2001 Tax Ct. Memo LEXIS 323">*324 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 for its taxable year ended May 31, 1995 (1995 taxable year). ¹ We must decide whether 2001 Tax Ct. Memo LEXIS 323">*325 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. Unless2001 Tax Ct. Memo LEXIS 323">*326 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 software2001 Tax Ct. Memo LEXIS 323">*327 produced by third parties. (We 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 considered2001 Tax Ct. Memo LEXIS 323">*328 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 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:

2001 Tax Ct. Memo LEXIS 323">*329 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 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:

  2001 Tax Ct. Memo LEXIS 323">*330         

Second, respondent made a $ 214,309 adjustment to reflect the current year's application of an accrual method to the following items:

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 asserts2001 Tax Ct. Memo LEXIS 323">*331 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 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 little2001 Tax Ct. Memo LEXIS 323">*332 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.

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">439 U.S. 522, 439 U.S. 522">532, 58 L. Ed. 2d 785">58 L. Ed. 2d 785, 99 S. Ct. 773">99 S. Ct. 773 (1979); 2001 Tax Ct. Memo LEXIS 323">*333 Commissioner v. Hansen, 360 U.S. 446">360 U.S. 446, 360 U.S. 446">467, 3 L. Ed. 2d 1360">3 L. Ed. 2d 1360, 79 S. Ct. 1270">79 S. Ct. 1270 (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 439 U.S. 522">439 U.S. at 532-533; Lucas v. Am. Code Co., 280 U.S. 445">280 U.S. 445, 280 U.S. 445">449, 74 L. Ed. 538">74 L. Ed. 538, 50 S. Ct. 202">50 S. Ct. 202 (1930); see also United States v. Catto, 384 U.S. 102">384 U.S. 102, 16 L. Ed. 2d 398">16 L. Ed. 2d 398, 86 S. Ct. 1311">86 S. Ct. 1311 (1966); Schlude v. Commissioner, 372 U.S. 128">372 U.S. 128, 372 U.S. 128">133-134, 9 L. Ed. 2d 633">9 L. Ed. 2d 633, 83 S. Ct. 601">83 S. Ct. 601 (1963); Am. Auto. Association v. United States, 367 U.S. 687">367 U.S. 687, 367 U.S. 687">697-698, 6 L. Ed. 2d 1109">6 L. Ed. 2d 1109, 81 S. Ct. 1727">81 S. Ct. 1727 (1961); Auto. Club of Mich. v. Commissioner, 353 U.S. 180">353 U.S. 180, 353 U.S. 180">189-190, 1 L. Ed. 2d 746">1 L. Ed. 2d 746, 77 S. Ct. 707">77 S. Ct. 707 (1957); Brown v. Commissioner, 291 U.S. 193">291 U.S. 193, 291 U.S. 193">203, 54 S. Ct. 356">54 S. Ct. 356, 78 L. Ed. 725">78 L. Ed. 725 (1934). Taxpayers challenging the Commissioner's authority must prove that the Commissioner's determination is "clearly unlawful" 2001 Tax Ct. Memo LEXIS 323">*334 or "plainly arbitrary". ²Thor Power Tool Co. v. Commissioner, supra 439 U.S. 522">439 U.S. 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 439 U.S. at 780; Prabel v. Commissioner, 91 T.C. 1101">91 T.C. 1101, 91 T.C. 1101">1112-1113 (1988), affd. 882 F.2d 820">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 91 T.C. 1101">91 T.C. 1112-1113. Thus, for example, if a taxpayer uses a method of accounting that clearly reflects income, the Commissioner may not require a change2001 Tax Ct. Memo LEXIS 323">*335 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">104 T.C. 367 (1995);Auburn Packing Co. v. Commissioner, 60 T.C. 794">60 T.C. 794 (1973); Garth v. Commissioner, 56 T.C. 610">56 T.C. 610 (1971); see also St. James Sugar Coop., Inc. v. United States, 643 F.2d 1219">643 F.2d 1219 (5th Cir. 1981); Photo-Sonics, Inc. v. Commissioner, 357 F.2d 656">357 F.2d 656, 357 F.2d 656">658 (9th Cir. 1966), affg. 42 T.C. 926">42 T.C. 926 (1964); Bay State Gas Co. v. Commissioner, 75 T.C. 410">75 T.C. 410, 75 T.C. 410">417 (1980), affd. 689 F.2d 1">689 F.2d 1 (1st Cir. 1982). Likewise, we have 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">88 T.C. 1500, 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 vice2001 Tax Ct. Memo LEXIS 323">*336 versa. RLC Indus. Co. & Subs. v. Commissioner, 98 T.C. 457">98 T.C. 457, 98 T.C. 457">492 (1992), affd. 58 F.3d 413">58 F.3d 413 (9th Cir. 1995);Wal-Mart Stores, Inc. & Subs. v. Commissioner, T.C. Memo. 1997-1, affd. 153 F.3d 650">153 F.3d 650 (8th Cir. 1998); see also Brown v. Helvering, 291 U.S. 193">291 U.S. 193, 291 U.S. 193">204-205, 78 L. Ed. 725">78 L. Ed. 725, 54 S. Ct. 356">54 S. Ct. 356 (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. 104 T.C. 367">Ansley-Sheppard-Burgess Co. v. Commissioner, supra; Peninsula Steel Prods. & Equip. Co. v. Commissioner, 78 T.C. 1029">78 T.C. 1029, 78 T.C. 1029">1045 (1982).

A special rule may apply where a taxpayer sells merchandise as part of its ordinary business. Under section 471(a),

2001 Tax Ct. Memo LEXIS 323">*337   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 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 corporation2001 Tax Ct. Memo LEXIS 323">*338 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:

2001 Tax Ct. Memo LEXIS 323">*339

   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">113 T.C. 376, 113 T.C. 376">382-383 (1999); see also Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d 352">420 F.2d 352, 420 F.2d 352">354-355 (1st Cir. 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., 2001 Tax Ct. Memo LEXIS 323">*340 420 F.2d 352">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">743 F.2d 781, 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 year end inventory. ⁴J.P. Sheahan Associates., Inc. v. Commissioner, T.C. Memo. 1992-239.

2001 Tax Ct. Memo LEXIS 323">*341 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. 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. 2001 Tax Ct. Memo LEXIS 323">*342 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 the Government, and is therefore an abuse of discretion. " We disagree. The change for the subject2001 Tax Ct. Memo LEXIS 323">*343 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">114 T.C. 1, 114 T.C. 1">12-13 (2000).

Petitioner has failed2001 Tax Ct. Memo LEXIS 323">*344 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.