                        T.C. Memo. 1996-433



                      UNITED STATES TAX COURT



OAKCROSS VINEYARDS, LTD., DENNIS D. GROTH, TAX MATTERS PARTNER,
   Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No.   11659-94.               Filed September 24, 1996.



     Richard J. Sideman, for petitioner.

     Kathryn K. Vetter, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     WELLS, Judge:   The instant case is a proceeding pursuant to

sections 6226-6231 for a readjustment of partnership items of

Oakcross Vineyards Ltd. (Vineyards), a partnership, for the

taxable year ending December 31, 1990.    In a Notice of Final

Partnership Administrative Adjustment, respondent increased

Vineyards’ income for that year by $1,625,423 and increased the
                               - 2 -

partnership’s self-employment income by the same amount.    Unless

otherwise noted, all section references are to the Internal

Revenue Code (Code) in effect for the year in issue, and all Rule

references are to the Tax Court Rules of Practice and Procedure.

     The issue to be decided is whether respondent's

determination that Vineyards must report its income from the sale

of grapes and other property on the accrual method, rather than

the cash receipts and disbursements method, in order to clearly

reflect its income was an abuse of respondent’s discretion.

                         FINDINGS OF FACT

     Some of the facts have been stipulated for trial pursuant to

Rule 91.   The parties’ stipulations of fact are incorporated

herein by reference and are found as facts in the instant case.

     At the time the petition in the instant case was filed,

Vineyards maintained its principal place of business in Oakville,

California.

General Background

     Vineyards

     Vineyards was organized on May 26, 1981, as a California

limited partnership to acquire and operate a vineyard in

California's Napa Valley.   Mr. Groth and his wife Judith

(sometimes referred to herein together as the Groths) are the

general partners of Vineyards and own an 85-percent interest in

the partnership.   Trusts for the benefit of each of the Groths'
                                - 3 -

three children are limited partners of Vineyards and own the

remainder of Vineyards, each trust holding a 5-percent interest.

     Vineyards is engaged in the business of growing wine grapes

and is a farmer for purposes of the Code.     Vineyards jointly

operates two vineyards:    the Oakcross Vineyard, a 121-acre parcel

acquired during 1981 for $2,180,000, and the Hillview Vineyard,

acquired during 1982 for $975,000.      Vineyards made downpayments

of $400,000 and $250,000, respectively, for each parcel and

financed the remainder of their purchase prices with mortgage

debt.   Vineyards borrowed $301,115 from the Production Credit

Association (PCA) for the purchase of the Hillview Vineyard.

Since it started business, Vineyards has used the cash receipts

and disbursements method of accounting.

     Vineyards' operations were initially financed by cash

contributions from the Groths, mortgage debt, and annual

operating loans.   Vineyards obtained operating or crop loans from

the PCA during each of the years 1981 through 1988.     The loans

were repaid each year.    During 1988, Vineyards obtained a

$300,000 line of credit from Napa National Bank.

     During 1990, Vineyards employed, inter alia, a vineyard

manager and two assistants.    Prior to and during 1990, Vineyards

maintained an office in a building on the Hillview Vineyard.

     Winery

     During 1982, having learned that operating a winery offered

greater potential for profit than operating a vineyard, the
                                - 4 -

Groths decided to enter the winery business.         Accordingly, during

that year, they established, pursuant to California law, Groth

Vineyards and Winery (Winery), an S corporation.        Winery is

engaged in the business of making and marketing wines, such as

cabernet sauvignon, chardonnay, and sauvignon blanc, which are

named for the varietal or type of grape from which each is made.

Since it started business, Winery has used the accrual method of

accounting.

     Initially, the Groths owned all of the outstanding shares of

Winery's stock.   In 1982, the Groths employed a professional

winemaker, Nils Venge, as general manager of Winery.        During

1990, Mr. Venge was responsible for all production operations of

Winery and for supervision of Vineyards' vineyard manager.1          Mr.

Venge's employment contract provided for options to acquire up to

10 percent of Winery's stock, which he exercised as they became

available.    During each of the following years, Mr. Venge held

the following percentage of Winery's stock:

          Year                          Percentage

          1985                             1.07
          1986                             2.71
          1987                             6.28
          1988                             8.85
          1989                            10.00
          1990                            10.00



1
     In general, a winemaker decides when to pick grapes and must
be satisfied with the viticultural practices of the vineyard
supplying grapes.
                                - 5 -

     During relevant periods, Mr. Groth was president and

secretary of Winery, and Mrs. Groth was vice president and chief

financial officer of Winery.    The Groths had overall

responsibility for all Winery operations.    Mr. Groth represents

to customers that he controls the production process from the

growing of the grape until the cork is put in the bottle.    During

1985, the Groths had taken over full-time management of Winery;

prior to that time, Mr. Groth had been, successively, a partner

of the accounting firm of Arthur Young and Company, the chief

financial officer of Atari, Inc., and president of Atari's

international division.

     Winery was initially financed by the Groths' personal

resources.   By the end of 1983, their investment in Winery's

stock was $900,000, and their loans to Winery totaled $365,390.

     Since it was established in 1982, Winery sought to build a

physical plant in which to make, store, and bottle its wines.

