                         T.C. Memo. 2003-95



                       UNITED STATES TAX COURT



 COLOR ARTS, INC., JOHN P. CSEPELLA, A PERSON OTHER THAN THE TAX
                   MATTERS PERSON, Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 5619-00.               Filed March 31, 2003.



     Jeffrey R. Brodek, for petitioner.

     J. Paul Knap, for respondent.



                         MEMORANDUM OPINION


     RUWE, Judge:    This case is before the Court fully stipulated

under Rule 122.1    The stipulation of facts, supplemental



     1
      All Rule references are to the Tax Court Rules of Practice
and Procedure, and unless otherwise indicated, all section
references are to the Internal Revenue Code in effect for the
year at issue.
                               - 2 -

stipulation of fact, stipulation of settled issue and remaining

issue, and the accompanying exhibits are incorporated herein by

this reference.

     This case arises from a Notice of Final S Corporation

Administrative Adjustment (FSAA) issued by respondent adjusting

Color Arts, Inc.’s (Color Arts) Federal income tax return for its

taxable year ending December 31, 1996 (1996 return).   Respondent

concluded, and petitioner has now conceded, inter alia, that a

$245,000 deduction for accrued vacation pay claimed on Color

Arts’s 1996 return was not allowable.2   The sole issue for

decision is whether Color Arts’s method of accounting for

vacation pay has been changed so as to require an adjustment

pursuant to section 481(a).

Background

     During the period at issue, Color Arts was an S corporation

within the meaning of the Code.   Color Arts filed Form 1120S,

U.S. Income Tax Return for an S Corporation, for its tax year

ended December 31, 1996.   Color Arts’s overall method of

accounting was the accrual method.

     At the time the FSAA was issued and the petition was filed,

Color Arts’s principal place of business was located in Racine,

Wisconsin.



     2
      The FSAA contained another adjustment, but that issue was
resolved by the parties.
                               - 3 -

     Vacation Pay Deduction

     On its 1996 return, Color Arts claimed a deduction of

$1,368,653.06 in salaries and wages.    Included in this figure was

accrued vacation pay of $245,000.    Respondent disallowed the

claimed deduction for vacation pay (disallowed vacation pay).

     Under Color Arts’s vacation pay policy, employees were

eligible to earn vacation pay conditionally during the year.

However, except in the case of death, disability, or retirement,

an employee was not entitled to receive vacation pay “earned”

during the year unless the employee was still employed by Color

Arts on the first working day of the following year.    The first

working day of 1996 was January 2, 1996, and the first working

day of 1997 was January 2, 1997.    Petitioner concedes that the

$245,000 accrued vacation pay was improperly deducted because

that expense was not properly accrued as of the end of 1996.

The parties also agree that the $245,000 disallowed vacation pay

deduction is properly claimed on Color Arts’s 1997 return.

     Color Arts had the same vacation pay policy in force and

accounted for accrued vacation pay in the same way in 1994 and

1995 that it had in 1996.   On its 1995 return, Color Arts claimed

a deduction for accrued vacation pay in the amount of

$271,671.04, which was attributable to employment during 1995.

The $271,671.04 vacation pay deduction claimed on Color Arts’s

1995 return did not accrue until the first working day of 1996.
                               - 4 -

Thus, the $271,671.04 deduction for vacation pay was prematurely

claimed on Color Arts’s 1995 return and should have been deducted

on Color Arts’s 1996 return.   Respondent did not examine Color

Arts’s return for any period before 1996.3

     Color Arts never requested consent from respondent to change

its method of accounting for vacation pay for 1996.

Discussion

     1.   Color Arts’s Entitlement to Deduction of Accrued
          Vacation Pay

     In the petition, petitioner argues that Color Arts is

entitled to claim on its 1996 return a deduction of $271,671.04

for vacation pay properly accrued in 1996.   For support,

petitioner looks to section 461(a) and the regulations

promulgated thereunder.   Petitioner argues that under the “all

events” test the $271,671.04 of vacation pay accrued in 1996.

Secs. 461(h); 1.461-1(a)(2), Income Tax Regs.   Respondent does

not dispute petitioner’s contention; his briefs assume Color

Arts’s entitlement to the $271,671.04 deduction in 1996.

However, respondent argues that since Color Arts’s method of

accounting for accrued vacation pay has been changed, an




     3
      The period of limitations on assessment for taxable years
before 1996 has expired.
                                 - 5 -

adjustment under section 481(a) should be made to avoid a

duplication of the deduction.4

     2.   Section 481(a) Adjustment

     Section 481 mandates the imposition of an “adjustment”

determined “to be necessary solely by reason of the change [in

accounting method] in order to prevent amounts from being

duplicated or omitted”.   Sec. 481(a)(2).   The required adjustment

is made in the “year of the change”.     Sec. 1.481-1(a)(1), Income

Tax Regs.   “The ‘year of the change’ is the taxable year for

which the taxable income of the taxpayer is computed under a

method of accounting different from that used for the preceding

taxable year.”   Id.   Here, the year of the purported change is

1996. Without a section 481(a) adjustment of a like amount, Color

Arts would receive a duplicate deduction of $271,671.04.

