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December 18, 2012
Show Me the Money!

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by George White

This article originally appeared in the December 10, 2012 edition of Tax Notes Today.

George White discusses a cash-method-based tax reform proposal by House Ways and Means Committee member Devin Nunes, R-Calif.

George White (Photo by Derek Squires)George White is a Tax Notes contributing editor and retired national tax partner at Ernst & Young LLP. Recently he was with the American Institute of Certified Public Accountants. An attorney and CPA, White is the author of several publications on consolidated returns and tax accounting and is an adjunct professor at the George Washington University School of Business, where he teaches graduate courses in tax accounting and corporate tax.

White analyzes a radical new model of business taxation proposed by Rep. Devin Nunes, R-Calif. Nunes suggests scrapping the accrual method of accounting for a comprehensive cash method.

* * * * *

Rep. Devin Nunes, R-Calif., must have been inspired by Tom Cruise's character in Jerry Maguire.

Nunes, who serves on the House Ways and Means Committee, recently previewed a radical plan to replace the income tax system with a totally new approach that he calls the American Business Competitiveness Act (ABC Act).1 The ABC Act, which Nunes describes as a "non-value-added consumption tax," would enshrine the cash method of accounting as the system for taxing all types of businesses: C corporations, S corporations, partnerships, and so on. Nunes suggests that the ABC Act draws on the fairly recent X-tax theory of economist David F. Bradford.2

But the ABC Act has its origins in the very dawn of the income tax. The first income tax law enacted after passage of the 16th Amendment, the Revenue Act of 1913, mandated the use of the cash method of accounting for businesses.3 It was only later that the IRS (then the Income Tax Bureau) authorized, by regulation, the use of accrual methods by businesses.4 The regulation was an obvious concession to businesses, which even then generally kept books on the accrual method.5 The concession obviated the need for businesses to keep two sets of books, one on cash and the other on accrual.

Central to the ABC Act, according to Nunes, is a new concept of taxable income, determined by subtracting expenses from income, all calculated on the cash method. "Whatever is left over is what you pay tax on," he says. The tax rate would be 25 percent. The end result of the plan, as Nunes describes it, is "anything you invest, whether you're buying a piece of furniture or a building or land or paying people, those are all investments and those are all written off."6

Nunes says he first started thinking about his plan about a year ago. Still in the draft stage (No. 12 at last count), the plan is being scored by the Joint Committee on Taxation for its revenue impact. Nunes hopes to introduce a bill in the lame-duck session.

Because details of the ABC Act are still not public, we're left to speculate about what might be involved and what it might mean for business. Nunes concedes there could be problems in transitioning to the new system because businesses are already depreciating assets on their books. For example, nonresidential real estate, which is subject to depreciation over 39 years, might have substantial adjusted bases yet to be recovered.7

Retailers would experience a significant difference in their tax treatment under the ABC Act. At least as far back as 1957, the regulations have required all taxpayers, even those on the cash method, to use the accrual method for inventory valuation.8 That limitation on the cash method derives from the basic formula for determining the cost of goods sold: beginning inventory plus purchases less ending inventory. The last-in, first-out method of inventory valuation is generally perceived as an effective way to cut taxes for those taxpayers that elect it because, in effect, it allows current costs of inventory to be expensed. Nunes's idea, with its immediate write-offs for inventory purchases, might be dubbed the all-in, all-out method of inventory valuation.9

The prospect of a comprehensive cash-based tax system is deceptively simple. Tax practitioners, if not the general public, are aware that the cash method embraces several categories of income in addition to the cash-in-hand basics (currency, checks, and credit card charges). One category is reflected in the concept of cash equivalence. Thorny questions arise whenever a seller of an asset takes back property from the buyer -- for example, the buyer's obligation to pay in the future instead of making an immediate payment.10 The regulations have long required a buyer's obligation to be reported currently at its ascertainable value. Only in rare and extraordinary circumstances may a buyer's obligation escape current valuation.11 One end of the spectrum is a buyer's simple promise to pay, without more. That type of promise does not require current valuation. At the other end is a buyer's obligation that is incorporated into a financial instrument. If, for instance, the instrument is made by a solvent debtor, is assignable, and is easily negotiated at a discount representing a reasonable rate of interest, case law requires current inclusion in income by a seller.12 Those issues cannot be swept aside under the ABC Act.13

Another category of income is reflected in the economic benefit doctrine. This theory is explained as follows in Pulsifer v. Commissioner,14 a colorful case involving the Irish sweepstakes: "An individual on the cash receipts . . . method of accounting is currently taxable on the economic and financial benefit derived from the absolute right to income in the form of a fund which has been irrevocably set aside for him in trust and is beyond the reach of the payor's debtors." The taxpayers in Pulsifer were minors, resident in Medford, Mass., whose father bought lottery tickets for them in the Irish sweepstakes. In 1969 the kids "hit the sweeps" (as we used to say in Massachusetts). Because they were minors, the Irish Hospital Trust refused to turn over their winnings, citing Irish law. Their winnings were instead placed in trust in the Bank of Ireland for their benefit until they reached the age of 21. The taxpayers understandably argued that they were not taxable on the winnings in 1969 because they had not received them. The Tax Court disagreed, holding for the IRS under the economic benefit theory: The taxpayers were enriched in 1969 when their winnings were set aside exclusively and irrevocably for them.