During 1982, Winery undertook to construct a winery plant,

investing $220,000, but the project was deferred when financing

could not be obtained.    During 1982, Winery contracted with

another winery to crush and ferment its grapes pursuant to a

custom crush contract.    During 1983, Winery constructed an open

pad in the Oakcross Vineyard for crushing and fermenting grapes,

investing $375,000.   Winery also relied on the facilities of

other wineries during that year for the custom crushing of grapes

and the bottling, aging, and storing of its wines.
                                - 6 -

     During 1983, Winery began selling some of its 1982 vintage

sauvignon blanc.   Once Winery had demonstrated that its wines

were salable, during December 1983, Bank of America granted

Winery a $500,000 line of credit and an equipment loan of

$200,000.   As a condition of granting the line of credit, Bank

of America required that (1) Vineyards and the Groths subordinate

all of the debts owed them by Winery, totaling $893,000, to

Winery's obligations to the bank and (2) no payments on those

debts be made by Winery without the bank's consent.     Vineyards

accordingly executed a subordination agreement to induce Bank of

America to extend credit to Winery.     The bank also required

cross-collateralization by Vineyards and personal guarantees by

the Groths of the loan.    During February 1985, Bank of America

increased Winery's line of credit to $1,000,000, and continued to

require Winery's debts to Vineyards to be subordinate to Winery's

obligations to the bank.    Vineyards subsequently executed

subordination agreements dated November 14, 1985, and March 31,

1986.

     During 1986, Winery was not achieving the sales goals

expected by Bank of America, and the bank declined to raise

Winery's line of credit to $1,500,000.     As a consequence, Winery

was put in a difficult financial position.     Winery sold some of

its 1984 and 1985 vintages in bulk, which fetched a lower price

than could have been obtained had the wine been bottled, but

which saved costs, as well as unused barrels.     During December
                               - 7 -

1986, Bank of America offered to renew Winery's line of credit in

the amount of $1,100,000, subject to continued subordination of

Vineyards' claims against Winery to those of the bank and other

restrictions on payments by Winery to Vineyards further described

below.   The terms imposed in connection with the renewal of the

line of credit continued until Winery ceased dealing with Bank of

America, which occurred during 1988.

     During November 1988, Winery negotiated a $1,500,000 line of

credit from Napa National Bank, which also agreed to provide a

construction loan of $2,200,000 to build Winery's plant and an

equipment loan of $550,000.   The bank required the same

subordination of Winery's debts to Vineyards to Winery's

obligations to the bank, the same cross-collateralization by

Vineyards, and the same payment schedule as Bank of America had

required.   During 1990, Winery's plant, which had the capacity to

produce 40,000 cases of wine, was completed and occupied.   Also

during 1990, Winery began using the term "estate bottled" to

describe its wines, meaning, inter alia, that Winery controlled

the viticultural practices of the vineyards in which the grapes

from which the wines had been made were grown.

     The following table summarizes Winery's wine sales through

1990:

                Year                   Sales

                1982                    $0
                1983                28,402
                1984               384,921
                               - 8 -

                 1985              656,293
                 1986            1,128,384
                 1987            1,332,803
                 1988            1,955,474
                 1989            1,909,743
                 1990            2,382,294


Activities of Vineyards and Winery

     Dealings between Vineyards and Unrelated Buyers

     From 1981 through 1990, Vineyards sold grapes to unrelated

buyers, and the sales were made at market value.   During 1981,

Vineyards sold all of its grapes to unrelated buyers.   During

certain of the years from 1981 through 1990, long-term agreements

with certain buyers for Vineyards' grapes that had been made by

the previous owners of its vineyards were continued and new

agreements were made.   Certain written agreements for the sale of

grapes, whether long term or otherwise, were on the purchaser's

letterhead, while others were on Winery's letterhead.   The

agreements on Winery's letterhead generally called for payment of

one half of the amount due 30 days after delivery and the balance

on January 10 of the year following the year of delivery.     The

contracts written on purchasers' letterheads provided similar

payment terms.   Vineyards sent invoices to buyers on Winery

letterhead.   Mr. Venge executed some of Vineyards' grape purchase

agreements on behalf of Mr. Groth.

     Vineyards charged and collected interest on the unpaid

balances due from unrelated purchasers.   Those buyers generally

paid Vineyards for grapes within 6 months of harvest, which
                               - 9 -

generally occurred during September or October of each year.

Accordingly, they generally made their final payments for grapes

purchased during either the year of purchase or the first quarter

of the following calendar year.   During 1989 and 1990, unrelated

buyers paid for their grape purchases before the end of those

years.   Vineyards made sales to unrelated buyers in the following

amounts from 1981 through 1990:




                Year                   Amount

                1981               $121,349
                1982                331,539
                1983                104,076
                1984                152,983
                1985                152,584
                1986                189,365
                1987                114,385
                1988                122,236
                1989                122,078
                1990                 31,486

The following table summarizes the relative amounts of the

purchase price of grapes received by Vineyards from unrelated

buyers during the year of sale and the subsequent year:

    Year of     Percentage Received--       Percentage Received--
     Sale           Year of Sale               Subsequent Year

     1981              17                          83
     1982              11.6                        88.32
     1983              21.4                        78.6

2
     A portion of the amount due Vineyards was not paid until
after 1983.
                               - 10 -

       1984             39.6                     60.4
       1985             16.3                     83.7
       1986             91.8                      8.2
       1987             95.6                      4.4
       1988             93                        7
       1989            100                        0
       1990            100                        0

       By letter dated September 15, 1982, Mr. Groth informed one

of Vineyards' customers for grapes from the Hillview Vineyard of

Mr. Groth's long-term plan to start a winery.    The letter further

stated that Mr. Groth would need grapes produced by the Hillview

Vineyard for that winery and that, for 1983, he wished to sell to

the customer only half of the amount of sauvignon blanc grapes

specified in the agreement that had been made between the

customer and the previous owner of the Hillview Vineyard, and,

thereafter, to take all of those grapes for his own winery.