     Petitioner argues that there was no change made in Color

Arts’s method of accounting, and therefore section 481 has no

application.

     3.   Change of Accounting Method

     Generally, taxable income must be computed under the method

of accounting by which the taxpayer regularly computes his income



     4
      Respondent contends that if Color Arts is entitled to a
deduction of $271,671.04 on its 1996 return for accrued vacation
pay, without the imposition of a sec. 481 adjustment in the same
amount, Color Arts will receive a double deduction. As stated
above, Color Arts already deducted $271,671.04 as “accrued”
vacation pay on its 1995 return.
                                - 6 -

on his books.   Sec. 446(a).   However, if the method of accounting

employed by the taxpayer 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.”

Sec. 446(b).    Respondent adjusted Color Arts’s income concluding

that it was improperly deducting accrued vacation pay.5

     The parties agree that Color Arts’s method of computing its

deduction for vacation pay was incorrect.   However, the parties

disagree on how this error should be perceived and thus labeled.

Respondent argues that he changed Color Arts’s method of

accounting, and petitioner argues that Color Arts merely

“overlooked” a fact in computing the deduction.   Petitioner

contends that Color Arts made a factual error in preparing its

1996 income tax return when it overlooked the fact that employees

had to be employed on the first working day of 1997 in order to

earn vacation pay attributable to work performed in 1996.   As

discussed infra, we agree with respondent that Color Arts’s

method of accounting for vacation pay was changed.




     5
      Respondent has broad authority to change Color Arts’s
method of accounting if in his opinion it does not clearly
reflect income. Thor Power Tool Co. v. Commissioner, 439 U.S.
522, 540 (1979).
                               - 7 -

     The Code does not specifically define “accounting method”.6

However, “A change in the method of accounting includes a change

in the overall plan of accounting for gross income or deductions

or a change in the treatment of any material item used in such

overall plan.”   Sec. 1.446-1(e)(2)(ii)(a), Income Tax Regs.    A

method of accounting includes “the consistent treatment of a

recurring, material item, whether that treatment be correct or

incorrect.”7   H.F. Campbell Co. v. Commissioner, 53 T.C. 439, 447

(1969), affd. 443 F.2d 965 (6th Cir. 1971).     “A change in method

of accounting occurs even when there is a change from an

incorrect to a correct method of accounting.”     Wayne Bolt & Nut

Co. v. Commissioner, 93 T.C. 500, 511 (1989) (citing First Natl.

Bank of Gainesville v. Commissioner, 88 T.C. 1069, 1085 (1987),

H.F. Campbell Co. v. Commissioner, supra; Dearborn Gage Co. v.

Commissioner, 48 T.C. 190, 197-198 (1967)).     “A material item is

any item which involves the proper time for the inclusion of the


     6
      Sec. 446(c) dictates the accounting methods which taxpayers
may use in computing their taxable income. Among the permissible
methods are “(1) the cash receipts and disbursements method; (2)
an accrual method; * * * or (4) any combination of the foregoing
methods”.
     7
      Consistent treatment of an item is shown by 2 or more
taxable years of application. Johnson v. Commissioner, 108 T.C.
448, 494 (1997), affd. in part and revd. in part 184 F.3d 786
(8th Cir. 1999); Rev. Proc. 97-27, 1997-1 C.B. 680; cf. sec.
1.446-1(e)(2)(ii)(a), Income Tax Regs. (“Although a method of
accounting may exist under this definition without the necessity
of a pattern of consistent treatment of an item, in most
instances a method of accounting is not established for an item
without such consistent treatment.”).
                              - 8 -

item in income or the taking of a deduction.”     Sec. 1.446-

1(e)(2)(ii)(a), Income Tax Regs.; see Knight-Ridder Newspapers,

Inc. v. United States, 743 F.2d 781, 798 (11th Cir. 1984); Wayne

Bolt & Nut Co. v. Commissioner, supra at 510.     Accordingly, “An

accounting practice involving the timing of when an item is

deducted is considered a method of accounting.”     FPL Group, Inc.

v. Commissioner, 115 T.C. 554, 562 (2000) (citing GMC v.

Commissioner, 112 T.C. 270, 296 (1999)).

     However, a change in a method of accounting does not occur

when the taxpayer seeks to correct a mathematical or posting

error, an error in the computation of tax liability, a change in

the treatment of an item based upon a change in the underlying

facts, or any other “‘adjustment of any item of income or

deduction which does not involve the proper time for the

inclusion of the item of income or the taking of a deduction.’”

