T.C. Memo. 1997-240
UNITED STATES TAX COURT
GALEDRIGE CONSTRUCTION, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 21463-94. Filed May 22, 1997.
P, an asphalt paving contractor, did not account for
inventories and kept its books and filed its returns on the
cash receipts and disbursements method of accounting. R
determined that the sale of merchandise was an income-
producing factor in P's business, that P must, pursuant to
sec. 1.471-1, Income Tax Regs., account for inventories, and
that P must use the accrual method of accounting to clearly
reflect income.
Held: Emulsified asphalt, which becomes useless in less
than 5 hours, is not merchandise held for sale by P. Held,
further, P has no inventories; thus, sec. 1.471-1, Income
Tax Regs., does not apply to P for the taxable years at
issue. Held, further, P's method of accounting clearly
reflects income; R abused her discretion in requiring P to
use the accrual method of accounting.
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John P. McDonnell, for petitioner.
Ronald G. Dong, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
PARR, Judge: Respondent determined deficiencies in
petitioner's Federal income tax for taxable years 1989 and 1990
of $111,613 and $775, respectively. Respondent also determined a
section 6661 addition to petitioner's tax of $27,903 for taxable
year 1989. All section references are to the Internal Revenue
Code in effect for the taxable years in issue, and all Rule
references are to the Tax Court Rules of Practice and Procedure,
unless otherwise indicated. All dollar amounts are rounded to
the nearest dollar.
The issue for decision is: Whether respondent's
determination that petitioner must account for inventories and
use the accrual method of accounting (accrual method) was an
abuse of discretion where petitioner accounted for the materials
consumed in its service business as supplies. We hold it was.1
FINDINGS OF FACT
Some of the facts have been stipulated. The stipulated
facts and the accompanying exhibits are incorporated into our
1
Due to our finding that petitioner is not required to
use an inventory method of accounting, and that respondent abused
her discretion in requiring petitioner to change its method of
accounting, we need not address the issue of whether petitioner
is liable for an addition to tax or penalty for a substantial
understatement of income tax.
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findings by this reference. At the time the petition in this
case was filed, petitioner's principal place of business was
located in Alviso, California. Petitioner keeps its books and
records on the cash method and has always done so. It files its
Federal income tax return using a fiscal year ending June 30.
Petitioner is a corporation engaged in the business of
asphalt paving and related services. Potential customers contact
petitioner, asking for an estimate to perform asphalt paving
work. Petitioner sends an estimator to examine the area to be
paved, to measure it, and to determine the approximate amount of
asphalt needed for the job. The estimator also considers the
equipment, number of workers, and time required to complete the
job. Two jobs could require the same amount of asphalt but have
different costs. For instance, it requires more time, and
possibly different equipment, to pave a parking lot with
structures on it than a wide-open parking lot.
The estimator prepares a "proposed worksheet", which
indicates all the factors involved in estimating a bid price for
a job. During the years in issue, the proposed worksheet had
three cost columns: Equipment, labor, and materials. The
equipment column had spaces to enter a description of the
equipment required, the hours required, and the hourly cost of
the equipment. The labor column had spaces to enter the
laborers' names, the hours required, and the hourly cost of each
laborer. Finally, the materials column had spaces for the
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quantity of asphalt required, the source of the asphalt, and the
unit rate of the asphalt charged by the supplier. Using his or
her best judgment, the estimator filled in the equipment and
labor columns. To fill in the materials column, the estimator
called an asphalt supplier to determine the unit rate for the
asphalt. This rate was then entered into the materials column;
petitioner did not increase the estimated cost of the asphalt.
After each column was completed, the column totals were summed
and combined to arrive at a total direct expense. The total
direct expense was then increased by either 20 or 25 percent to
recover overhead expenses and to make a profit on the job.
The proposal sent to the customer contained a lump-sum bid;
it did not break out the various costs making up the bid.
Petitioner used two or three asphalt suppliers during the years
at issue and generally would not adjust its bids to compete with
an opposing paving contractor. If accepted, the proposal formed
the basis of the contract between petitioner and the customer.2
Once the contract was signed, petitioner obtained the
asphalt to be used in the paving job. Petitioner never acquired
asphalt from a supplier without a signed contract with a
customer.