A final category of income embraced by the cash method is reflected in the constructive receipt doctrine. Here the case law is too messy to summarize. One case is particularly interesting because it represents a situation in which the taxpayer asserted the doctrine to try to put the income in a year earlier (presumably a closed year) than the IRS contended. The taxpayer, the noted Green Bay Packers running back and kicker (and gambler), Paul Hornung, had starred in the 1961 National Football League championship game played December 31, 1961 (pre-Super Bowl era). For his heroics that day, Horning was awarded a Corvette by Sport Magazine. The IRS asserted that the fair market value of the Corvette was includable in Hornung's 1962 income when the car first became available to him. Hornung argued it was income in 1961, when the award was announced immediately after the game. The Tax Court held for the IRS, rejecting Hornung's constructive receipt argument, because the car dealership holding the Corvette was closed that day (New Year's Eve), making it impossible for Hornung to take possession of the car in 1961.15

None of these categories on income would disappear under the ABC Act, because they are inherent in the cash method of accounting.

The deduction side of the cash method is considerably less complicated. Here there are two main issues: (1) expenses paid with borrowed funds, and (2) prepaid expenses. The results are well settled regarding the first issue. Expenses paid by check or credit card are currently deductible. Even expenses paid with borrowed funds are currently deductible unless the funds are borrowed from the lender, for example, an interest expense "paid" to a finance company by adding to the borrower's debt.

For the area of prepaid expenses, however, the ABC Act would make a significant difference. The rules were developed in case law and have now been largely incorporated in regulations.16 Expenses representing less than 12 months of prepayment, such as rent, are currently deductible.17 But when expenses represent longer periods of prepayment (for example, three years of prepaid insurance), the deduction must be prorated.18 Finally, no current deduction is allowed for prepayments that are essentially deposits. That rule was promulgated to stop a tax shelter popular in the '70s whose investors decided to get into the cattle business by purchasing large quantities of cattle feed shortly before year-end.19 If the ABC Act allows the cost of a building or land to be written off currently, all issues regarding prepaid expenses become moot.


At first (and maybe even a second or third) reading, the ABC Act seems too far outside the box to deserve serious consideration. But perhaps there's something to be said for a radical overhaul of the corporate income tax. To defend the current system may beg the question: Do we have a true corporate income system? It gives you pause when you see the apparent ease with which U.S.-based multinational corporations (MNCs) shift profits to low-tax jurisdictions.20 Is it cynical to suggest that calls for a cut in the corporate rate are pointless because businesses will always seek out a lower rate elsewhere? The situation today in the United Kingdom provides a cautionary tale for advocates of a more favorable corporate tax environment in the United States.

The United Kingdom definitely has a corporate income tax system, with a taxpayer-friendly rate of 28 percent and a commitment to drop it to 23 percent.21 But controversy has erupted over whether MNCs are paying any of it. The U.S. and U.K. media have featured multiple stories of late highlighting well-known MNCs that pay little or no U.K. corporate tax -- for example, Starbucks, Amazon, eBay, Facebook, Google, and Ikea.22 The U.K. prime minister, David Cameron, in tones reminiscent of Captain Renault in Casablanca,23 has expressed shock that so many seem to be paying so little.24

The U.K. is threatening to crack down on MNCs, like Google. For example, in reporting to the SEC, Google stated it had $4 billion in British sales last year, yet it reported to the United Kingdom only £31 million in taxable income, on which it paid just £6 million in U.K. taxes.25


1 Devin Nunes, "A Tax Reform to Get Businesses Expanding," The Washington Post, Oct. 11, 2012.

2 David F. Bradford, "The X-Tax in the World Economy," CEPS Working Paper No. 93 (2003).

3 The language of the 1913 statute appeared to authorize accrual accounting, but the Supreme Court held otherwise in Maryland Casualty Co. v. United States, 251 U.S. 342 (1920), relying on the explicit language in the Excise Tax Act of 1909 requiring use of the cash method. See Stephen F. Gertzman, Federal Tax Accounting, section 3.02 (1993).

4 Id.; reg. section 33 (1913). See Michael B. Lang et al., Federal Tax Accounting (2011).

5 Gertzman, supra note 3.

6 Except for the financial industry, no deduction would be allowed for interest expense. This ban, according to Nunes, would eliminate the long-standing bias in our tax system that favors debt over equity financing.