During 1985, Vineyards entered into a contract with Renaissance

Wine Company for the purchase of grapes that would continue from

year to year until canceled; if canceled, the parties were

obligated to buy and sell the same amount of grapes at the same

price as had been bought and sold during the preceding year.     The

contract called for the purchase of 50 tons of grapes at $750 per

ton.    Consequently, the buyer was obligated to buy annually 50

tons of grapes for at least 2 years.    In a cover letter with

respect to the contract dated March 15, 1985, Mr. Groth stated

that "$750 per ton is a price that is below our normal selling

price and is designed to help you [Renaissance Wine Company]

achieve your average sell price of $36/case."
                              - 11 -

     Dealings Between Winery and Unrelated Growers

     From 1983 through 1986, Winery purchased grapes from

unrelated growers pursuant to agreements that would continue

until canceled.   The agreements, which were prepared on Winery

letterhead, provided that Winery would pay one half of the

purchase price 30 days after delivery of the grapes and the

balance by December 15 of the year of delivery.   For grapes

purchased from one grower during 1983, Winery paid one half of

the purchase price during 1983 and the balance during 1984.    For

grapes purchased from other growers during 1983, and for all

grapes purchased during 1984, 1985, and 1986, Winery paid for its

purchases by yearend pursuant to the terms of its agreements.

     During relevant periods, Winery could not have purchased all

of the grapes that it needed from unrelated growers without

additional capital.   Bank of America did not suggest that the

unrelated vineyards from which Winery purchased grapes execute

subordination agreements similar to those executed by Vineyards.

Winery did not purchase grapes from unrelated vineyards from 1987

through 1990 and purchased grapes only from Vineyards during

those years.

     A February 5, 1985, letter to Mr. Venge from one of the

unrelated growers supplying Winery confirms an agreement to (1)

sell Winery 60 tons of chardonnay grapes and (2) review the

pricing structure used in the past "and possibly reduce and align
                                - 12 -

the price per ton to the Napa Valley average."     The letter states

that:

     We are always willing to work closely with you should
     disparities arise in price. For this reason we will be
     taking a look at the price per ton of Chardonnay. It
     would be more of an incentive for us to do this if we
     know that Groth would buy at least 60 tons of
     Chardonnay for an additional three years beginning in
     1986.

     Dealings between Vineyards and Winery

             Grape Sales

        During 1982, Vineyards began selling grapes to Winery and

continued selling grapes to Winery each year thereafter through

1990.     In general, the amount of grapes that Winery purchased

increased each year, and, during 1990, Winery purchased

approximately 96 percent of Vineyards' grapes.     Prior to 1991,

Winery was not able to use all of the grapes produced by

Vineyards.     After 1990, Vineyards did not sell grapes to

unrelated buyers.     The percentage of Vineyards' total grape sales

represented by its sales to Winery during each year from 1981

through 1991 was as follows:

             Year                Percentage Sold to Winery

             1981                           0
             1982                          29.2
             1983                          70.8
             1984                          61.7
             1985                          68.7
             1986                          62.1
             1987                          72.9
             1988                          83.8
             1989                          85.7
             1990                          95.6
             1991                         100
                              - 13 -

     Vineyards sold grapes to Winery at market value.   Winery

made no payments to Vineyards during 1982 or 1983 for grape

purchases because funds were not available.    Vineyards sold

grapes to Winery during 1983 because Mr. Groth believed that

Winery would eventually become successful.    During March 1984,

Winery made its first payment to Vineyards for 1982 sauvignon

blanc grapes used in wine being sold at that time.    That payment,

and subsequent payments to Vineyards, were made with funds

provided by Winery's line of credit from Bank of America, and the

bank consented to the March 1984 payment.    In deciding whether to

approve the payment, the bank considered whether the wines made

from the grapes purchased from Vineyards had been released for

sale, and Vineyards would be paid 6 months after a wine's

release.   At that time, Winery customarily released its sauvignon

blanc after 1 year, its chardonnay after 2 years and its cabernet

sauvignon after 3 years.   Winery also produced relatively small

quantities of a reserve cabernet sauvignon that was released 1

year after the estate cabernet was released.    A subsequent

vintage was not released until the prior one had been sold.

     By addenda to subordination agreements dated November 14,

1985, and March 31, 1986, that were executed by it, Vineyards

consented to receive payments from Winery only for those grapes

that had been made into wine that had been released for sale by

Winery for a minimum of 7 months.   Vineyards acknowledged,

however, that payments were allowed only to the extent they did
                              - 14 -

not jeopardize Winery's ability to meet its obligations to Bank

of America.

     The terms on which Winery paid Vineyards for grape purchases

were further modified in connection with the renewal of Winery's

line of credit during December 1986.   As a condition of renewing

the line, Bank of America required that payments to Vineyards for

grapes be made quarterly no earlier than 60 days after each

quarter's end and ratably as the wine made from Vineyard's grapes

was sold.   In a letter dated November 24, 1986, to Bank of

America discussing the bank's proposal with respect to the timing

of Winery's payments to Vineyards for grapes, Mr. Groth wrote

that "Judy and I have provided generous delayed payment terms to

the Winery that are still adequate."   As noted above, the

foregoing payment arrangement between Winery and Vineyards

continued for the remainder of the period that Bank of America

provided a line of credit to Winery as well as subsequently, when

Winery obtained a line of credit from Napa National Bank during

November 1988.