FPL Group, Inc. v. Commissioner, supra at 570 (quoting N. States

Power Co. v. United States, 151 F.3d 876, 883 (8th Cir. 1998));

sec. 1.446-1(e)(2)(ii)(b), Income Tax Regs.

     Petitioner argues that the disallowance of Color Arts’s

$245,000 deduction for vacation pay was based on a change in the

underlying facts and not a change to its method of accounting.

Petitioner relies upon an example in the regulations.     In the

example, an overall accrual method taxpayer changed from a “not

completely vested” vacation pay plan to a “completely vested”
                                 - 9 -

vacation pay plan.   Sec. 1.446-1(e)(2)(iii), Example (3), Income

Tax Regs.   This change had the effect of accruing the vacation

pay deduction in a different taxable year.    The example explains

that since there has been a change in the underlying facts, that

is, a change in the type of vacation pay plan used by the

taxpayer, the taxpayer has not changed his method of accounting.

This example does not support petitioner’s argument because,

unlike the example in the regulations, Color Arts did not change

the operative provisions of its vacation plan.

     In the alternative, petitioner argues that the change in the

way Color Arts computes its vacation pay deduction is simply the

correction of a posting error or an error in the computation of

its tax liability.   See sec. 1.446-1(e)(2)(ii)(b), Income Tax

Regs.   Petitioner likens Color Arts’s situation with that of

taxpayers in cases like N. States Power Co. v. United States,

supra, and Korn Indus., Inc. v. United States, 209 Ct. Cl. 559,

532 F.2d 1352 (1976).     In N. States Power Co. v. United States,

supra at 884, the taxpayer’s tax department was unaware that

certain capital accounts included unrecouped losses.    The

taxpayer filed a refund claim “when it learned that the work

order account included currently deductible contract losses.     In

so doing, it sought to treat the * * * contract losses in the

same manner that it has consistently treated similar types of

losses”.    Id. at 884.   The court held that the taxpayer’s
                              - 10 -

mistakes were not an unauthorized change of accounting method,

but more “akin to posting errors”.     Id. at 885.   Similarly, in

Korn Indus., the court held that where a taxpayer inadvertently

forgot to include several categories of costs in calculating its

finished goods inventory, the subsequent inclusion was not an

accounting method change.   As the court explained, the taxpayer

“did not change to any different method.”     Id. at 1355.

     Our reasoning in Wayne Bolt & Nut Co. v. Commissioner,

supra, is more illustrative of Color Arts’s situation.       For

numerous years before 1982, the taxpayer calculated its opening

and ending inventory using a “seriously flawed” perpetual

inventory record-keeping system.     Id. at 508.   Historically, the

taxpayer verified inventory by taking a partial physical

inventory.   In 1982, the taxpayer performed a complete physical

inventory which indicated that opening inventory for fiscal 1982

was 10 times greater than ending inventory reflected on the books

and as originally reported for the end of the prior fiscal year.

For its 1982 fiscal year, the taxpayer reconstructed its opening

and ending inventory on the basis of the results of the complete

inventory.   We held that “Since * * * [the taxpayer’s] pre-1982

method of determining inventory involved the proper time for

reporting income, it was a ‘material item’” and that the

taxpayer’s “change from a seriously flawed and disorganized

method of determining inventory to a method of determining both
                                - 11 -

opening and ending inventory for fiscal year 1982 on the basis of

a complete physical inventory [was] a change in the treatment of

a material item and, therefore, constitutes a change in

accounting method.”     Id. at 511; accord Knight-Ridder Newspapers,

Inc. v. United States, supra; Firetag v. Commissioner, T.C. Memo.

1999-355 (the Commissioner’s determination that the taxpayer had

previously used an improper method of accounting which involved a

systematic and consistent treatment of a significant item was not

a computational or posting error but rather a change in his

method of accounting), affd. 232 F.3d 887 (4th Cir. 2000).

     The Court of Appeals for the Seventh Circuit, to which this

case is appealable, has decided a substantially similar case.     In

Peoples Bank & Trust Co. v. Commissioner, 415 F.2d 1341 (7th Cir.

