                        T.C. Memo. 2001-288



                      UNITED STATES TAX COURT



          NEMETSCHEK NORTH AMERICA, INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 7829-99.                  Filed October 29, 2001.



     Joseph Schmelzle (an officer), for petitioner.

     William J. Gregg, for respondent.




             MEMORANDUM FINDINGS OF FACT AND OPINION


     LARO, Judge:   Petitioner’s predecessor, Diehl Graphsoft,

Inc. (Diehl), petitioned the Court to redetermine respondent’s

determination of a $142,986 deficiency in its Federal income tax
                                - 2 -

for its taxable year ended May 31, 1995 (1995 taxable year).1     We

must decide whether respondent abused his discretion under

section 446 when he determined that Diehl must change its overall

method of accounting from a hybrid method to an accrual method.

We hold he did not.   Unless otherwise indicated, section

references are to the Internal Revenue Code in effect for the

subject year.

                          FINDINGS OF FACT

     Some facts were stipulated and are so found.    The stipulated

facts and the exhibits submitted therewith are incorporated

herein by this reference.    Diehl is a publicly traded corporation

whose principal place of business was in Columbia, Maryland, when

its petition was filed.

     Diehl designs, develops, manufactures, and sells unmodified

software that allows sophisticated design and engineering

projects to be performed on computer hardware.    Diehl also

develops and sells to its software users, usually as part of the

software sale, three manuals which are an integral part of the

software.   The manuals, which are printed and bound by outside

vendors, consist of a:    (1) Programming language manual, (2)

technical reference manual, and (3) tutorial manual.    Diehl also

sells to its customers software produced by third parties.     (We



     1
       Respondent also determined that Diehl is liable for the
increased rate of interest under sec. 6621(c).
                               - 3 -

hereinafter refer collectively to all of the products sold by

Diehl as products.)   In addition to its products, Diehl provides

to its customers free of charge access to its customer support

services.

     Diehl sells some of its products within the United States

through its employees, dealers, and distributors.    It sells the

remainder of its products outside the United States through

foreign distributors and resellers.    Most of Diehl’s sales

(approximately 85 percent of them by revenue) are of a single

product (MiniCad5) that is sold to users of MacIntosh computers.

     Diehl’s gross receipts for the subject year were $4,848,333.

All of these receipts were attributable to Diehl’s sale of its

products.   Diehl’s sales were made as follows:   (1) Ten percent

as direct sales between Diehl and end users, (2) 4 percent as

sales through dealers, and (3) 86 percent as sales through

distributors (both foreign and domestic).    Diehl’s sales were

made either:   (1) By delivering its products electronically

through an electronic code and serial number or (2) by delivering

its products in boxes containing the software (usually on a

disk), manuals, and any other item that Diehl considered

necessary for the particular market.    In the latter case, the

boxes and the manuals were significant parts of the sales.

     Upon its inception in 1985 and throughout the subject year,

Diehl used a hybrid method of accounting for book and tax
                                   - 4 -

purposes.     Specifically, Diehl used the:       (1) Cash receipts and

disbursements method (cash method) to report its receipts and

certain expenditures and (2) lower of cost or market method to

value its yearend inventory.       At the beginning and end of its

1995 taxable year, Diehl had an inventory valued for Federal

income tax purposes at $112,945 and $132,820, respectively.

Diehl’s inventory consisted of:       (1) Blank disks, (2) software,

manuals, binders, and videos, and (3) shipping materials and

other supplies.      The values of those items on May 31, 1994 and

1995, were as follows:

                                                May 31, 1994   May 31,

1995

       Blank disks                                 $11,530        $16,156
       Software, manuals, binders, and videos        85,904       106,353
       Shipping materials and other supplies         15,513        10,311
                                                   1
         Total                                       112,947      132,820
        1
       The $2 difference between this amount and the $122,945 listed
immediately above and below is attributable to rounding.