2
When a job exceeded the scope of the original contract,
petitioner charged the customer on a time and materials basis.
The record is sparse with respect to the specific computation of
the time and materials charge. In any event, it appears that
this type of charge was uncommon.
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In performing its contracts, petitioner took delivery of the
materials directly from the asphalt supplier. Petitioner's
driver picked up the asphalt and took it directly to the job
site. The asphalt had to be laid within 2 to 5 hours from the
time it was picked up from the plant, or it would become rock
hard and have to be thrown away. Petitioner had no way to extend
the time that asphalt is in an emulsified condition. Once the
asphalt hardened, it could not be melted and reused; nor could it
be returned for credit to the asphalt supplier.
Petitioner generally worked on only one job at a time,
lasting a week or less. When the job was finished, petitioner
billed the customer and created an accounts receivable on its
books. The asphalt company sent petitioner an invoice, usually
due within 30 days, which petitioner paid only after it received
payment from its customer. Although petitioner, not the
customer, usually paid the supplier, there were some customers
who paid the supplier directly for the asphalt used on a job.
This was an uncommon event, however, that did not occur during
the years at issue. Occasionally, customers issued a joint check
to petitioner and the supplier so that, in effect, the customer
paid the supplier.
Petitioner's asphalt costs for the tax years 1989 and 1990
were $930,960 and $855,566, respectively. Petitioner deducted
the cost of the asphalt as a supplies expense on its tax returns
for the years at issue.
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OPINION
The principal issue for decision is whether it was an abuse
of respondent's discretion to require petitioner to change from
the cash method of accounting to the accrual method of
accounting.3 Subsumed in this issue is the question of whether
petitioner should be required to use inventories for tax
purposes.4
3
Sec. 446 provides in pertinent part:
SEC. 446(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.
4
Sec. 471 provides in pertinent part:
SEC. 471(a). General Rule.--Whenever in the
opinion of the Secretary the use of inventories is
necessary in order clearly to determine the income of
(continued...)
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A taxpayer that has inventories is required to use the
accrual method, unless it can show that use of another method
(here, the cash method) would produce a substantial identity of
results and that the Commissioner’s determination requiring a
change is an abuse of discretion. Ansley-Sheppard-Burgess Co. v.
Commissioner, 104 T.C. 367, 377 (1995); see also Knight-Ridder
Newspapers, Inc. v. United States, 743 F.2d 781, 789, 791-793
(11th Cir. 1984); Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d
352 (1st Cir. 1970), affg. T.C. Memo. 1969-79.
A. Merchandise
Respondent determined that during the years in issue
petitioner's asphalt was merchandise that was an income-producing
factor, that petitioner therefore had inventories, and thus it
must use the accrual method of accounting in order to clearly
reflect taxable income. Petitioner asserts that it is primarily
in the business of providing service; its clients purchase its
expertise in paving. Furthermore, petitioner contends that
4
(...continued)
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.
By regulation, the Secretary has determined that inventories
are necessary if the production, purchase, or sale of merchandise
is an income-producing factor. Sec. 1.471-1, Income Tax Regs.
Completing the statutory and regulatory scheme, sec. 1.446-
1(c)(2)(i), Income Tax Regs., provides that a taxpayer that has
inventory must also use the accrual method of accounting with
regard to purchases and sales.
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respondent has no authority to require it to use an inventory
method of accounting when there is nothing on hand at the end of
the day to count. Finally, petitioner argues that the asphalt is
neither merchandise nor an income-producing factor.
Petitioner deducted the cost of the asphalt as a supplies
expense under section 162 and section 1.162-3, Income Tax Regs.
