Rev. Rul. 86-35

Caution: Superseded by 87-60

ACCOUNTING METHODS; HYBRID METHOD

Published: March 10, 1986

Section 446.-General Rule for Methods of Accounting, 26 CFR 1.446-1: General rule for methods of accounting

  Accounting methods; hybrid method. A financial institution using the accrual method of accounting for all items of income and expense, except for interest income from commercial loans and mortgage loans, is not using a permissible method of accounting.

ISSUE

  Is the taxpayer's method of accounting, which is a combination of the accrual and cash receipts and disbursements methods, a permissible method of accounting under section 446(c) of the Internal Revenue Code, under the circumstances described below?

FACTS

  The taxpayer, a financial institution, has for several years consistently reported all items of income and expense on the accrual method of accounting except for interest income from commercial loans and mortgage loans, which is reported on the cash receipts and disbursements method.

LAW AND ANALYSIS

  Section 446(b) of the Code provides that if no method of accounting has been regularly used by a taxpayer, or the method used does not clearly reflect income, the computations of taxable income shall be made under such method as, in the opinion of the Secretary, does clearly reflect income.

  Section 446(c) of the Code enumerates methods of accounting taxpayers may use to compute taxable income. The use of these permissible methods is subject to the provisions of 446(b). That is, the accounting method used by a taxpayer must clearly reflect income. Such permissible methods are the cash receipts and disbursements method, the accrual method, any other method permitted under chapter 1 of the Code, and combinations of these methods permitted under the regulations.

  Section 1.446-1(c)(1)(iv)(a) of the Income Tax Regulations provides that any combination of methods of accounting will be permitted if it clearly reflects income and is consistently used. A taxpayer using the accrual method of accounting with respect to purchases and sales may use the cash receipts and disbursements method in computing all other items of income and expense. However, a taxpayer who uses the cash receipts and disbursements method of accounting in computing gross income from a trade or business must use the cash receipts and disbursements method in computing expenses of such trade or business. Similarly, a taxpayer who uses the accrual method of accounting in computing business expenses must use the accrual method in computing items affecting gross income in such trade or business.

  Rev. Rul. 75-171, 1975-1 C.B. 140, concerns a real estate developer who uses the accrual method of accounting for all items of income and expense except for lot sale contracts, which are reported on the installment method. The revenue ruling addresses the proper method of reporting the interest income attributable to the lot sale contracts. Rev. Rul. 75-171 concludes that the interest income must be reported on the accrual method because, under section

1.4461(c)(1)(iv)(a) of the regulations, if the accrual method is used for deducting business expenses, then, in order to clearly reflect income, the accrual method must also be used for computing items affecting gross income.

  The fact that the taxpayer consistently reported its income using the method described above does not mean that the method clearly reflects income. A failure to clearly reflect income over many years cannot be justified on grounds of tenure. Coors v. Commissioner, 60 T.C. 368, 395 (1973), affd, 519 F.2d 1280 (10th Cir. 1975), cert. denied, 423 U.S. 1087 (1976); Madison Gas and Electric Company v. Commissioner, 72 T.C. 521, 554 (1979), affd on another issue, 633 F.2d 512 (7th Cir. 1980).

  In the present situation, the taxpayer uses the accrual method of accounting in computing business expenses for all its operations, including expenses relating to the mortgage and commercial loan operations. In order to clearly reflect its income, the taxpayer must report interest income from commercial loans and mortgage loans on the accrual method.

HOLDING

  The taxpayer's method of accounting, which is a combination of the accrual and cash receipts and disbursements methods, is not a permissible method of accounting under section 446(c) of the Code.

  Any change by the taxpayer from its present method of reporting interest income is a change in method of accounting subject to the provisions of section

446 and 481 of the Code and the regulations thereunder.

  This ruling is identified as a designated ruling pursuant to section 5.12(2) of Rev. Proc. 84-74, 1984-2 C.B. 736

Rev. Rul. 86-35, 1986-1 C.B. 218, 1986-10 I.R.B. 10.