        Diehl reported taxable income of $1,603,678 for its 1995

taxable year.      It computed and reported its cost of goods sold as

follows:

             Inventory at beginning of year        $112,945
             Purchases                              510,898
             Cost of labor                           32,260
             Commissions                              4,961
             Inventory scrap                         17,680
             Total                                  678,744
             Inventory at end of year               132,820
             Cost of goods sold                     545,924

        Respondent determined that Diehl was required to use an

overall accrual method to reflect its income clearly.          Respondent
                                - 5 -

made two positive (increase to income) adjustments to Diehl’s

reported taxable income to reflect this determination.       First,

respondent made a $206,108 adjustment under section 481(a) to

reflect the effect of the change from the cash method to an

accrual method as of June 1, 1994:

                         Application of   Application of
                           cash method    accrual method   Difference
   Accounts receivable         -0-           $260,527       $260,527
   Interest receivable         -0-             38,769         38,769
   Prepaid expenses         $11,647           173,460        161,813
   Prepaid advertising         -0-           (159,700)      (159,700)
   Accounts payable          (8,208)         (103,509)       (95,301)
      Total                   3,439           209,547        206,108

Second, respondent made a $214,309 adjustment to reflect the

current year’s application of an accrual method to the following

items:

                          Balance on        Balance on
                         June 1, 1994      May 31, 1995    Difference
   Accounts receivable     $260,527          $522,775       $262,248
   Interest receivable       38,769             7,817        (30,952)
   Prepaid expenses         173,460            64,495       (108,965)
   Prepaid advertising     (159,700)          (54,240)       105,460
   Accounts payable        (103,509)         (116,991)       (13,482)
      Total                 209,547           423,856        214,309

                               OPINION

     Petitioner argues that respondent abused his discretion when

he determined that Diehl must change from its hybrid method to an

accrual method.   Petitioner generally makes four assertions in

support of its argument.   First, petitioner asserts that the cash

method is listed in section 446(c) as a permissible method of

accounting and that a taxpayer who consistently uses the cash

method may continue to use that method until it fails the $5
                               - 6 -

million gross receipts exception of section 448.   Petitioner

claims that Diehl has consistently used the cash method since its

inception and that Diehl met the $5 million gross receipts

exception for the relevant year.   Second, petitioner asserts that

a taxpayer meeting the $5 million gross receipts exception may

use the cash method whenever its sale of merchandise is not an

income-producing factor.   Petitioner claims that Diehl primarily

earned its income by selling intellectual property, which,

petitioner claims, is not merchandise.   Petitioner claims that

Diehl’s sales of the manuals and other inventory items were not

an income-producing factor in its business because, petitioner

claims, the sales merely helped Diehl sell and market its

intellectual property.   Third, petitioner asserts that Diehl

could use the cash method because its sales of the manuals and

other inventory items were insignificant as a function of its

gross receipts and that the amount of these items fluctuated

little from one yearend to the next.   Petitioner claims that it

is a per se abuse of discretion when respondent’s change in

method of accounting generates adjustments to accounts receivable

and not to the amount of inventory at the beginning or end of the

year.   Fourth, petitioner asserts that respondent’s determination

is an abuse of discretion because Diehl changed to an overall

accrual method 2 years after the subject year.
                               - 7 -

     We disagree with petitioner that respondent’s determination

is an abuse of discretion.   Section 446(a) contains the general

rule for tax accounting.   Section 446(a) provides that the

accounting method used to compute taxable income generally must

be based on the method of accounting used to compute book income.

When the accounting method used to compute taxable income does

not clearly reflect income, section 446(b) gives the Commissioner

broad authority to prescribe a method that does clearly reflect

income.   Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 532

(1979); Commissioner v. Hansen, 360 U.S. 446, 467 (1959); see

also sec. 1.446-1(a)(2), Income Tax Regs. (“no method of

accounting is acceptable unless, in the opinion of the

Commissioner, it clearly reflects income”).   The Commissioner’s

exercise of authority under section 446(b) is given “much

latitude” and cannot be disturbed unless “clearly unlawful”.