Section 162(a) allows a deduction for "all the ordinary and
necessary expenses paid or incurred during the taxable year in
carrying on any trade or business". Section 1.162-3, Income Tax
Regs., provides in pertinent part:
Cost of materials.--Taxpayers carrying materials and
supplies on hand should include in expenses the charges
for materials and supplies only in the amount that they
are actually consumed and used in operation during the
taxable year for which the return is made, provided
that the costs of such materials and supplies have not
been deducted in determining the net income or loss or
taxable income for any previous year. * * *
The statute and regulations do not define "merchandise" or
"inventory", nor do they clearly distinguish between "materials
and supplies" that are not actually consumed and remain on hand,
and inventory. However, we must decide whether the emulsified
asphalt petitioner uses is a supply within the meaning of section
162 or inventory within the meaning of section 471. We begin by
acknowledging that the authorities in this area are not easily
reconcilable.5
5
See Nolan, “Can the Cash Method of Accounting Clearly
Reflect Income?” Tax Notes 1063 (Feb. 24, 1997) and 1175 (March
(continued...)
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At the outset, we note that it is clear that petitioner
provides a service to its clients; if its clients wanted only to
purchase asphalt, they could have done so by dealing directly
with the asphalt supplier.
Previously, we examined certain service transactions to
determine whether the transaction in substance involved solely
the sale of a service, or whether the transaction involved the
sale of a service and merchandise. Wilkinson-Beane, Inc. v.
Commissioner, supra (funeral business's caskets are merchandise);
Thompson Elec., Inc. v. Commissioner, T.C. Memo. 1995-292
(electrical contractor's wire, conduit, and electrical panels are
merchandise); Honeywell Inc. v. Commissioner, T.C. Memo. 1992-453
(taxpayer's "consideration" of cost of rotable parts in
determining amount of fixed fee charged customers in maintenance
service business does not establish that those parts were
acquired and held for sale; held, rotable spare parts are not
merchandise), affd. without published opinion 27 F.3d 571 (8th
Cir. 1994); J.P. Sheahan Associates, Inc. v. Commissioner, T.C.
Memo. 1992-239 (contractor's roofing materials are merchandise);
Surtronics, Inc. v. Commissioner, T.C. Memo. 1985-277
(electroplating metals are merchandise). In this case, we must
decide whether petitioner is a seller of only a service or a
seller of a service and merchandise.
5
(...continued)
3, 1997), and the authorities cited therein.
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Petitioner asserts that respondent has no authority to
require it to use inventory accounting when there is nothing on
hand at the end of the day to count. Petitioner acquired asphalt
directly from the supplier, drove to the job site, and poured it
within a few hours. Any asphalt not laid within 2 to 5 hours of
acquisition hardened and had to be discarded. Thus, hardened-
but-unlaid asphalt was worthless for the job for which it was
ordered and for any other job.
Petitioner’s position has commonsense appeal and some
support in law and in industry practice. See Ansley-Sheppard-
Burgess Co. v. Commissioner, supra (Commissioner agreed that
taxpayer/contractor did not have inventory). Furthermore, until
the early 1990's, the Commissioner generally permitted
construction contractors to account for construction materials
and supplies as supplies, rather than as inventory. See, e.g.,
id. at 375 ("The cash method of accounting has been widely used
throughout the contracting industry and accepted by respondent
since time immemorial."); Hunt Engg. Co. v. Commissioner, T.C.
Memo. 1956-248 (construction contractor purchasing materials for
various jobs as they were needed maintained no inventories; cash
method clearly reflected income).
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Beginning in the early 1990's, the Commissioner began to
require contractors to account for the materials used in
construction as merchandise inventory.6
In J.P. Sheahan Associates, Inc. v. Commissioner, supra, a
roofing company argued that because it ordered materials only on
an “as needed” basis (leftover materials were either returned to
the supplier for credit or held by the taxpayer at one of its
base locations until shipped to a job site), it had no yearend
inventory and therefore did not hold merchandise for sale within
the meaning of the regulations. The Court said:
In so contending, petitioner ignores the fact that the
regulations speak in terms of “every case in which the
production, purchase, or sale of merchandise is an
income-producing factor.” This is the foundation for
the determination by respondent, pursuant to section
471, that inventories should be used; the fact that
such use may produce a zero or minimal year-end
inventory is irrelevant. [Citations omitted.7]
Under J.P. Sheahan Associates, Inc., it is irrelevant
whether the taxpayer has merchandise on hand at the end of the
year for the determination that it must "utilize the inventory
method in computing its taxable income." Id. Thus, the fact
that petitioner had no emulsified asphalt on hand at the end of
6
See Nolan, "Can the Cash Method of Accounting Clearly
Reflect Income?" Tax Notes 1063 (Feb. 24, 1997).