     During 1986, Vineyards and Winery executed a Grape Payment

Calculation that provided, inter alia, that:   (1) Vineyards would

sell grapes to Winery in quantities as needed by Winery, with

Winery having first choice of grapes and Mr. Venge having

authority to select among the grapes available and to coordinate

sales with unrelated buyers; and (2) payment for the grapes would

occur ratably as the wine made from the grapes was sold by
                             - 15 -

Winery, with payments occurring periodically during the year, but

with full payment for actual sales during a year being made no

later than the quarter following the year's end.

     The following table summarizes the amount of Winery's grape

purchases from, and payments to, Vineyards for grapes from 1982

through 1990:

     Year           Amount of Purchase         Amount of Payment

     1982                $140,079                         $0
     1983                 252,665                          0
     1984                 246,252                     40,563
     1985                 334,738                    208,746
     1986                 310,156                     41,514
     1987                 308,319                    425,536
     1988                 447,752                    360,930
     1989                 734,432                    321,968
     1990                 714,083                    435,313

     The amounts owed to Vineyards by Winery for grapes at the

end of each calendar year from 1982 through 1990 are as follows:




            Year                    Account Receivable

            1982                          $140,079
            1983                           392,744
            1984                           598,444
            1985                           724,435
            1986                           993,077
            1987                           875,859
            1988                           962,681
            1989                         1,375,145
            1990                         1,653,915
                               - 16 -

Vineyard's $1,653,915 account receivable from Winery as of

December 31, 1990, comprised amounts due for the purchase of the

following vintages and varietals of grapes:

           Cabernet                     Sauvignon
Vintage    Sauvignon       Chardonnay     Blanc        Merlot

 1986        $7,311                                    $1,528
 1987        45,413                                    10,436
 1988       167,513         $10,177                    23,218
 1989       315,245         229,177      $80,224       49,590
 1990       347,070         213,360       90,143       63,510

By the end of 1990, Winery had paid only $60,196 with respect to

its 1989 grape purchases, which totaled $734,432, and had paid

nothing for its 1990 purchases.

            Interest Payments by Winery to Vineyards

     Vineyards charged Winery interest on the unpaid receivables

from Winery, but Winery paid none of that interest during 1982 or

1983.   Beginning in 1984, Winery paid Vineyards some of the

interest that had been accruing on Vineyard's receivables from

Winery.    Pursuant to addenda to the subordination agreements

executed by Vineyards that were dated November 14, 1985, and

March 31, 1986, Vineyards was permitted to collect interest from

Winery on the receivables due from Winery at the rate of 12

percent.    Vineyards acknowledged, however, that payments of

interest were allowed only to the extent they did not jeopardize

Winery's ability to meet its obligations to the Bank of America.

Interest payments continued until 1986, when Bank of America

required Winery to cease accruing interest on Vineyard's
                               - 17 -

receivables without the bank's consent as a condition of renewing

Winery's line of credit.    Furthermore, all accrued and unpaid

interest owed to Vineyards was eliminated from Winery's books at

the end of 1986 and was never paid to Vineyards.

       No interest accrued on Vineyards' receivables for the

remainder of the time that Winery dealt with Bank of America.

The Grape Payment Calculation executed by Winery and Vineyards

during 1986, however, provided that Vineyards would be paid

interest at the rate of 10 percent on its receivables from Winery

for grape purchases.    During November 1988, Winery obtained a

line of credit from Napa National Bank, which allowed interest on

the receivables to be accrued and paid quarterly.    The following

table summarizes the accrual and payment of interest to Vineyards

on its receivables from Winery for grape purchases from 1982

through 1990:

Year        Interest Accrued         Interest Paid       Balance

1982             $4,202                      $0           $4,202
1983             24,388                       0           28,590
1984             50,729                   7,017           72,302
1985             57,819                  49,419           80,702
1986            (79,739)                    963                0
1987                  0                       0                0
1988             80,616                  80,616                0
1989            100,339                 100,339                0
1990            128,047                 128,047                0



       Rent Payments by Winery to Vineyards

       The land at the Oakcross Vineyard that was used for the

crush pad was rented by Winery from Vineyards for $18,000 per
                                - 18 -

year.   Prior to and during 1990, Winery's offices were located in

a building at the Hillview Vineyard, which was rented from

Vineyards for $500 per month.    As a condition for the renewal of

Winery's line of credit, Bank of America required that payment of

rent by Winery to Vineyards be suspended during 1986 and 1987.

After Winery ceased dealing with Bank of America during 1988,

rent payments resumed.

                                OPINION

     The issue to be decided is whether respondent's

determination, pursuant to section 446(b), that Vineyards must

use the accrual, and not the cash, method to account for its

income from the sale of grapes and other property in order to

clearly reflect its income constitutes an abuse of respondent’s

discretion.   Vineyards was a farmer for purposes of the Code and

used, pursuant to sections 1.61-4 and 1.471-6(a), Income Tax

Regs., the cash receipts and disbursements method of accounting

to compute its income.

