (MiniCad5) that is sold to users of MacIntosh computers.
Diehl's gross receipts for the subject year were $4,848,333. All of these receipts were attributable to Diehl's sale of its products. Diehl's sales were made as follows: (1) Ten percent as direct sales between Diehl and end users, (2) 4 percent as sales through dealers, and (3) 86 percent as sales through distributors (both foreign and domestic). Diehl's sales were made either: (1) By delivering its products electronically through an electronic code and serial number or (2) by delivering its products in boxes containing the software (usually on a disk), manuals, and any other item that Diehl considered necessary for the particular market. In the latter case, the boxes and the manuals were significant parts of the sales.
Upon its inception in 1985 and throughout the subject year, Diehl used a hybrid method of accounting for book and tax purposes. Specifically, Diehl used the: (1) Cash receipts and disbursements method (cash method) to report its receipts and certain expenditures and (2) lower of cost or market method to value its yearend inventory. At the beginning and end of its 1995 taxable year, Diehl had an inventory valued for Federal income tax purposes at $112,945 and $132,820, respectively. Diehl's inventory consisted of: (1) Blank disks, (2) software, manuals, binders, and videos, and (3) shipping materials and other supplies. The values of those items on May 31, 1994 and 1995, were as follows:
May 31, 1994 May 31, 1995
Blank disks ............................................... $ 11,530 $ 16,156
Software, manuals, binders, and videos .................... 85,904 106,353
Shipping materials and other supplies ..................... 15,513 10,311
Total ................................................... 1112,947 132,820
1 The $2 difference between this amount and the $122,945 listed immediately above and below is attributable to
rounding
Diehl reported taxable income of $1,603,678 for its 1995 taxable year. It computed and reported its cost of goods sold as follows:
Inventory at beginning of year ......... $ 112,945
Purchases .............................. 510,898
Cost of labor .......................... 32,260
Commissions ............................ 4,961
Inventory scrap ........................ 17,680
_______
Total .................................. 678,744
Inventory at end of year ............... 132,820
________
Cost of goods sold ..................... 545,924
Respondent determined that Diehl was required to use an overall accrual method to reflect its income clearly. Respondent made two positive (increase to income) adjustments to Diehl's reported taxable income to reflect this determination. First, respondent made a $206,108 adjustment under section 481(a) to reflect the effect of the change from the cash method to an accrual method as of June 1, 1994:
Application of Application of
cash method accrual method Difference
Accounts receivable ....................... -0- $260,527 $260,527
Interest receivable ....................... -0- 38,769 38,769
Prepaid expenses .......................... $11,647 173,460 161,813
Prepaid advertising ....................... -0- (159,700) (159,700)
Accounts payable .......................... (8,208) (103,509) (95,301)
________ ________ ________
Total ................................. 3,439 209,547 206,108
Second, respondent made a $214,309 adjustment to reflect the current year's application of an accrual method to the following items:
Balance on Balance on
June 1, 1994 May 31, 1995 Difference
Accounts receivable ........................ $ 260,527 $522,775 $262,248
Interest receivable ........................ 38,769 7,817 (30,952)
Prepaid expenses ........................... 173,460 64,495 (108,965)
Prepaid advertising ........................ (159,700) (54,240) 105,460
Accounts payable ........................... (103,509) (116,991) (13,482)
_________ __________ _________
Total ................................... 209,547 423,856 214,309
OPINION
Petitioner argues that respondent abused his discretion when he determined that Diehl must change from its hybrid method to an accrual method. Petitioner generally makes four assertions in support of its argument. First, petitioner asserts that the cash method is listed in section 446(c) as a permissible method of accounting and that a taxpayer who consistently uses the cash method may continue to use that method until it fails the $5 million gross receipts exception of section 448. Petitioner claims that Diehl has consistently used the cash method since its inception and that Diehl met the $5 million gross receipts exception for the relevant year. Second, petitioner asserts that a taxpayer meeting the $5 million gross receipts exception may use the cash method whenever its sale of merchandise is not an income-producing factor. Petitioner claims that Diehl primarily earned its income by selling intellectual property, which, petitioner claims, is not merchandise. Petitioner claims that Diehl's sales of the manuals and other inventory items were not an income-producing factor in its business because, petitioner claims, the sales merely helped Diehl sell and market its intellectual property. Third, petitioner asserts that Diehl could use the cash method because its sales of the manuals and other inventory items were insignificant as a function of its gross receipts and that the amount of these items fluctuated little from one yearend to the next. Petitioner claims that it is a per se abuse of discretion when respondent's change in method of accounting generates adjustments to accounts receivable and not to the amount of inventory at the beginning or end of the year. Fourth, petitioner asserts that respondent's determination is an abuse of discretion because Diehl changed to an overall accrual method 2 years after the subject year.
We disagree with petitioner that respondent's determination is an abuse of discretion. Section 446(a) contains the general rule for tax accounting. Section 446(a) provides that the accounting method used to compute taxable income generally must be based on the method of accounting used to compute book income. When the accounting method used to compute taxable income does not clearly reflect income, section 446(b) gives the Commissioner broad authority to prescribe a method that does clearly reflect income. Thor Power Tool Co. v. Commissioner [79-1 USTC ¶ 9139], 439 U.S. 522, 532 (1979); Commissioner v. Hansen [59-2 USTC ¶ 9533], 360 U.S. 446, 467 (1959); see also sec. 1.446-1(a)(2), Income Tax Regs. (). The Commissioner's exercise of authority under section 446(b) is given "much latitude" and cannot be disturbed unless "clearly unlawful". Thor Power Tool Co. v. Commissioner, supra at 532-533; Lucas v. Am. Code Co. [2 USTC ¶ 483], 280 U.S. 445, 449 (1930); see also United States v. Catto [66-1 USTC ¶ 9376], ...
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