7
In so holding, the Court distinguished as dicta certain
language in Asphalt Prods. Co. v. Commissioner, 796 F.2d 843 (6th
Cir. 1986), affg. in part and revg. in part Akers v.
Commissioner, T.C. Memo. 1984-208.
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the day is not dispositive of the issue of whether it must
maintain an inventory.
It is equally clear from J.P. Sheahan Associates, Inc.,
that before the Commissioner may require the taxpayer to utilize
an inventory method of accounting, the taxpayer must (1) produce,
purchase, or sell merchandise (2) that is an income-producing
factor. Thus, to find that inventories are necessary, we must
first find as fact that petitioner produces, purchases, or sells
merchandise. Honeywell Inc. v. Commissioner, supra. If so, then
we must find that the production, purchase, or sale of that
merchandise is an "income-producing factor". Wilkinson-Beane,
Inc. v. Commissioner, 420 F.2d at 355; Honeywell Inc. v.
Commissioner, supra; sec. 1.471-1, Income Tax Regs.
The fact that petitioner had no emulsified asphalt on hand
at the end of the day is not dispositive of whether it must use
an inventory method of accounting. We think, however, that there
is a significant difference between a taxpayer who has no
material on hand at the end of the year because it was returned
to the supplier for credit, see, e.g., J.P. Sheahan Associates,
Inc. v. Commissioner, supra, and a taxpayer who has no material
on hand at the end of the day because of the ephemeral quality of
the material. Thus, we consider the ephemeral quality of the
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emulsified asphalt to be a factor that must be considered in our
analysis of whether the emulsified asphalt is "merchandise".8
Although not specifically defined in the Internal Revenue
Code (the Code) or the regulations, courts have held that
"merchandise", as used in section 1.471-1, Income Tax Regs., is
an item acquired and held for sale. See, e.g., Wilkinson-Beane,
Inc. v. Commissioner, supra at 354-355 (a canvassing of
authorities in the accounting field yields several definitions,
such as "goods purchased in condition for sale," "goods awaiting
sale," "articles of commerce held for sale," and "all classes of
commodities held for sale"; the common denominator seems to be
that the items in question are merchandise if held for sale);
Honeywell Inc. v. Commissioner, T.C. Memo. 1992-453 (rotable
spare parts are merchandise if they were acquired and held for
sale). Whether an item was acquired and held for sale is
governed by the substance of the transaction and not its form.
Honeywell Inc. v. Commissioner, supra. Thus, to determine whether
an item is "merchandise", we must take into account the
particular facts and circumstances of the taxpayer in each case
and the manner and context in which the taxpayer operates the
8
In construing the word "merchandise" we apply the rule
that "'The natural and ordinary meaning of words will be applied
[in construing tax statutes] unless the Congress has definitely
indicated an intention that they should be otherwise construed'".
Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d 352, 354 (1st
Cir. 1970) (quoting Huntington Sec. Corp. v. Busey, 112 F.2d 368,
370 (6th Cir. 1940)), affg. T.C. Memo. 1969-79.
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business at hand. Wilkinson-Beane, Inc. v. Commissioner, supra;
Thompson Elec., Inc. v. Commissioner, T.C. Memo. 1995-292;
Honeywell Inc. v. Commissioner, supra; J.P. Sheahan Associates,
Inc. v. Commissioner, T.C. Memo. 1992-239.
Previously, this Court has held that a manufacturer/supplier
of emulsified asphalt and asphalt products that maintained a
yearend inventory of raw materials must use the accrual method of
accounting, even though it had no finished product inventory at
the end of the year. Akers v. Commissioner, T.C. Memo. 1984-208,
affd. on this issue and revd. in part sub nom. Asphalt Prods. Co.
v. Commissioner, 796 F.2d 843, 849 (6th Cir. 1986). In Asphalt
Prods. Co., the taxpayer was in the business of manufacturing
emulsified asphalt from pure asphalt using a chemical treatment
and a physical process. It maintained an inventory of raw
materials and had a fixed production plant with large tanks in
which it was able to preserve the emulsified condition of its
finished product, and therefore its marketable quality,
indefinitely.9 The facts of Asphalt Prods. Co. and the case at
9
Very little road contracting work was done by Asphalt
Products in the colder months of December, January, and February.