     Respondent contends that use of the cash method materially

distorted Vineyard's income because of the large and increasing

account receivable from Winery, which did not pay for its grape

purchases until wine made from the grapes was released for sale

or sold, between 2 and 5 years afterwards.   Respondent points out

that Vineyards did not give the same terms to unrelated buyers of

its grapes and argues that the deferred payment arrangement

served no business purpose of Vineyards.
                                - 19 -

     Petitioner contends that Vineyards was permitted to use the

cash method, that the method was generally accepted in the

vineyard industry, that it was consistently applied by Vineyards,

and that it clearly reflected Vineyards' income.    Petitioner

argues that it is not required to show a business purpose for the

deferred payment arrangement with Winery but that such a purpose

exists, namely the establishment of a long-term relationship

between Vineyards and Winery.    Petitioner urges that the

relationship of Vineyards to Winery is irrelevant to the question

whether Vineyards may use the cash method of accounting.

     Generally, section 446(b) provides that, if a taxpayer's

method of accounting does not clearly reflect income, then the

computation of taxable income shall be made pursuant to a method

that, in the opinion of the Commissioner, does clearly reflect

income.   Section 446(b) vests the Commissioner with broad power

to determine whether the accounting methods used by a taxpayer

clearly reflect income, Thor Power Tool Co. v. Commissioner, 439

U.S. 522, 532 (1979), and to require revision of a method that

does not clearly reflect income, Commissioner v. Van Raden, 650

F.2d 1046, 1048 (9th Cir. 1981), affg. 71 T.C. 1083 (1979); Cole

v. Commissioner, 586 F.2d 747, 749 (9th Cir. 1978), affg. 64 T.C.

1091 (1975); Stephens Marine, Inc. v. Commissioner, 430 F.2d 679,

686 (9th Cir. 1970), affg. T.C. Memo. 1969-39.    "An action taken

by the Commissioner under section 446 will be set aside by the

courts only if there is a clear abuse of discretion."    Cole v.
                               - 20 -

Commissioner, supra at 749; see also Stephens Marine, Inc. v.

Commissioner, supra at 686.   Accordingly, a determination

pursuant to section 446(b) is entitled to more than the usual

presumption of correctness, Ansley-Sheppard-Burgess Co. v.

Commissioner, 104 T.C. 367, 370 (1995), and cases cited therein,

and the taxpayer bears a heavy burden of proof in overcoming a

determination that an accounting method does not clearly reflect

income, Thor Power Tool Co. v. Commissioner, supra at 532-533.

Moreover, even if a taxpayer, including a farmer, is otherwise

entitled to use the cash method of accounting, section 446(b) may

be used to prevent abuses of the method, Van Raden v.

Commissioner, 71 T.C. at 1103, and mere compliance with a

generally permitted method does not foreclose the Commissioner's

exercise of discretion pursuant to section 446(b), Ford Motor Co.

v. Commissioner, 102 T.C. 87, 99 (1994), affd. 71 F.3d 209 (6th

Cir. 1995).   A taxpayer may challenge the Commissioner's

determination on the grounds that its accounting method clearly

reflects income, Auburn Packing Co. v. Commissioner, 60 T.C. 794

(1973), and, if the taxpayer's method of accounting does clearly

reflect income, the Commissioner may not require a change to

another method that more clearly reflects income.     Ansley-

Sheppard-Burgess Co. v. Commissioner, supra at 371.

     Historically, farmers have been allowed to use the cash

method, which enables them to employ a simplified accounting

procedure.    United States v. Catto, 384 U.S. 102, 116 (1966);
                             - 21 -

Kennedy v. Commissioner, 89 T.C. 98, 103 (1987).   Although it is

generally acknowledged that distortions of income may result from

use of the cash method, Frysinger v. Commissioner, 645 F.2d 523,

527 (5th Cir. 1981), affg. T.C. Memo. 1980-89; Ansley-Sheppard-

Burgess Co. v. Commissioner, supra at 374; Rojas v. Commissioner,

90 T.C. 1090, 1107 (1988), affd. 901 F.2d 810 (9th Cir. 1990);

Kennedy v. Commissioner, supra at 103; Magnon v. Commissioner, 73

T.C. 980, 1004-1005 (1980), such distortions do not prevent the

cash method from clearly reflecting income so long as the method

is consistently applied and no attempt is made to unreasonably

prepay expenses or defer receipt of income, Ansley-Sheppard-

Burgess Co. v. Commissioner, supra at 375; Kennedy v.

Commissioner, supra at 103-104; Magnon v. Commissioner, supra at

1005-1006; Van Raden v. Commissioner, 71 T.C. at 1104.   Moreover,

farmers are allowed great flexibility in timing the receipt of

income from harvested crops and may sell them in one year

pursuant to a contract calling for payment in a later year.

Schniers v. Commissioner, 69 T.C. 511, 520 (1977).

     A taxpayer, including a farmer, using the cash method of

accounting is ordinarily entitled to report income in the year it

is actually or constructively3 received, secs. 1.61-4(a), 1.451-

1(a), Income Tax Regs., but may not do so where application of

the general rule results in a material distortion of income.    See

3
     Respondent does not contend that Vineyards was in
constructive receipt of any of the amounts due it from Winery.
                              - 22 -

Van Raden v. Commissioner, 71 T.C. at 1102-1103.   Where a

taxpayer's method of accounting results in a material distortion

of income, the Commissioner is empowered by section 446(b) to

require use of a different accounting method so that income is

clearly reflected.   Commissioner v. Van Raden, 650 F.2d at 1048-

1049; Burck v. Commissioner, 533 F.2d 768, 773 (2d Cir. 1976),

affg. 63 T.C. 556 (1975); Keller v. Commissioner, 79 T.C. 7, 38-

41 (1982), affd. 725 F.2d 1173 (8th Cir. 1984); Baird v.

