Ralston Development Corp. v. U.S.

• Decision Date: 25 June 1991
• Docket Number: Nos. 89-1144,89-1243,s. 89-1144
• Parties: -5178, 91-2 USTC P 50,333 RALSTON DEVELOPMENT CORPORATION, Plaintiff-Appellee, v. UNITED STATES of America, Defendant-Appellant.
• Court: U.S. Court of Appeals — Tenth Circuit

Page 510

937 F.2d 510

68 A.F.T.R.2d 91-5178, 91-2 USTC P 50,333

RALSTON DEVELOPMENT CORPORATION, Plaintiff-Appellee, v. UNITED STATES of America, Defendant-Appellant.

Nos. 89-1144, 89-1243.

United States Court of Appeals Tenth Circuit.

June 25, 1991.

Charles Bricken, Atty. (Shirley D. Peterson, Asst. Atty. Gen., Gary R. Allen and Gilbert S. Rothenberg, Attys. (Michael J. Norton, U.S. Atty., of counsel), with him on the briefs), Tax Div., Dept. of Justice, Washington, D.C., for defendant-appellant.

C. Scott Crabtree of Inman, Erickson & Flynn, Denver, Colo. (Michael T. McDonnell, Englewood, Colo., with him on the briefs), for plaintiff-appellee.

Before LOGAN and MOORE, Circuit Judges, and GREENE, District Judge. ^*

LOGAN, Circuit Judge.

Taxpayer, Ralston Development Corporation (Ralston), ¹ brought suit in the district court seeking a refund of federal income taxes assessed and collected by the Internal Revenue Service (IRS). The district court entered judgment on a jury verdict in favor of Ralston for all taxes paid plus interest. The district court also awarded Ralston attorney's fees, expert witness fees, and costs under Sec. 7430 of the Internal Revenue Code (I.R.C.), 26 U.S.C. Sec. 7430. The government now appeals, arguing that the district court erred: (1) by refusing either to direct a verdict or grant judgment notwithstanding the verdict in favor of the government or to give the government's tendered instruction defining a "clear reflection of income;" and (2) by finding that Ralston was a "prevailing party" entitled to its litigation costs.

During the years pertinent to this appeal, Ralston manufactured, supplied, and maintained an inventory of water treatment control system parts and components. Ralston always has used the accrual method of accounting to prepare its financial statements and the cash method of accounting to prepare its income tax returns. Several IRS audits of Ralston approved its use of the cash method of tax reporting.

In 1982, the IRS audited Ralston for the tax years 1979, 1980, and 1981. As a result, the IRS determined that Ralston should have used the accrual rather than the cash method of accounting for tax purposes because the cash method did not clearly reflect Ralston's income. Based on this determination, the IRS made an upward adjustment to Ralston's 1979-81 taxable income of almost $2,000,000. The IRS also determined that an embezzlement loss for which Ralston had taken deductions on its 1979 and 1980 tax returns was not discovered during 1979 and that, as of the close of Ralston's 1980 taxable year, a reasonable expectation of recovering the loss existed. ² Accordingly, the IRS disallowed the related deductions taken in those years. As a result of these adjustments, the IRS assessed deficiencies of $408,950.23 and $268,439.46 for Ralston's 1980 and 1981 taxable years, reduced the amount of a 1979 loss reported by Ralston, and disallowed in part Ralston's claim that it was entitled to a refund for the 1978 taxable year.

After paying the 1980 and 1981 deficiencies, Ralston filed a refund claim for those years and an amended refund claim for the 1978 tax year. When the IRS failed to act on these claims, Ralston filed suit in the district court. A jury found in favor of Ralston on both the accounting method and embezzlement issues, awarding Ralston a corresponding refund of taxes paid and interest assessed for taxable years 1978-81. ³ Finding that the government's litigation position was not substantially justified, the district court additionally awarded Ralston $48,907.50 in attorney's fees, $12,680.20 in expert witness fees, and $2,003.09 in costs pursuant to I.R.C. Sec. 7430. The government appeals the judgment on the accounting method issue and the award of litigation costs under Sec. 7430; it does not appeal the jury verdict on the embezzlement issue.

I

The government contends that the district court erred in refusing to direct a verdict or grant judgment notwithstanding the verdict in its favor because the IRS Commissioner, as a matter of law, did not abuse his discretion by requiring Ralston to switch from the cash to the accrual method of accounting for tax purposes. When reviewing a district court's denial of a motion for a directed verdict or judgment notwithstanding the verdict, "we may find error only if the evidence points but one way and is susceptible to no reasonable inferences supporting the party for whom the jury found; we must construe the evidence and inferences most favorably to the nonmoving party." Zimmerman v. First Federal Sav. & Loan Ass'n, 848 F.2d 1047, 1051 (10th Cir.1988).