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

Am. Code Co., 280 U.S. 445, 449 (1930); see also United States v.

Catto, 384 U.S. 102 (1966); Schlude v. Commissioner, 372 U.S.

128, 133-134 (1963); Am. Auto. Association v. United States, 367

U.S. 687, 697-698 (1961); Auto. Club of Mich. v. Commissioner,

353 U.S. 180, 189-190 (1957); Brown v. Commissioner, 291 U.S.

193, 203 (1934).   Taxpayers challenging the Commissioner’s

authority must prove that the Commissioner’s determination is
                               - 8 -

“clearly unlawful” or “plainly arbitrary”.2    Thor Power Tool Co.

v. Commissioner, supra at 532-533.     The Commissioner’s authority

under section 446(b) encompasses overall methods of accounting,

as well as specific methods used to report any item of income or

expense.   Thor Power Tool Co. v. Commissioner, supra at 780;

Prabel v. Commissioner, 91 T.C. 1101, 1112-1113 (1988), affd. 882

F.2d 820 (3d Cir. 1989); sec. 1.446-1(a), Income Tax Regs.

     The fact that the Commissioner possesses broad authority

under section 446(b) does not mean that the Commissioner can

change a taxpayer’s method of accounting with impunity.     See,

e.g., Prabel v. Commissioner, supra at 1112-1113.     Thus, for

example, if a taxpayer uses a method of accounting that clearly

reflects income, the Commissioner may not require a change to

another method merely because the Commissioner believes that the

latter method will reflect income more clearly.     Ansley-Sheppard-

Burgess Co. v. Commissioner, 104 T.C. 367 (1995); Auburn Packing

Co. v. Commissioner, 60 T.C. 794 (1973); Garth v. Commissioner,

56 T.C. 610 (1971); see also St. James Sugar Coop., Inc. v.

United States, 643 F.2d 1219 (5th Cir. 1981); Photo-Sonics, Inc.

v. Commissioner, 357 F.2d 656, 658 (9th Cir. 1966), affg. 42 T.C.

926 (1964); Bay State Gas Co. v. Commissioner, 75 T.C. 410, 417

(1980), affd. 689 F.2d 1 (1st Cir. 1982).     Likewise, we have


     2
       Petitioner asserts mistakenly that respondent bears the
burden of proving that Diehl’s use of the cash method did not
clearly reflect income.
                                 - 9 -

allowed the use of an accounting method that was challenged by

the Commissioner when the taxpayer’s method clearly reflected

income and the Commissioner’s method did not.    See Rotolo v.

Commissioner, 88 T.C. 1500, 1514 (1987).

     When a taxpayer challenges the Commissioner’s authority

under section 446(b), we inquire whether the accounting method in

issue clearly reflects income.    The answer to this question does

not rest on whether the taxpayer’s method is superior to the

Commissioner’s method, or vice versa.    RLC Indus. Co. & Subs. v.

Commissioner, 98 T.C. 457, 492 (1992), affd. 58 F.3d 413 (9th

Cir. 1995); Wal-Mart Stores, Inc. & Subs. v. Commissioner, T.C.

Memo. 1997-1, affd. 153 F.3d 650 (8th Cir. 1998); see also Brown

v. Helvering, 291 U.S. 193, 204-205 (1934).     Nor does the answer

rest solely on whether a consistently applied method of

accounting is listed in section 446(c) as a “permissible method”.

Sec. 446(b) (Commissioner may change any “method used [that] does

not clearly reflect income”) and (c) (“Subject to the provisions

of subsections (a) and (b), a taxpayer may compute taxable income

under any of the following methods of accounting” (emphasis

added)); see also sec. 1.446-1(a)(2), Income Tax Regs.    Instead,

the answer must be found by analyzing the facts and circumstances

of the case.   Ansley-Sheppard-Burgess Co. v. Commissioner, supra;

Peninsula Steel Prods. & Equip. Co. v. Commissioner, 78 T.C.