Asphalt Products generally closed its operations completely in
mid-December, and all of its employees took vacations from mid-
December until early January. Asphalt Products did not keep any
finished product in its tanks during the 2-week shutdown period.
Akers v. Commissioner, supra.
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hand are clearly distinguishable. Petitioner is in the business
of laying emulsified asphalt, not in the business of
manufacturing emulsified asphalt. Petitioner acquires asphalt
from a producer of emulsified asphalt, has no yearend (or even
dayend) inventory of raw materials, and is unable to prevent or
even delay the asphalt from becoming rock hard and worthless
within 2 to 5 hours of its acquisition from the supplier. Thus,
Asphalt Prods. Co. is not dispositive of the issue of whether the
asphalt is merchandise sold by petitioner.
In Thompson Elec., Inc. v. Commissioner, supra, the taxpayer
used materials such as wiring, conduits, electrical panels, and
lighting fixtures in its electrical contracting business. The
taxpayer maintained an inventory of unassigned materials on its
premises that it used for small contracts, in addition to
delivering materials directly from the supplier to its large-
contract customers' sites. The taxpayer reported yearend
inventory of $68,617 and $74,876 for taxable years 1988 and 1989,
respectively. We concluded that the material at issue was
merchandise which was an income-producing factor even though the
taxpayer did not display the material to customers or to the
public, the material was not itemized on bids or invoices nor
separately charged to the customer, the taxpayer did not sell
material separately from its services, and the taxpayer’s
customers generally did not select the materials to be used.
Thus, the fact that petitioner did not sell emulsified asphalt
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separately from its services is not a fact that would preclude
asphalt from being merchandise inventory.
The facts of Thompson Elec., Inc., however, are so different
from the facts of the instant case that it is not dispositive of
the issue of whether asphalt is merchandise. In contrast to the
durable quality of the electrical materials that allowed Thompson
Electric, Inc., to maintain yearend inventories on its premises,
the peculiar physical properties of emulsified asphalt make it
impossible for petitioner to have any item to hold for sale at
the end of the day at either its clients' sites or its own
premises.10
The seminal case on the issue of whether material provided
in conjunction with the sale of a service is merchandise is
Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d 352 (1st Cir.
1970). In Wilkinson-Beane, Inc., the taxpayer was an undertaking
establishment that sold caskets as part of its funeral service.
In construing the word "merchandise", the court used the ordinary
meaning of the word and found that the common denominator in all
the definitions was that the items in question are merchandise if
they are held for sale. Id. at 354-355. In finding caskets were
10
Similarly, the instant case is factually
distinguishable from J.P. Sheahan Associates, Inc. v.
Commissioner, T.C. Memo. 1992-239, on the quality of the material
used in the performance of the contracts. In J.P. Sheahan
Associates, Inc., the record showed that excess roofing materials
were either returned to the seller for credit or held for use on
another job.
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merchandise, the court noted that the taxpayer normally kept an
inventory of some 35 caskets, that the caskets were not
necessarily used during the year they were purchased and
occasionally were carried for long periods of time, and that
there was a direct relationship between the magnificence of the
caskets and the cost of the service. Id.
The factors that led the court to conclude in Wilkinson-
Beane, Inc. that the caskets were merchandise are not present in
the instant case. Using the ordinary meaning of the word
"merchandise", we find that the physical properties of the
emulsified asphalt prevent petitioner from holding it for sale.
Unlike the taxpayer in Wilkinson-Beane, Inc., who was able to
hold a stockpile of 35 caskets through multiple annual accounting
periods without diminished utility, the facts in this case show
that from the moment it received the emulsified asphalt from the
supplier petitioner was joined in a race that had an unalterable
predetermined outcome; within 2 to 5 hours the emulsified asphalt
would be rock hard and worthless. Accordingly, under the facts
and circumstances of this case, we cannot find that the
emulsified asphalt is merchandise.
