                        T.C. Memo. 2001-126



                      UNITED STATES TAX COURT



             CROSS OIL COMPANY, INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 19154-99.                 Filed May 30, 2001.



     Paul E. Northcutt, for petitioner.

     Ann L. Darnold, for respondent.


             MEMORANDUM FINDINGS OF FACT AND OPINION

     COHEN, Judge:   Respondent determined deficiencies of $20,596

and $15,803 in petitioner’s Federal income tax for the years

ended June 30, 1996, and June 30, 1997, respectively.    The

parties agree that the notice of deficiency contains a

mathematical error in the computation of the section 481 tax

amount and that the deficiency in dispute is $15,720 for the tax

year ended June 30, 1996.   The sole issue for decision is whether
                                - 2 -

it was an abuse of respondent’s discretion, under section 446, to

require petitioner to change from the cash method of accounting

to the accrual method of accounting in order to reflect clearly

the income of petitioner’s oil and gas business.

     Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.

                          FINDINGS OF FACT

     Some of the facts have been stipulated, and the stipulated

facts are incorporated in our findings by this reference.

     Petitioner Cross Oil Company, Inc., is an Oklahoma

corporation with its principal place of business in Ponca City,

Oklahoma.    Petitioner is engaged in the wholesale and retail sale

of gasoline, diesel fuel, oil, and other petroleum products.

     Petitioner sells and distributes a premanufactured product

to its customers.   Petitioner’s sales are mostly in bulk form, in

which large orders of petroleum products are loaded at the local

refinery and delivered directly to the customer by petitioner or

by a contract truck hired by petitioner.     Petitioner also

maintains an inventory, of generally not more than a 2-1/2 week

supply of products, at its business location.     The inventory that

is available for sale at petitioner’s place of business is either

delivered to or picked up by the customers.     Petitioner’s

purchases of petroleum products are made as a 10-day net sale
                                       - 3 -

from the local refinery, and payments for all invoices are made

by an automatic draft from petitioner’s checking account on the

10th day following any purchase.           All invoices for the sale of

products to customers by petitioner use a 10-day net collection

period.

     Richard and Vivian Cross, who together own 100 percent of

petitioner, incorporated the business from a sole proprietorship

in 1978.     Petitioner has maintained its books and records using

the cash or hybrid method of accounting since its incorporation.

Petitioner has reported its income for Federal tax purposes using

the cash method of accounting.

     Petitioner’s financial information is summarized in the

following charts.          Petitioner’s ending inventory, gross sales,

and percentages of ending inventory to gross sales are as

follows:
                                                              Percentage of
                                Ending          Gross       Ending Inventory
            Year Ended         Inventory        Sales        to Gross Sales

           June 30, 1996       $104,148    $2,119,386              4.91
           June 30, 1997         96,513     2,590,025              3.73

Petitioner’s purchases, gross receipts, and percentages of

purchases to gross receipts are as follows:

                                                              Percentage of
                                                                Purchases
                                                 Gross           to Gross
           Year Ended          Purchases        Receipts         Receipts

          June 30, 1996       $1,765,594       $2,119,386            83
          June 30, 1997        2,288,090        2,590,025            88
                                    - 4 -

Petitioner’s total income (i.e., gross income less cost of goods

sold) that was computed under the cash method and accrual method

of accounting, and the differences in amounts and differences as

percentages, are as follows:
                                                      Amount      Percentage
     Year Ended     Cash Method    Accrual Method   Difference    Difference

   June 30, 1996    $355,491         $343,704         ($11,787)        (3.4)
   June 30, 1997     264,300          339,748           75,448         22.2

Petitioner’s taxable income (i.e., total income less deductions)

that was computed under the cash method and accrual method of

accounting, and the differences in amounts, are as follows:

                                                            Amount
       Year Ended      Cash Method     Accrual Method      Differenc
                                                               e

        June 30,         $20,649            ($6,759)       ($27,408)
          1996
        June 30,         (16,340)            59,108           75,448
          1997

     Following an audit, the Commissioner sent a notice of

deficiency to petitioner that stated:           “It is determined the

accrual method of accounting more clearly reflects income than

your current ‘Cash Basis’ method of accounting.”

                                   OPINION

     The issue presented is whether it was an abuse of

respondent’s discretion, under section 446, to require

petitioner to change from the cash method of accounting to the

accrual method of accounting in order to reflect clearly the

income of petitioner’s oil and gas business.
                              - 5 -

     Section 446(b) vests the Commissioner with broad discretion

in determining whether a particular method of accounting clearly

reflects income.   See Commissioner v. Hansen, 360 U.S. 446, 467

(1959); Knight-Ridder Newspapers, Inc. v. United States, 743

F.2d 781, 788 (11th Cir. 1984); Ansley-Sheppard-Burgess Co. v.