Commissioner, 68 T.C. 115, 131 (1977) and cases cited therein;

see also Clement v. United States, 217 Ct. Cl. 495, 580 F.2d 422,

430-431 (1978).   The question of whether a taxpayer's method of

accounting materially distorts or clearly reflects income is one

of fact and is to be resolved on a case-by-case basis.     Cole v.

Commissioner, supra at 749; Ansley-Sheppard-Burgess Co. v.

Commissioner, supra at 371; Packard v. Commissioner, 85 T.C. 397,

433 (1985).

     The cases that involve the question of whether a material

distortion has occurred with respect to the receipt of income

take into account the same considerations and factors that are

examined in cases involving the question of whether a material

distortion has occurred with respect to the claim of a deduction.

Compare Ansley-Sheppard-Burgess Co. v. Commissioner, supra at

374-375; Applied Communications, Inc. v. Commissioner, T.C. Memo.

1989-469; C.A. Hunt Engg. Co. v. Commissioner, T.C. Memo. 1956-

248, with Van Raden v. Commissioner, 71 T.C. at 1096-1106; Sandor
                              - 23 -

v. Commissioner, 62 T.C. 469, 479-481 (1974), affd. 536 F.2d 874

(9th Cir. 1976).   Accordingly, we consider cases dealing with

material distortions of income arising in connection with the

claim of deductions.   In Van Raden v. Commissioner, 71 T.C. at

1105-1106, we set forth the following approach to considering the

question whether a distortion of income was material:

          Because the method of accounting and the nature of
     the trade or business are so interdependent, we
     conclude that the distortion of income must not be
     examined in a vacuum but in light of the business
     practice or business activities which give rise to the
     transaction which the Commissioner has determined must
     be accorded a different accounting treatment. For
     example, material distortions of income may occur if
     the sales force of a business is more successful in
     December than in January, yet such a distortion would
     not require adjustment to clearly reflect income
     because the distortion resulted from the business
     activity itself. * * *

       A material distortion of income generally does not occur

where a deferral of income arises in the regular course of

business and not from a manipulation of the cash method.     Gold-

Pak Meat Co. v. Commissioner, 522 F.2d 1055, 1057 (9th Cir.

1975), remanding T.C. Memo. 1971-83.   Courts have also considered

whether a business purpose exists for a transaction in deciding

whether a taxpayer's method of accounting for the transaction

materially distorts income.   Frysinger v. Commissioner, supra at

528; Packard v. Commissioner, supra at 428-430; Van Raden v.

Commissioner, 71 T.C. at 1105-1106.    A business purpose exists

where the taxpayer establishes a reasonable expectation of

receiving some business benefit from the aspect of the
                                - 24 -

transaction challenged by the Commissioner.    Packard v.

Commissioner, supra at 428.    Furthermore, a material distortion

of income is likely to be found where the amount of an item

differs substantially from what might normally be expected in an

arm's-length transaction structured without special regard to tax

consequences.4    Lewis v. Commissioner, 65 T.C. 625, 629 (1975).

Moreover, we have recognized that the interval of time between

the reporting of the payment of expenses and the receipt of

associated income can be so great that the use of the cash method

of accounting by a taxpayer results in an impermissible

distortion of income.    Silberman v. Commissioner, T.C. Memo.

1983-782, affd. without published opinions sub nom. Appeal of

David Whin, Inc., Appeal of Giordano, Appeal of Malanka, Stamato

v. Commissioner, 770 F.2d 1068, 1069, 1072, 1075 (3d Cir. 1985)

     Where related parties deal with each other on the same terms

as with unrelated parties, a method of accounting will not be

considered to materially distort income simply because the

parties to a transaction are related.    Gold-Pak Meat Co. v.

Commissioner, supra at 1057.    Nonetheless, it is also well

established that transactions between related parties are closely

scrutinized.     Spicer Accounting, Inc. v. United States, 918 F.2d

90, 92 (9th Cir. 1990); Hulter v. Commissioner, 91 T.C. 371, 394

4
     We note that an accounting method can produce a material
distortion of income even where a taxpayer does not have a tax
avoidance motive in employing it. Anderson v. Commissioner, T.C.
Memo. 1975-302, affd. 568 F.2d 386 (5th Cir. 1978).
                              - 25 -

(1988); Harwood v. Commissioner, 82 T.C. 239, 258 (1984), affd.

without published opinion 786 F.2d 1174 (9th Cir. 1986); Velvet

Horn, Inc. v. Commissioner, T.C. Memo. 1981-227.

     We accordingly shall consider whether use of the cash method

of accounting to report Vineyards' income from the sales of

grapes and other property materially distorted its income.     We

note at the outset that the Groths were the general partners of

Vineyards and held an 85-percent interest in the partnership,

with trusts for the benefit of each of their children holding the

remaining 15-percent interest.   At relevant times, the Groths

also owned at least 90 percent of the stock of Winery, with Mr.

Venge holding at most 10 percent.5     As stated above, the fact

that the Groths controlled both Vineyards and Winery requires

that we carefully scrutinize the transactions between them.