It is irrelevant that the laid asphalt contained the
potential of providing many years of service to its ultimate
beneficiary, the owner of the paved surface. The utility that
must be considered is that afforded the service provider working
with the material. If petitioner was victorious in the race and
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the asphalt was laid within the brief period that it remained in
its emulsified condition, its change of state into a rock hard
solid provided utility only to the owner of the paved surface.
If, however, petitioner managed no better than to place or show,
and all the emulsified asphalt was not laid within 2 to 5 hours
of receipt, the unlaid amount would become entirely and
irrevocably worthless to everyone. In either event, the utility
provided by the material entirely vanished within 2 to 5 hours of
its receipt. This peculiar physical property of the emulsified
asphalt is a material difference that distinguishes it from the
roofing materials, electrical materials, and caskets of the
aforementioned cases.
Furthermore, unlike Wilkinson-Beane, Inc., the variable
factor in the cost of the service provided by petitioner was the
relative complexity of the client's site, and the additional
amount of labor and machinery required to lay the asphalt on a
more complex site, not the relative "magnificence" of the
material. The facts of the instant case are thus distinguishable
from those of Wilkinson-Beane, Inc. and its progeny.
In Knight-Ridder Newspapers, Inc. v. United States, 743 F.2d
781, 790 (11th Cir. 1984), the Court of Appeals for the Eleventh
Circuit considered the issue of whether the taxpayer, who was in
the business of producing and selling newspapers, was required to
use an inventory method of accounting. The taxpayer argued that
it was in a service business (the business of providing
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information for its readership and running advertisements for its
clients), and that it was not the type of merchandiser envisioned
by the inventory regulations. Id. The court found that even
though the taxpayer sold an extremely perishable commodity (a 2-
day-old newspaper is stale), and therefore it had virtually no
inventories of finished goods, the taxpayer was required to
account for inventories because the sale of merchandise was an
income-producing factor and there was a significant fluctuation
of newsprint and ink on hand, which had a significant effect on
taxable income. Id. at 790-791.
The Court of Appeals also stated that in deciding whether a
taxpayer must adopt inventories, the size of the account and the
fluctuations are relevant. Id. at 791. After discussing the
language in section 1.471-1, Income Tax Regs., that requires
inventories in “every case in which the * * * sale of merchandise
is an income-producing factor”, the court said:
Nevertheless, given that the ultimate goal of the
regulation is “to reflect taxable income correctly,”
id., we hold that purpose is not served where
inventories and inventory fluctuations would be de
minimis and have virtually no effect on the reflection
of income. * * * On the other hand, if either the
absolute level of the inventory account or its
fluctuation during the year would be substantial, then
the taxpayer must use inventories if it meets the other
requirements of section 1.471-1. [Id.]
See also Ezo Products v. Commissioner, 37 T.C. 385, 393 (1961).
Similarly, in Asphalt Prods. Co. v. Commissioner, 796 F.2d
at 849, the court said, in dicta:
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If the temporary and rather insignificant increase in
inventories of raw materials had been the only basis
for the Commissioner’s determination, we would have
been inclined to find an abuse of discretion. We do
not construe the Code provisions and regulations
relating to inventories in the absolute terms adopted
by the Commissioner and the Tax Court. * * *
In contrast to the facts of Knight-Ridder Newspapers, Inc.,
petitioner has no raw materials inventory; thus, there is no
fluctuation in either the absolute value or the value relative to
taxable income. Furthermore, we are unable to find as a fact
that the emulsified asphalt is merchandise. Thus, we find no
factual or legal indicators in Knight-Ridder Newspapers, Inc.
that lead us to conclude that petitioner must use an inventory
method of accounting.
Our analysis of the material at issue, and our finding that
under the facts and circumstances of this case the ephemeral
quality of the emulsified asphalt bars its inclusion in the class
of goods or commodities held for sale as "merchandise", support a
conclusion that is different from, but not contrary to, the
holdings in Wilkinson-Beane, Inc. and its progeny.