7 This, of course, would not present a novel problem for the administration of the tax accounting rule. A similar problem can arise when a taxpayer seeks to change its accounting method for an item. The transition might be handled on a cutoff basis; i.e., old assets would continue on their established depreciation methods, and newly acquired assets would be written off under the ABC Act. Alternatively, a section 481-type adjustment could be required to switch to the new system. The IRS's current practice in approving method changes is a one-year write-off on negative adjustments. Rev. Proc. 2002-19, 2002-1 C.B. 696, Doc 2002-6514, 2002 TNT 51-9, as amended. It seems highly unlikely that that degree of largesse would be available in the transition to the new system.

8 T.D. 6282 (1957), currently reg. section 1.446-1(c)(2).

9 A notable benefit of an all-in, all-out method is that it would eliminate the need to comply with the UNICAP rules of section 263A for capitalizing indirect costs in inventory valuations, since every expense would be immediately written off.

10 This discussion is limited to single payments. When the obligation is payable in installments, section 453 renders most of the issues moot.

11 Reg. section 1.1001-1(a). Taxpayers regularly complain that the regulation is virtually impossible to satisfy in a free market economy. That's why it was ironic that Treasury invoked the difficulty in valuation when it rebutted the criticism of Notice 2008-83, 2003-2 C.B. 747, Doc 2003-20406, 2003 TNT 178-14 , by Sen. Charles E. Schumer, D-N.Y. (Doc 2008-27057 , 2008 TNT 248-16). Notice 2008-83 is popularly known as the Wells Fargo/Wachovia ruling because it called off the draconian limits in section 382 otherwise applicable to Wachovia's depressed loan portfolio. Treasury's rationale for the notice was that "meaningful loan values cannot be determined." The notice made Wachovia a more attractive acquisition for Wells Fargo. See George White, "Happy Anniversary, Wells Fargo and Wachovia!" Tax Notes, Oct. 25, 2010, p. 463, Doc 2010-21812, or 2010 TNT 208-15 .

12 Cowden v. Commissioner, 289 F.2d 20 (1st Cir. 1961).

13 A further example undoubtedly baffles the general public, if not tax professionals. The regulations require current inclusion in income of "treasure trove" (also known as found property) according to its fair market value. Reg. section 1.61-14(a). Tax purists would maintain that the sure-fingered Yankees fan who snatched Derek Jeter's 3,000th hit last year in the left-field bleachers at Yankee Stadium also picked up income at the same time equal to the FMV of the baseball. See White, "The Jeter Baseball and the Tax Perils of Found Property," Tax Notes, Aug. 8, 2011, p. 631, Doc 2011-16873, or 2011 TNT 152-8.

14 64 T.C. 245 (1975).

15 Contrast that situation with this year's World Series in which Pablo Sandoval of the San Francisco Giants was named the Series' most valuable player, and his prize, a blue Corvette, was driven right onto the field following the final game.

16 Reg. section 1.263(a). These are the so-called INDOPCO regs (after the Supreme Court decision that raised havoc for both taxpayers and the government: INDOPCO Inc. v. Commissioner, 503 U.S. 79 (1992), Doc 92-1849, 92 TNT 44-1). The regulation was adopted as a pragmatic measure to settle seemingly endless disputes between taxpayers and the government over the treatment of intangible expenditures.

17 Reg. section 1.263(a)-4(f), reflecting the decision in Zaninovich v. Commissioner, 616 F.2d 429 (9th Cir. 1980).

18 Reg. section 1.263(a)-4(d)(3), reflecting the decision in Commissioner v. Boylston Market Ass'n, 131 F.2d 966 (1st Cir. 1942).

19 Rev. Rul. 79-229, 1979-2 C.B. 210.

20 Testimony of Martin A. Sullivan, "International Tax Reform Should Precede Domestic Efforts" (Jan. 20, 2011), Doc 2011-1281, 2011 TNT 14-44.

21 Testimony of Stephen Edge (May 24, 2011), Doc 2011-11270, 2011 TNT 101-48.

22 Stephanie Soong Johnston, "U.K. to Investigate Starbucks's Tax Affairs," Doc 2012-21444; Simon Neville and Shiv Malik, "Starbucks Wakes Up and Smells the Stench of Tax Avoidance Controversy," The Guardian (U.K.), Nov. 11, 2012.

23 Captain Renault (played by the great Claude Rains) as he picked up his winnings: "I'm shocked, shocked to find that gambling is going on in here!"

24 David Cameron, "I'm not happy with the current situation." Neville and Malik, supra note 22.

25 Eric Pfanner, "European Countries Seek More Taxes From U.S. Multinational Corporations," The New York Times, Nov. 18, 2012.


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