     We note at the outset that Vineyards and Winery did not deal

with one another on the same terms as they dealt with unrelated

parties.   Although Vineyards sold grapes to unrelated parties and

to Winery at market value, unrelated parties generally paid

Vineyards for grapes within 6 months of harvest.     The written

sales agreements pursuant to which Vineyards sold grapes to

unrelated parties that were written on Winery's letterhead

generally provided that the buyer would pay 50 percent of the


5
     Pursuant to the employment contract between the Groths and
Mr. Venge, Mr. Venge acquired 10 percent of the stock of Winery
between 1985 and 1989.
                              - 26 -

amount due 30 days after delivery and 50 percent during January

of the following calendar year.   Other sales agreements that were

written on unrelated purchasers' letterheads provided for payment

of the sale price at similar times, usually determined with

reference to the time grapes were delivered.   Certain of those

agreements provided for payment of a portion of the price, at the

latest, during the calendar year following delivery.   Generally,

unrelated buyers made their final payment for grapes purchased

during either the year of purchase or the first quarter of the

following calendar year.   Vineyards collected interest from

unrelated buyers on overdue amounts.

     Similarly, Winery's agreements for the purchase of grapes

from unrelated growers provide that 50 percent of the purchase

price was to be paid 30 days after delivery and the remainder by

December 15 of the year of delivery.    We consider the foregoing

payment arrangements to be the result of arm's-length bargaining

between unrelated buyers and sellers.

     In contrast, Vineyards allowed Winery more liberal payment

terms.   During 1982 and 1983, Winery purchased grapes from

Vineyards, but did not pay for them because the cash to do so was

not available.   Vineyards also allowed, or acquiesced in, the

control by Winery's lenders of the payment of amounts due

Vineyards.   Vineyards agreed to subordinate its claims against

Winery to those of Bank of America and later to Napa National

Bank, but unrelated sellers of grapes to Winery did not.    Winery
                              - 27 -

could not make payments to Vineyards without the consent of its

lenders.   Winery's first payment to Vineyards during March 1984

was made with the consent of Bank of America with funds provided

by a line of credit that the bank had extended to Winery.     The

test used by the bank to decide whether payment was to be allowed

was whether the wine made from Vineyard's grapes was released for

sale.   The March 1984 payment accordingly was made for 1982

grapes used in wine that had been released for sale approximately

6 months prior to the time of that payment.

     Vineyards subsequently consented in addenda to subsequent

subordination agreements to receive payment for grapes that had

been made into wine that had been released for sale by Winery for

a minimum of 7 months.   As a condition of renewing Winery's line

of credit during late 1986, Bank of America insisted that Winery

pay Vineyards for grapes quarterly, but only as the wine made

from the grapes was sold.   The Grape Payment Calculation entered

into by Vineyards and Winery during 1986, provided similar

payment terms.   That payment arrangement remained in place

through the remainder of Winery's relationship with Bank of

America and continued when Winery replaced its line of credit

from that bank with one obtained from Napa National Bank during

November 1988.   The foregoing payment practices resulted in an

account receivable from Winery to Vineyards in the amount of

$1,615,915 as of December 31, 1990, over 80 percent of which was

attributable to Winery's 1989 and 1990 grape purchases.
                              - 28 -

Generally, Winery's payments to Vineyards for grape purchases

were deferred between 1 and 4 years after delivery.

     Vineyards permitted Winery to defer payment of the interest

accruing on Vineyards' receivables from Winery.    Vineyards

further allowed, or acquiesced in, the control by Winery's

lenders of payments to it of interest and rent.    During each year

from 1984 until 1986, Winery began paying to Vineyards some of

the interest accrued on Vineyards' receivables from Winery using

funds from Winery's line of credit.    Vineyards also made

agreements with Bank of America concerning the amount of interest

it was entitled to collect from Winery with respect to the

receivables.   Bank of America, however, as a condition of

renewing Winery's line of credit during late 1986, required that:

(1) Payments of interest to Vineyards cease; (2) no further

accruals occur without its consent; and (3) all accrued and

unpaid interest owed by Winery to Vineyards, totaling $79,739, be

eliminated from Winery's books.6   The interest eliminated was

never paid to Vineyards.   Despite a provision in the Grape

Payment Calculation that called for the payment to Vineyards of


6
     While petitioner maintains that the interest accrued was
eliminated at the insistence of Bank of America, we note that the
letter from Bank of America to Winery outlining the terms on
which Winery's line of credit would be renewed states that "As
Borrower [Winery] has proposed, all existing accrued and unpaid
interest owed by Borrower to Guarantors [including Vineyards] is
to be reversed and eliminated from Borrower's books by 12/31/86."
There is accordingly some question concerning whether the accrued
interest was eliminated at the instance of the Bank of America.
                              - 29 -

interest at 10 percent on the unpaid balance of grape purchases

by Winery, no interest was accrued for 1987 by Winery with

respect to the amounts due Vineyards.    Winery's rent payments to

Vineyards also ceased during 1986.     This was done at the instance

of Bank of America.   Once Winery obtained a line of credit from

Napa National Bank, however, interest and rent payments resumed.

     The foregoing facts demonstrate that Vineyards and Winery

dealt with each other on terms that were significantly different

from those on which they dealt with unrelated parties.     Moreover,

the record indicates to us that the terms on which they dealt

were intended to benefit Winery and imposed burdens on Vineyards.

