Customer Disputes and Accrual of Income

W manufactures products H and M and sells them to retailers for resale. It uses an accrual method of accounting and a calendar tax year. For Federal income tax purposes, W recognizes gross income from product sales when it ships the product to the retailer.

Situation 1: In October 2002, X, a retailer, orders 1,000 cases of M from W for $15 per case. In November 2002, W ships 1,000 cases of M to X. Due to a data entry mistake, the invoice is improperly stated as $16,000, rather than $15,000. In January 2003, X notifies W of the mistake and subsequently pays the $15,000 to W.

Situation 2: In September 2002, Y, a retailer, orders 600 cases of M from W for $15 per case. In October 2002, W ships 600 cases of H (rather than M) to Y with an invoice for $9,000. In November 2002, Y discovers the mistake and notifies W that it will not pay for H. In January 2003, W and Y settle the dispute by agreeing that Y will pay W $4,500 for the H.

Situation 3: Z is a retailer that purchases H and M from W. Each month, W ships Z 300 cases of H at $10 per case and 700 cases of M at $15 per case. On Dec. 28, 2002, W mistakenly ships 400 cases of H and 600 cases of M to Z, with an invoice for $13,000. On Jan. 3, 2003, Z notifies W that it shipped the wrong amounts of H and M. To adjust for the mistake, W ships 200 cases of H and 800 cases of M to Z on Jan. 28, 2003. In February 2003, Z pays W $13,000 for the H and M it received in December 2002; in March 2003, Z pays W $14,000 for the products it received in January 2003.

Under the accrual method, Regs. Secs. 1.446-1(c)(1)(ii)(A) and 1.451-1(a) provide that income is includible in gross income when all events have occurred that fix the right to receive the income, and the amount thereof can be determined with reasonable accuracy. All the events that fix the right to receive income occur when (1) the required performance takes place, (2) payment is due or (3) payment is made, whichever happens first.

According to Regs. Sec. 1.446-1(e)(2)(ii)(b), a change in accounting method does not include correction of mathematical or posting errors, or errors in the computation of a tax liability.

Regs. Sec. 1.451-1(a) provides that if a taxpayer improperly accrues an income amount on the basis of a reasonable estimate and subsequently determines the exact amount, the difference (if any) should be taken into account for the tax year in which the determination is made. Additionally, if a taxpayer ascertains that an item was improperly included in gross income in a prior tax year, the taxpayer should file (if within the limitations period) a claim for credit or refund of any tax overpayment arising therefrom (Gould-Mersereau Co., 21 BTA 1316 (1931), acq., 1931-2 CB 27). If the right to income is substantially in controversy, the taxpayer may not accrue the income until the controversy is resolved (North American Oil Consolidated, 286 US 417 (1932)).

In Situation 1, Ws 2002 invoice to X is for an improper amount, resulting from a clerical mistake. As such, W may not accrue $16,000 of gross sales in 2002, because it does not have a fixed right to that amount. Instead, it accrues $15,000 in gross sales and includes that amount (less the corresponding cost of goods sold) in its 2002 gross income.

Generally, if W has already filed its 2002 return when the mistake is discovered, W should file (if within the limitations period) a claim for refund of any tax overpayment arising from reporting the improper amount on that return. If, however, W has regularly and consistently treated invoice amounts as a reasonable estimate of accrued income for a period of two or more tax years and it later determines that the exact amount was different and has taken the difference into account for the tax year in which it made such determination, W should seek consent for an accounting-method change if it wants to begin taking such differences into account in the year of sale.

In Situation 2, the dispute arises in the tax year of sale. Because W does not have a fixed right to the income, it cannot include any amount from that transaction (including the corresponding cost of goods sold) in gross income in 2002. W accrues $4,500 of gross sales and includes $4,500 (less the corresponding cost of goods sold) in gross income in 2003, when W and Y settle their dispute.

In Situation 3, W mistakenly ships the wrong amount of H and M to Z in December 2002 and sends an invoice for $13,000 to Z. However, because Z does not dispute the shipment, W has a fixed right to income from the 2002 shipment. Accordingly, W accrues $13,000 of gross sales and includes $13,000 (less the corresponding cost of goods sold) in gross income in 2002, because the all-events test is met.

Rev. Rul. 2003-10, IRB 2003-3