Commissioner, 104 T.C. 367, 370 (1995); RLC Indus. Co. v.

Commissioner, 98 T.C. 457, 491 (1992), affd. 58 F.3d 413 (9th

Cir. 1995).   The Commissioner’s determination is entitled to

more than the usual presumption of correctness.    See Ansley-

Sheppard-Burgess Co. v. Commissioner, supra at 370; RLC Indus.

Co. v. Commissioner, supra at 491.    Accordingly, the

Commissioner’s interpretation of the “clear-reflection standard

[of section 446(b)] ‘should not be interfered with unless

clearly unlawful.’”   Thor Power Tool Co. v. Commissioner, 439

U.S. 522, 532 (1979) (quoting Lucas v. American Code Co., 280

U.S. 445, 449 (1930)); see also Ansley-Sheppard-Burgess Co. v.

Commissioner, supra at 370.

     The taxpayer bears “a ‘heavy burden of [proof],’” and the

Commissioner’s determination “is not to be set aside unless

shown to be ‘plainly arbitrary.’”     Thor Power Tool Co. v.

Commissioner, supra at 532-533 (quoting Lucas v. Kansas City

Structural Steel Co., 281 U.S. 264, 271 (1930)).    The

Commissioner may not, however, require a taxpayer to change from

an accounting method that clearly reflects income to an
                                - 6 -

alternate method of accounting merely because the Commissioner

considers the alternate method to reflect more clearly the

taxpayer’s income.   See Ansley-Sheppard-Burgess Co. v.

Commissioner, supra at 371.

     The issue of whether the taxpayer’s method of accounting

clearly reflects income is a question of fact to be determined

on a case-by-case basis.   See id.; Ford Motor Co. v.

Commissioner, 102 T.C. 87, 91-92 (1994), affd. 71 F.3d 209 (6th

Cir. 1995).   In reviewing the Commissioner’s determination that

the taxpayer’s method of accounting does not clearly reflect

income, the Court must determine whether there is an adequate

basis in law for the Commissioner’s conclusion.    See Ansley-

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

Consequently, to prevail, a taxpayer must prove that the

Commissioner’s determination was arbitrary, capricious, or

without sound basis in fact or law.     See id.; Ford Motor Co. v.

Commissioner, supra at 91-92.

     Respondent determined, pursuant to section 446, that

petitioner was required to change from the cash method to the

accrual method of accounting for income tax purposes based on

respondent’s finding that petitioner’s purchase and resale of

petroleum products was an income-producing factor in

petitioner’s business, and, thus, petitioner was required to

take inventories pursuant to section 1.471-1, Income Tax Regs.,

and was required to use the accrual method of accounting
                                - 7 -

pursuant to section 1.466-1(c)(2)(i), Income Tax Regs., to

reflect accurately the income of its business activities.

     Petitioner maintains that its cash method of accounting

more clearly reflects the income and expenses of its business.

Petitioner argues that respondent may not change its method of

accounting from one that clearly reflects income to another

method of accounting because the Commissioner determines that

the alternate method will reflect petitioner’s income more

clearly.

     Section 446 provides:

     SEC. 446.    GENERAL RULE FOR METHODS OF ACCOUNTING.

          (a) General Rule.–-Taxable income shall be
     computed under the method of accounting on the basis
     of which the taxpayer regularly computes his income in
     keeping his books.

          (b) Exceptions.–-If no method of accounting has
     been regularly used by the taxpayer, or if the method
     used does not clearly reflect income, the computation
     of taxable income shall be made under such method as,
     in the opinion of the Secretary, does clearly reflect
     income.

          (c) Permissible Methods.-–Subject to the
     provisions of subsections (a) and (b), a taxpayer may
     compute taxable income under any of the following
     methods of accounting-–

               (1) the cash receipts and disbursements
           method;

                 (2) an accrual method;

               (3) any other method permitted by this
           chapter; or

               (4) any combination of the foregoing methods
           permitted under regulations prescribed by the
           Secretary.
                                - 8 -

Income-Producing Factor

     Respondent determined that the purchase and sale of

petroleum products was merchandise and an income-producing

factor in petitioner’s business.    Even though petitioner

maintains inventories, petitioner argues that its inventories

are not an income-producing factor because the amount of its

inventory at the end of the years in issue was insignificant

and represents 4.91 percent and 3.73 percent, respectively, of

total sales during the years in issue.

     Section 471(a) provides:

     SEC. 471.   GENERAL RULE FOR INVENTORIES.

          (a) General Rule.–-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.