Vineyards executed agreements subordinating its claims against

Winery to those of Winery's lenders to induce those lenders to

grant credit to Winery.   The terms on which Winery purchased

grapes from Vineyards were also intended to favor Winery.    For

instance, in a November 24, 1986, letter to Bank of America, Mr.

Groth wrote that "Judy and I have provided generous delayed

payment terms to the Winery that are still adequate."    Without

the generous payment terms granted by Vineyards, Winery could not

have purchased the grapes it required without the infusion of

additional capital.

     Winery did not make payments to Vineyards for grape

purchases during 1982 and 1983 because funds were not available.

Winery began to pay Vineyards after Winery obtained a line of

credit during 1984, but payments were subject to the control of
                              - 30 -

Winery's lenders.   These arrangements apparently allowed Winery

to use available resources to develop itself.   Mr. Groth admitted

at trial that "perhaps" Vineyards would have been paid for its

grapes sooner had it sold to unrelated parties.

     Petitioner contends that Vineyards had a legitimate business

purpose for extending such generous payment terms to Winery.    At

trial, Mr. Groth, a general partner of Vineyards, testified that

he sought to establish a long-term relationship with Winery

because (1) such a relationship would provide Vineyards with a

continuing market for its grapes, and (2) the best prices for

grapes tended to be paid on long-term contracts.   Mr. Groth also

testified that a vineyard would do well if it established a long-

term relationship with a successful winery.

     The record indicates that grape growers offered favorable

terms to large-quantity purchasers given the prospect of

developing a long-term relationship with those buyers.

Accordingly, we would not consider it unusual if Vineyards

offered some accommodation to Winery to foster such a

relationship.   The record, however, indicates that, when

unrelated parties dealt with each other, the inducement typically

offered for a long-term relationship was a lower price per ton of

grapes purchased, rather than substantial deferral of payment of

the purchase price.7   Accordingly, even if Vineyards had desired

7
     In petitioner's Sur-Reply Brief, petitioner points to a
                                                   (continued...)
                              - 31 -

to accommodate Winery in order to foster a long-term

relationship, petitioner has not established that the deferral of

payments for grapes was a practice adopted by parties dealing at

arm's length.   Furthermore, the accommodations Vineyards gave

Winery went even further, including subordinating Vineyards'

claims against Winery to those of its lenders and allowing

Winery's lenders to control the payment of amounts due for grape

purchases, interest, and rent to Vineyards.

     Moreover, we note that other factors influenced the

development of the relationship between Vineyards and Winery.

The record indicates that, as early as 1982, Mr. Groth intended

that Vineyards' grapes would supply Winery's needs and that

Vineyards' relationships with other purchasers were to be

7
 (...continued)
Market Segment Specialization Program study of the wine industry
prepared by the Internal Revenue Service that was released in
April 1995. Market Segment Specialization Program--The Wine
Industry, TPDS 83919Y, reprinted in 37 Tax Analysts Daily Tax
Highlights and Documents, at 1971-1989 (May 9, 1995). Petitioner
relies on certain statements in the study to support the
contention that the payment arrangements between Vineyards and
Winery were widespread in the wine industry. Although petitioner
relies on the study to show facts concerning the practices of the
wine industry, the study is not otherwise in the record, nor does
petitioner attempt to establish that it is admissible in
evidence, and respondent has not had an opportunity to object to
its admission. Petitioner claims that the study has probative
value; however, the study, which was released in 1995, does not
necessarily reflect the practices of the wine industry in 1990,
the year in issue. Moreover, the study also states, in a portion
not relied on by petitioner, that deferred payment practices,
which the study indicates occur only between related parties,
distort the income of vineyards using the cash method. Id. at
1980. Accordingly, we shall disregard the study cited by
petitioner.
                              - 32 -

subordinated to its relationship with Winery.   Also, Winery's

control of Vineyards' viticultural practices entitled it to use

the term "estate bottled" to describe its wines.   Consequently,

the evidence supports an inference that a long-term relationship

between Vineyards and Winery could have been established even

without Vineyards' generous payment terms.

     Because the dealings between Vineyards and Winery are at

variance with the practices of unrelated parties with similar

objectives dealing at arm's length, we are not prepared to accept

that they occurred in the ordinary course of Vineyards' business

or were actuated by the business purposes claimed for them.

Petitioner has pointed to no nontax benefit received by Vineyards

from Winery commensurate with the substantial concessions and

accommodations made by Vineyards for Winery's benefit.   Moreover,

petitioner has not shown that Vineyards could not have sold, as

it did in 1981, all of its grapes to third parties at market

value on terms that did not entail the same period of deferral as

its sales to Winery.   To the contrary, it appears to us that

Vineyards was able to sell to unrelated buyers all of the grapes

that Winery did not require without such a deferral of payment of

the purchase price.8   Accordingly, we conclude that petitioner

has not established that there was a legitimate business purpose



8
     Mr. Groth testified that he had significant experience
selling Vineyards' grapes to unrelated parties.
                             - 33 -

for Vineyards' generous payment terms to Winery and that no

material distortion of Vineyards' income occurred.

     We further conclude that petitioner has failed to establish

that respondent’s determination that use of the cash method to

report Vineyards' income from sales of grapes and other property

did not clearly reflect Vineyards' income and that use of the

accrual method was required in order to clearly reflect its

income was an abuse of respondent’s discretion.

     To reflect the foregoing,


                                        Decision will be entered

                                   for respondent.