Under I.R.C. Sec. 471, a taxpayer required to employ an inventory accounting system must account for its inventories "on such basis as the Secretary may prescribe as conforming [to industry accounting practices] and as most clearly reflecting the income." The regulations implementing this section explain that inventories must be used whenever "the production, purchase, or sale of merchandise is an income-producing factor." Treas.Reg. Sec. 1.471-1. The regulations further explain that when inventories must be used, "the accrual method of accounting must be used with regard to purchases and sales...." Id. Sec. 1.446-1(c)(2)(i) (emphasis added). The Commissioner, however, may permit the taxpayer "to continue the use of a method of accounting consistently used by the taxpayer, even though not specifically authorized by the regulations ... if, in the opinion of the Commissioner, income is clearly reflected by the use of such method." Id. Sec. 1.446-1(c)(2)(ii) (emphasis added).

Ralston has never disputed that inventories are an income producing factor in its business. Rather, Ralston convinced the jury that the Commissioner abused his discretion in determining that the cash method of accounting did not clearly reflect Ralston's income.

The Commissioner is entitled to substantial deference in determining whether the accounting method used by a taxpayer with inventories clearly reflects income. See Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 532-33, 99 S.Ct. 773, 780-81, 58 L.Ed.2d 785 (1979). Although his discretion "is not unbridled and may not be arbitrary," id. at 533, 99 S.Ct. at 781, the Commissioner's decision should not be set aside unless clearly unlawful or plainly arbitrary. Id. at 532-33, 99 S.Ct. at 780-81. In light of this deference, a taxpayer arguing that the Commissioner has abused his discretion "must demonstrate substantial identity of results between his method and the method selected by the Commissioner." Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d 352, 356 (1st Cir.1970). Accord Asphalt Products Co. v. Commissioner, 796 F.2d 843, 849 (6th Cir.1986), rev'd on other grounds, 482 U.S. 117, 107 S.Ct. 2275, 96 L.Ed.2d 97 (1987); Fred H. McGrath & Son, Inc. v. United States, 549 F.Supp. 491, 493-94 (S.D.N.Y.1982); Surtronics, Inc. v. Commissioner, 50 T.C.M. (CCH) 99, 104 (1985). See also Knight-Ridder Newspapers, Inc. v. United States, 743 F.2d 781, 789 (11th Cir.1984) ("If the taxpayer must use inventories, the Commissioner may also require it to adopt the accrual method."). ⁴

In the instant case, the cash and accrual methods of accounting do not achieve a substantial identity of results. ⁵ The accrual method increases Ralston's gross income by $715,515 (157%) for 1979, $467,284 (36%) for 1980, and $739,581 (48%) for 1981. ⁶ Ralston does not dispute these calculations. It nevertheless argues that when the evidence and all inferences are viewed in its favor, we must affirm the district court's refusal to take the case from the jury.

Ralston first points to the testimony of its president and its C.P.A. that the cash method of accounting clearly reflected its income for the years in question. Although both of these witnesses gave opinions that the cash method clearly reflected Ralston's income, neither contested the government's calculation of the substantial differences achieved under the cash and accrual methods for the years in question. Indeed, Ralston's own financial statements reflect that the cash and accrual methods reach substantially different results for the years in question. ⁷

Ralston next contends that evidence produced at trial raises an inference that "the IRS had been motivated by some improper motive" in requiring the change in accounting methods. Brief for the Appellee at 14. Ralston had used the cash method of accounting to prepare its income tax returns since 1960. Several IRS audits approved this practice. ⁸ The IRS's initial 1979-81 audit once again approved Ralston's use of the cash method and determined that Ralston was due a $144,000 refund. Before the refund was paid, however, the IRS revised its audit and determined that the cash method did not clearly reflect income. As a result, Ralston received no refund and was assessed a substantial tax deficiency for the years in question. Ralston essentially argues that the Commissioner's sudden change of heart was not based on a decision that the cash method did not clearly reflect income, but on a desire to avoid making a $144,000 tax refund.

We do not agree that these facts require affirmance of the district court's refusal to take the case from the jury. Neither a taxpayer's consistent use of the cash method of accounting nor the Commissioner's prior acceptance of that method prevents the Commissioner from requiring a change for years in which the cash method does not clearly reflect income. See Asphalt Products, 796 F.2d at 848-49; Knight-Ridder Newspapers, 743 F.2d at 793 ("Greater experience with the actual effects of the method or a significant change in the nature of the taxpayer's business may convince the Commissioner that the consent given for earlier years is no longer appropriate."). The relevant inquiry is whether the Commissioner abused his discretion in determining that the cash method does not clearly reflect income.

In the instant case, the...