     Under section 1.471-1, Income Tax Regs., a taxpayer must

account for inventories if the production, purchase, or sale of

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

business.   A taxpayer who is required to maintain inventories

must use the accrual method of accounting with regard to

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

Regs.

     Petitioner’s argument that the amount of inventories it

maintains is insignificant ignores the recognized standard used

when evaluating whether petitioner’s petroleum products are an
                              - 9 -

income-producing factor.   That standard requires comparison of

the cost of the merchandise to the taxpayer’s gross receipts

computed under the cash method of accounting.    See Wilkinson-

Beane, Inc. v. Commissioner, 420 F.2d 352, 355 (1st Cir. 1970),

affg. T.C. Memo. 1969-79; Knight-Ridder Newspapers, Inc. v.

United States, 743 F.2d at 790; Euw v. Commissioner, T.C. Memo.

2000-114.

     If the cost of material that a taxpayer uses to provide a

service is substantial compared to its receipts, the material

is a substantial income-producing factor.   See Wilkinson-Beane,

Inc. v. Commissioner, supra at 355 (income-producing factor

where the cost of the 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, supra at 790 (17.6 percent of total cash receipts

suggests that supplies 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).

     Petitioner’s business operations consisting of the sale

and delivery of merchandise are similar to the facts presented

in Euw v. Commissioner, supra.   In Euw, the taxpayer operated a

sand and gravel transportation business that acquired and

delivered sand and gravel to its customers during the same

business day.   The cost of sand and gravel constituted

31 percent of the taxpayer’s gross receipts.    The taxpayer was
                               - 10 -

required to maintain inventories because the Court found that

the sand and gravel were merchandise and an income-producing

factor in the taxpayer’s business.      The taxpayer was required

to report its taxable income on the accrual method of

accounting.   The Court held that the Commissioner did not abuse

his discretion under section 446 when the Commissioner required

the taxpayer to change from the cash method to the accrual

method of accounting.    See id.

     Petitioner’s purchases were substantial and represent

83 percent and 88 percent of its gross receipts in 1996 and

1997, respectively.     Here, petitioner’s purchase of petroleum

products was substantial compared to its gross receipts and, as

such, those products are an income-producing factor in

petitioner’s business.     Petitioner is required to use the

accrual method of accounting, unless it is able to establish

that the cash and accrual methods yield substantially identical

results.

Substantial Identity of Results

     Petitioner argues that a substantial identity of results

exists between its cash method of accounting and the accrual

method of accounting selected by the Commissioner.      Petitioner
                             - 11 -

claims that its receivables, inventory, and payables have

remained consistent from the inception of the business and that

it has not attempted to distort its income by unreasonably

prepaying expenses, purchasing supplies in advance, or delaying

the receipt of payment from its customers.   Respondent argues

that petitioner has failed to demonstrate that there is a

substantial identity of results between the cash method and

accrual method of accounting based on the differences in income

between the cash method and accrual method of accounting.

     The substantial identity of results test is a judicial

creation that was first articulated in Wilkinson-Beane, Inc. v.

Commissioner, supra.   In Wilkinson-Beane, Inc., a cash-method

taxpayer who was required to maintain an inventory and, thus,

report income on the accrual basis argued that the difference

in income that was determined by the method it used and the

method selected by the Commissioner was negligible.   The Court

of Appeals held that, where the Commissioner has determined

that the accounting method that is used by a taxpayer does not

clearly reflect income, "the taxpayer must demonstrate

substantial identity of results between his method and the

method selected by the Commissioner" in order to prevail.     Id.

at 356.   In Ansley-Sheppard-Burgess Co. v. Commissioner, supra

at 377, this Court held that a taxpayer that is required to use

the inventory method of accounting must meet the substantial
                              - 12 -

identity of results test in order to show that the

Commissioner's determination, requiring it to change from the

cash method to the accrual method of accounting, was an abuse

of discretion.

       The Court of Appeals in Wilkinson-Beane, Inc. v.

Commissioner, 420 F.2d at 356, explained that the substantial

identity of results test is a “rigorous standard [that] may

occasionally work a harsh result” and that “the standard * * *

[the taxpayer] must satisfy is extremely high.”    Id. at 356-

357.    In Wilkinson-Beane, Inc., the taxpayer failed to

demonstrate that the cash method of accounting and accrual

method of accounting produced substantial identity of results

where differences in gross income resulting from the different

methods were $2,094.80 and $4,009.76, respectively, during the

years in issue.    The court went on to state that “it must be

borne in mind that regardless of the accuracy of taxpayer’s

cash method in the past, there is no guarantee that the

stability of sales, costs, collections and other factors which

make for that result will continue in the future.”    Id.; see

also Ralston Dev. Corp. v. United States, 937 F.2d 510, 513

(10th Cir. 1991) (cash and accrual methods did not achieve

substantial identity of results where use of the accrual method

increased gross income by $715,515 (157 percent), $467,284 (36

percent), and $739,581 (48 percent)); Tebarco Mech. Corp. v.
                            - 13 -

Commissioner, T.C. Memo. 1997-311 (taxpayer failed to meet the

substantial identity of results test where taxable income under

the cash method of accounting was $54,128 and under the accrual

method of accounting would be $328,549, and where gross

receipts under the accrual method of accounting increased by

$349,769); Thompson Elec., Inc. v. Commissioner, T.C. Memo.