We do not interpret section 1.471-1, Income Tax Regs., to
require that if a material is an income-producing factor it must,
per se, be "merchandise". The section provides that "inventories
* * * are necessary in every case in which the production,
purchase, or sale of merchandise is an income-producing factor".
Sec. 1.471-1, Income Tax Regs. (emphasis added). Thus, we find
that the emulsified asphalt is a supply consumed in the operation
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of petitioner's service business, not merchandise. The expense
of the asphalt is properly deducted under section 162 and the
regulations thereunder.11
Since the emulsified asphalt is not merchandise, we do not
reach the question of whether "merchandise is an income-producing
factor" in petitioner's business.
B. Inventory
In construing the word "inventory" we note that the natural
and ordinary meaning of words will be applied in construing tax
statutes unless the Congress has definitely indicated an
11
Furthermore, treating the emulsified asphalt as a
supplies expense because it is consumed in providing service to a
client is not a treatment unique to this case. For instance, the
Commissioner has issued guidance regarding expensing material
consumed in providing service to the taxpayer's customers, see,
e.g., Rev. Rul. 75-407, 1975-2 C.B. 196 (public utility should
continue to deduct the cost of fuel actually consumed and used to
generate electricity distributed during its taxable year), and
for expensing materials consumed in operation of a taxpayer's
business, see, e.g., Rev. Rul. 90-65, 1990-2 C.B. 41 (the cost of
unrecovered platinum from prills used in refining petroleum is a
material or supply expense allowed under sec. 1.162-3, Income Tax
Regs., during period prills are in use; the expense is then
required to be capitalized as provided under sec. 263A).
In addition, provided the taxpayer can verify the amount of
the expense, the Commissioner has allowed deductions for supplies
transferred to clients in the operation of taxpayer's service
business. See, e.g., Tomsykoski v. Commissioner, T.C. Memo.
1974-105 (drugs and supplies provided free of charge to
patients).
Finally, this Court has held that supplies consumed in the
provision of a service are not subject to sec. 1.471-1, Income
Tax Regs. See, e.g., Smith Leasing Co. v. Commissioner, 43 T.C.
37, 40-41 (1964) (truck leasing company allowed to charge cost of
gasoline, tires and tubes, and replacement parts directly to
expense).
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intention that they should be otherwise construed.12 See supra
note 8. Inventory is, simply stated, property that is held for
sale. Grant Oil Tool Co. v. United States, 108 Ct. Cl. 620, 381
F.2d 389, 397 (1967).
We have found that the emulsified asphalt is not merchandise
held for sale by petitioner in the operation of petitioner's
service business, and that petitioner does not keep any raw
materials or finished goods on hand. Previously, the Court of
Appeals for the Second Circuit considered the fact that the
taxpayer had no stock or merchandise on hand and no warehouse or
storeroom for merchandise, and that goods were delivered directly
from the manufacturer to the customer, to be conclusive in
finding that the taxpayer did not maintain inventories. See
Simon v. Commissioner, 176 F.2d 230, 232 (2d Cir. 1949) (buyer
12
"Inventory" is defined in The Random House College
Dictionary (1982) as:
1. a detailed, often descriptive, list of articles, giving
the code number, quantity, and value of each; catalog. * * *
3. a complete listing of merchandise or stock on hand, raw
materials, etc., made each year by a business concern. 4.
the objects or items represented on such a list, as a
merchant's stock of goods. 5. their aggregate value.
Similarly, "inventory" is defined in Webster's Second New
International Dictionary (1957) as:
1. an account, catalog, or schedule, made by an executor or
administrator, of all the goods and chattels, and sometimes
of the real estate, of a deceased person; a list of the
property of a person or estate; hence an itemized list of
goods or valuables, with their estimated worth; specif., the
annual account of stock taken in any business; * * * 2.
Inventoriable goods, hence stock of such; * * * .
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and seller of paper box-board maintained no inventory, was not
engaged in business of "merchandising" requiring use of accrual
method in computing income for Federal income tax purposes).13
If petitioner made "a complete listing of merchandise or stock on
hand, raw materials, etc.", either at the beginning or end of any
day, there could be nothing to list; thus, the amount and value
of petitioner's opening and closing inventory would always be
zero.14 Therefore, we hold that petitioner does not maintain
inventories.