1969), affg. 50 T.C. 750 (1968), the taxpayer was a calendar

year, overall accrual method bank which paid interest on its

savings accounts.     Because of the interplay between when the

taxpayer paid interest and its tax year, for 2 months of the year

the taxpayer calculated its interest expense on the basis of a

“fairly accurate” experience factor, although the interest was

not payable until the following tax year.     Like here, the

interest expense failed the “all events test” the Commissioner

corrected the taxpayer’s method, and imposed a section 481(a)

adjustment.   This Court agreed with the Commissioner and

sustained his determination finding that the taxpayer’s method of
                              - 12 -

accounting for interest expense was changed and that the

adjustment was appropriate.   Before the Court of Appeals for the

Seventh Circuit, the taxpayer argued, inter alia, that the

improper accrual was not a change of accounting method but was a

change of a single item.   The court disagreed and explained:

       Section 446(c) defines accounting methods which
       may be used in computing taxable income. Among
       those included are “(1) the cash receipts and
       disbursements method; (2) an accrual method; * * *
       (4) any combination of the foregoing methods
       permitted under regulations prescribed by the
       Secretary or his delegate.” An item which has
       been improperly accrued before it is due would be
       included in “any combination of the foregoing
       methods.” [Id. at 1344 (citing Graff Chevrolet Co.
       v. Campbell, 343 F.2d 568, 569-571 (5th Cir.
       1965)); see sec. 446(c).]

Accordingly, the court held that the Commissioner changed the

taxpayer’s method of accounting for interest expense and applied

section 481, stating:

            When a taxpayer uses an accounting method
       which reflects an expense before it is proper to
       do so or which defers an item of income that
       should be reported currently, he has not succeeded
       (and does not purport to have succeeded) in
       permanently avoiding the reporting of any income;
       he has impliedly promised to report that income at
       a later date, when his accounting method, improper
       though it may be, would require it. Section 481,
       therefore, does not hold the taxpayer to any
       income which he has any reason to believe he has
       avoided, and does not frustrate the policy that
       men should be able, after a certain time, to be
       confident that past wrongs are set at rest. [Id.
       at 1344.]

     Similarly in this case, Color Arts’s method of accounting

for accrued vacation pay has been changed.   Before respondent’s
                                - 13 -

administrative adjustment, Color Arts used an improper method of

accounting that failed to consider the conditional element of its

vacation pay policy.   As a result, Color Arts consistently and

systematically claimed vacation pay deductions before their

proper accrual.8   See sec. 461(h); H.F. Campbell Co. v.

Commissioner, 53 T.C. at 447.     Under Color Arts’s improper method

of accounting, the deduction for vacation pay was accelerated; it

is clearly a “material item” within the contemplation of the

regulations since it “involves the proper time for * * * taking

of a deduction.”   Sec. 1.446-1(e)(2)(ii)(a), Income Tax Regs.

The premature deduction of accrued vacation pay was not due to a

computational or posting error.    The only “error” Color Arts

cites is its application of an improper method of accounting

which resulted in the deduction of vacation pay before its proper

accrual.   Accordingly, we hold that Color Arts’s method of

accounting for its vacation pay has been changed and, as a

result, that section 481 is applicable.

     We disagree with petitioner that if we impose a section

481(a) adjustment, Color Arts will lose “whatever proper

deduction that it should have taken in 1995 because that year is

now a barred tax year under the statute of limitations”.    The

record demonstrates that Color Arts has employed the same


     8
      As stated above, Color Arts employed this improper method
of accounting for vacation pay for at least 3 consecutive tax
years.
                               - 14 -

erroneous method of accounting for vacation pay since at least

1994.9    Since the record is silent, we assume that on its 1994

return Color Arts also prematurely claimed a deduction for

vacation pay which (under the corrected method) should have been

claimed on its 1995 return.    On its 1995 return, Color Arts

prematurely claimed a $271,671.04 deduction for vacation pay.

Respondent examined only Color Arts’s 1996 return.10    Respondent

concluded, and petitioner agrees, that the $245,000 deduction for

accrued vacation pay claimed by Color Arts on its 1996 return

should have been claimed on Color Arts’s 1997 return.

     The record demonstrates that Color Arts consistently claimed

a deduction for vacation pay a year before its proper accrual,

and there is no evidence that any vacation pay deductions are

lost by the imposition of the section 481(a) adjustment.

However, the failure to impose such an adjustment will allow

Color Arts to keep the $271,671.04 deduction it claimed in 1995

in addition to the $271,671.04 deduction in 1996.

Conclusion

     We hold that Color Arts’s method of accounting for its

vacation pay has been changed.    Color Arts is entitled to a



     9
      The record does not indicate how long Color Arts has
employed the erroneous method of premature deduction. Given our
reasoning, infra, we do not think this absence is of substantive
significance.
     10
         See supra note 3.
                              - 15 -

deduction of $271,671.04 of accrued vacation pay on its 1996

return.   However, to avoid the duplication of a deduction as a

result of the change in method of accounting, a section 481(a)

adjustment in the amount of $271,671.04 is appropriate.


                                    An appropriate order will

                               be issued.11




     11
      In his brief, respondent stated that because the parties
settled an issue before trial, a Rule 155 computation will be
required. Rule 155 contemplates only a “deficiency, liability,
or overpayment” and is not appropriate under these circumstances.
The Court does, however, anticipate that the parties will submit
a proposed decision document stating the adjustments to Color
Arts, Inc.’s 1996 income tax return.