1995-292 (cash method did not produce substantial identity of

results where taxable income under cash method is $138,418 and

$135,958 and under the accrual method is $331,925 and $289,039,

respectively); J.P. Sheahan Associates, Inc. v. Commissioner,

T.C. Memo. 1992-239 (taxpayer failed to meet substantial

identity of results test where variations in taxable income

ranged from a decrease in income of $111,263 to an increase in

income of $99,055); Surtronics, Inc. v. Commissioner, T.C.

Memo. 1985-277 (cash method did not produce substantially

identical results to the accrual method where the use of the

accrual method would increase net income by $132,437 and

$73,673 and increase gross receipts by $148,212 and $92,771,

respectively).

     Petitioner produced several comparative charts that

summarized the differences in income between the cash method

and accrual method of accounting.    Petitioner’s total income

under the cash method of accounting was $355,491 for the year

ended June 30, 1996, and $264,300 for the year ended June 30,
                               - 14 -

1997.     Total income under the accrual method of accounting

would be $343,704 for the year ended June 30, 1996, and

$339,748 for the year ended June 30, 1997.     Thus, a change in

accounting method from the cash method to the accrual method

would yield a decrease in total income of $11,787, or

approximately 3.4 percent, for the year ended June 30, 1996,

and an increase in total income of $75,448, or approximately

22.2 percent, for the year ended June 30, 1997.

     Petitioner’s taxable income for the year ended June 30,

1996, under the cash method of accounting was income of $20,649

and under the accrual method of accounting would be a loss of

$6,759, and a change in the method of accounting would yield a

decrease in taxable income of $27,408.     Petitioner’s taxable

income for the year ended June 30, 1997, under the cash method

of accounting was a loss of $16,340 and under the accrual

method of accounting would be income of $59,108, and a change

in the method of accounting would yield an increase in taxable

income of $75,448.     Consistent with the cases that have been

decided on this issue, we conclude that the cash method and the

accrual method of accounting do not produce substantially

identical results.

Section 448

        Petitioner considers itself a small business that is a

“mom-and-pop” operation.     Petitioner has used the cash method
                                  - 15 -

of accounting since its incorporation, and its owners claim

that they do not understand the accrual method of accounting.

Petitioner contends, based on section 448, that it is a small

business with gross receipts of less than $5 million; it is

exempt from the provision that requires a C corporation to

adopt the accrual method of accounting; and, thus, it should be

allowed to continue to use the cash method to report income for

tax purposes.

     Section 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
          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 * * *.

     The effect of section 448 on section 446(b) is explained

in section 1.448-1T(c), Temporary Income Tax Regs., 52 Fed.

Reg. 22767 (June 16, 1987), which, in pertinent part, provides:
                             - 16 -

          Nothing in section 448 shall have any effect on
     the application of any other provision of law that
     would otherwise limit the use of the cash method, and
     no inference shall be drawn from section 448 with
     respect to the application of any such provision.
     For example, nothing in section 448 affects * * * the
     requirement of section 1.446-1(c)(2) that an accrual
     method be used with regard to purchases and sales of
     inventory. Similarly, 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 * * *

     As discussed above, petitioner maintains inventories that

are an income-producing factor in petitioner’s business and is

required to use the accrual method of accounting.    Thus,

section 1.446-1(c)(2), Income Tax Regs., which limits the use

of the cash method, overrides the exception under section 448

that allows certain corporations to use the cash method of

accounting.   Similarly, section 448 does not affect the

Commissioner’s authority, under section 446(b), to require

petitioner to change from the cash method to the accrual method

of accounting.

     Petitioner has failed to demonstrate that the

Commissioner’s determination was arbitrary, capricious, or

without sound basis in fact or law.   We conclude that

respondent did not commit an abuse of discretion, under section

446, in determining that petitioner is required to change from

the cash method of accounting to the accrual method of

accounting.   We have carefully considered all of the remaining
                            - 17 -

arguments that have been made by the parties for a result

contrary to that expressed herein, and, to the extent not

discussed above, they are irrelevant or without merit.

     To correct the mathematical error in the notice of

deficiency,

                                     Decision will be entered

                              under Rule 155.