C. Accrual Method of Accounting
Petitioner used the cash receipts and disbursements method
of accounting (cash method) to report its income for the taxable
13
Interpreting the requirements of Reg. 111, sec.
29.22(c)-1. For the taxable year before the court, Reg. 111,
sec. 29.22(c)-1 provided:
Need of Inventories.--In order to reflect the net income
correctly, inventories at the beginning and end of each
taxable year are necessary in every case in which the
production, purchase, or sale of merchandise is an income-
producing factor. * * * Merchandise should be included in
the inventory only if title thereto is vested in the
taxpayer. Accordingly, the seller should include in his
inventory goods under contract for sale but not yet
segregated and applied to the contract and goods out upon
consignment, but should exclude from inventory goods sold
(including containers), title to which has passed to the
purchaser. A purchaser should include in inventory
merchandise purchased (including containers), title to which
has passed to him, although such merchandise is in transit
or for other reasons not been reduced to physical
possession, but should not include goods ordered for future
delivery, transfer of title to which has not yet been
effected.
14
Although cognizant of this fact, respondent proposes to
require petitioner to use an inventory method of accounting "as
if" petitioner had merchandise or stock on hand.
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years at issue. Respondent determined that petitioner had
inventories and therefore was required to use the accrual method
of accounting. We have found that petitioner has no merchandise
inventories; however, our finding does not preclude the
possibility that petitioner may be required to use the method of
accounting selected by respondent in order to clearly reflect
income.
The issue we must decide is whether respondent's
determination that petitioner must report its income on the
accrual method of accounting constitutes an abuse of discretion.
The Commissioner is granted broad discretion in determining
whether a taxpayer's use of an accounting method clearly reflects
income. Sec. 446(b); United States v. Catto, 384 U.S. 102, 114 &
n.22 (1966), rehearing denied 384 U.S. 981 (1966); Commissioner
v. Hansen, 360 U.S. 446, 468 & n.12 (1959); Lucas v. American
Code Co., 280 U.S. 445, 449 (1930). No method of accounting is
acceptable unless, in the opinion of the Commissioner, it clearly
reflects income. Sec. 1.446-1(a)(2), Income Tax Regs. Thus, a
prerequisite to the Commissioner's requirement that a taxpayer
change its present method of accounting is a determination that
the method used by the taxpayer does not clearly reflect income.
Sec. 446(b); Hallmark Cards, Inc. v. Commissioner, 90 T.C. 26, 31
(1988).
Whether an abuse of discretion has occurred depends on
whether the Commissioner's determination is without sound basis
in fact or law. Ansley-Sheppard-Burgess Co. v. Commissioner, 104
- 25 -
T.C. at 371; Ford Motor Co. v. Commissioner, 102 T.C. 87, 91-92
(1994), affd. 71 F.3d 209 (6th Cir. 1995); see Cole v.
Commissioner, 586 F.2d 747, 749 (9th Cir. 1981), affg. 64 T.C.
1091 (1975). The reviewing court's task is not to determine
whether, in its own opinion, the taxpayer's method of accounting
clearly reflects income but to determine whether there is an
adequate basis in law for the Commissioner's conclusion that it
does not. Ansley-Sheppard-Burgess Co. v. Commissioner, supra at
371; Hospital Corp. of Am. v. Commissioner, T.C. Memo. 1996-105.
Consequently, section 446 imposes a heavy burden on the taxpayer
disputing the Commissioner's determination on accounting matters.
Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 532-533
(1979). To prevail, a taxpayer must establish that the
Commissioner's determination is "clearly unlawful" or "plainly
arbitrary". Id. However, if the taxpayer's method of
accounting is specifically authorized by the Code or the
regulations thereunder and has been applied on a consistent
basis, the Commissioner is ordinarily not permitted to reject the
taxpayer's method, as not providing a clear reflection of income,
and require the use of another method. Hallmark Cards, Inc. v.
Commissioner, supra at 31; Peninsula Steel Prods. & