Duty of Consistency Required Taxpayers to Adhere to Improper Accounting
The Tax Court determined that a calendar year S corporation could not exclude from income for the year at issue checks that were received in the prior year but not deposited or reported until the following year. Although the court, the IRS, and the S corporation’s shareholders all acknowledged that this accounting was incorrect, because the IRS had relied on the original reporting and the prior year was closed, the doctrine of consistency required the shareholders to stick with their initial reporting. Squeri v. Comm’r, T.C. Memo. 2016-116.
Robert Squeri and Gregory Dellanini organized Preferred Building Services, Inc. (PBS), a full-service janitorial business, as a California subchapter S corporation in 1992. PBS was a cash basis taxpayer and determined the gross receipts reported on its Forms 1120S using deposits made into its bank accounts during the calendar year. The reported gross receipts for the years at issue did not include the checks that were actually received in the last quarter of that year. Rather, each year’s gross receipts included checks received in the fourth quarter of the prior year, but deposited the following January.
The IRS issued Squeri and Dellanini notices of deficiency relating to the reporting of their proportionate shares of income from PBS for 2009 and 2010. In the notices, the IRS determined that PBS had improperly computed its gross receipts by excluding the checks that were received during the last quarter of the prior year. In calculating the adjustment to PBS’s gross receipts for 2010, the IRS: (1) included the checks that were received in 2010 but deposited by PBS in January of 2011, and (2) excluded the checks that were deposited in January of 2010, but received in 2009. For 2009, however, the IRS included the checks received in 2009 but deposited in 2010, but did not exclude the checks that had been received in 2008, but deposited in January 2009, because 2008 was a closed tax year.
Code Sec. 441(a) requires that taxable income be computed on the basis of the taxpayer’s tax year. For purposes of calculating taxable income, Code Sec. 451(a) provides that all items of income received in a tax year must be reported as income for that tax year unless the method of accounting requires that the item be accounted for in a different tax period.
The Tax Court noted that the taxpayers and the IRS did not dispute that PBS incorrectly computed its gross receipts by using bank account deposits. Instead, the taxpayers argued that gross receipts of $1,634,720 should be excluded from their 2009 income because they were actually received in 2008 and that the IRS did not have authority to make adjustments for the 2008 tax year as it was outside the period of limitations for adjustments. The IRS argued that under the duty of consistency, the taxpayers should be required to include on their 2009 returns amounts of 2008 income, as they originally reported.
The Tax Court agreed with the IRS. Citing Est. of Letts v. Comm’r, 109 T.C. 290 (1997), the court stated that the duty of consistency is an equitable doctrine which prevents a taxpayer from benefiting in a later year from an error or omission in an earlier year which cannot be corrected because the limitations period for the earlier year has expired. In invoking the duty of consistency, the court said, three conditions must be met:
(1) a representation or report by the taxpayer;
(2) reliance by the IRS; and
(3) an attempt by the taxpayer after the statute of limitations has run to change the previous representation or to re-characterize the situation in such a way as to harm the IRS.
In the instant case, the court said, the taxpayers made a clear representation on the 2009 Form 1120S for PBS when they represented that PBS had received the $1,634,720 of gross receipts
in 2009. Thus, the court determined, the first element of the duty of consistency had been met.
With regard to the second element (reliance by the IRS on the taxpayer’s representation), the taxpayers argued that the IRS did not reasonably rely on their representation because the IRS knew
that the notices of deficiency did not accurately reflect their income from 2009. The court disagreed, noting that the IRS had already relied on the taxpayers’ representations by accepting the 2008 tax returns and allowing the statutory period of limitations to expire. The court thus determined the second element had also been met.
The third element of the duty of consistency, the court observed, requires an attempt by the taxpayer after the statutory period of limitations has expired to change the previous representation or to re-characterize the situation in such a way as to harm the IRS. The court noted that the taxpayers admitted that reporting the 2008 payments for 2008 rather than for 2009 would be inconsistent with their previous reporting. The period of limitations had expired on the 2008 tax year, the court said, and allowing the taxpayers to re-characterize their income as
belonging in 2008 would harm the IRS because it would allow the taxpayers to avoid tax on $1,634,720. The court thus found that the third element had been met.
Because the IRS had established that all of the elements for the duty of consistency had been met, the court concluded that the $1,634,720 in gross receipts that PBS received in 2008 but reported for 2009 were required to be recognized as income for tax year 2009.