1029, 1045 (1982).
                                  - 10 -

     A special rule may apply where a taxpayer sells merchandise

as part of its ordinary business.      Under section 471(a),

     Whenever in the opinion of the Secretary the use of
     inventories is necessary in order clearly to determine
     the income of any taxpayer, inventories shall be taken
     by such taxpayer on such basis as the Secretary may
     prescribe as conforming as nearly as may be to the best
     accounting practice in the trade or business and as
     most clearly reflecting the income.

Applicable regulations clarify that a taxpayer must account for

inventories whenever the production, purchase, or sale of

merchandise is an income-producing factor in the taxpayer’s

business.    Sec. 1.471-1, Income Tax Regs.     Other pertinent

regulations mandate that a taxpayer who is required to maintain

inventories must use an accrual method with regard to purchases

and sales.    See sec. 1.446-1(c)(2)(i), Income Tax Regs.

     Section 448 does not displace this special rule.3      That


     3
         Sec. 448 provides:

     SEC. 448. LIMITATION ON USE OF CASH METHOD OF
               ACCOUNTING.

          (a) General Rule.--Except as otherwise provided in
     this section, in the case of a--

                 (1) C corporation,

                  *   *       *   *    *    *     *

     taxable income shall not be computed under the cash
     receipts and disbursements method of accounting.

            (b) Exceptions.--

                  *   *       *   *    *    *     *

                 (3) Entities with gross receipts of not
                                                     (continued...)
                                - 11 -

section generally prohibits a C corporation from using the cash

method.    Sec. 448(a)(1).   Although section 448(b)(3) provides an

exception to this prohibition in the case of a C corporation that

satisfies the $5 million gross receipts test of section

448(c)(1), we read nothing in section 448 that provides that a C

corporation may use the cash method merely because it meets that

exception.    In fact, section 1.448-1T(c), Temporary Income Tax

Regs., 52 Fed. Reg. 22767 (June 16, 1987), explains clearly the

effect of section 448 on section 446(b).    That section states:

            nothing in section 448 affects the authority
            of the Commissioner under section 446(b) to
            require the use of an accounting method that
            clearly reflects income * * *. For example, a
            taxpayer using the cash method may be required
            to change to an accrual method of accounting
            under section 446(b) because such method
            clearly reflects that taxpayer’s income, even
            though the taxpayer is not prohibited by
            section 448 from using the cash method. * * *

     Petitioner also asserts that Diehl did not sell merchandise

that was an income-producing factor in its business.    We

disagree.    The term “merchandise” includes any item held for

sale.    Osteopathic Med. Oncology & Hematology, P.C. v.

Commissioner, 113 T.C. 376, 382-383 (1999); see also Wilkinson-

Beane, Inc. v. Commissioner, 420 F.2d 352, 354-355 (1st Cir.


     3
        (...continued)
            more than $5,000,000.--Paragraphs (1) and (2)
            of subsection (a) shall not apply to any
            corporation or partnership for any taxable
            year if, for all prior taxable years
            beginning after December 31, 1985, such
            entity met the $5,000,000 gross receipts test
            * * *.
                               - 12 -

1970), affg. T.C. Memo. 1969-79.    Merchandise is an income-

producing factor whenever its cost is significant to the

taxpayer’s gross receipts computed under the cash method.    See,

e.g., Wilkinson-Beane, Inc. v. Commissioner, supra at 355

(income-producing factor where cost of coffin was included in

price of funeral package and represented 15.4 percent and 14.7

percent of cash basis receipts); Knight-Ridder Newspapers, Inc.

v. United States, 743 F.2d 781, 790 (11th Cir. 1984) (17.6

percent of total cash receipts suggests that items are an

income-producing factor); Thompson Elec., Inc. v. Commissioner,

T.C. Memo. 1995-292 (income-producing factor where cost of

materials consisted of 37 percent to 44 percent of gross

receipts).    Merchandise may be properly characterized as an

income-producing factor even if it is not maintained in yearend

inventory.4   J.P. Sheahan Associates., Inc. v. Commissioner, T.C.

Memo. 1992-239.

     In the case of Diehl, it manufactured or purchased all of

its products, and its sale of those products was its only source

of income.    Under the facts at hand, we conclude that Diehl’s

products were “merchandise” and that Diehl’s sale of its

merchandise was an income-producing factor in its business.


     4
       In this regard, we disagree with petitioner that it is a
per se abuse of discretion when respondent’s change in method of
accounting generates adjustments to accounts receivable and not
to the amount of inventory at either the beginning or end of the
year. We also disagree with petitioner’s assertion that the
fluctuation of the amount of yearend inventory is dispositive to
our analysis.
                               - 13 -

Accord Applied Communications, Inc. v. Commissioner, T.C. Memo.

1989-469 (seller of prepackaged software required to use accrual

method to report its “software sales”).   Petitioner invites the

Court to hold that Diehl’s primary product was not “merchandise”

under section 1.471-1, Income Tax Regs., because it was

intellectual property.   We decline to do so.   Each of Diehl’s

products generally consisted of a package with manuals and a

disk.    We believe that where this package is held for sale as an

item and imbued with the characteristics which one normally

associates with merchandise, it is “merchandise” for purposes of

section 1.471-1, Income Tax Regs.   Given the fact that most of

Diehl’s sales involved transfers of tangible products, the

purchase and sale of those products required Diehl, on the basis

of the record at hand, to use an overall accrual method as

determined by respondent.5

     Petitioners’ final argument centers on the fact that Diehl

changed from the cash method to an accrual method 2 years after

the subject year in order to comply with section 448(a).

Petitioner rationalizes on brief that requiring the change in the

subject year is “unreasonable, offering no practical benefit to


     5
       The fact that Diehl’s business is product oriented, rather
than service oriented, also distinguishes this case from
Honeywell v. Commissioner, T.C. Memo. 1992-453, affd. 74 AFTR 2d
5192 (8th Cir. 1994), the primary case relied upon by petitioner.
There, the Court held that the taxpayer, a servicer of computer
equipment, did not have to inventory the materials which it used
in its businesses because those materials were incidental to its
service-oriented business. See also Osteopathic Med. Oncology &
Hematology, P.C. v. Commissioner, 113 T.C. 376 (1999).
                              - 14 -

the Government, and is therefore an abuse of discretion.”    We

disagree.   The change for the subject year was neither

unreasonable nor an abuse of discretion; adjustments to prevent

amounts from being duplicated or omitted were specifically

required to be made in the first year in which Diehl’s method of

accounting was changed to an accrual method.6    See sec.

481(a)(1); sec. 1.481-1(a)(1), Income Tax Regs.; see also Suzy’s

Zoo v. Commissioner, 114 T.C. 1, 12-13 (2000).

     Petitioner has failed to demonstrate that the Commissioner’s

determination was clearly unlawful or plainly arbitrary.

Accordingly, we hold that respondent did not abuse his discretion

under section 446 when he determined that Diehl had to change

from its hybrid method to an accrual method.    All arguments for a

contrary holding have been considered and have been rejected as

meritless to the extent not discussed.

                                         Decision will be entered

                                    for respondent.




     6
       Petitioner also notes that the Commissioner had previously
examined some of Diehl’s earlier returns and had not changed
Diehl’s use of the cash method on those returns. Petitioner
suggests that the Commissioner is estopped from making the sec.
481 adjustment for the subject year. We find this suggestion
unavailing. The fact that the Commissioner had the opportunity
to, but did not, change an improper method of accounting in an
earlier year does not mean that he is estopped from making the
change in the later year. See Knight-Ridder Newspapers Inc. v.
United States, 743 F.2d 781 (11th Cir. 1984).
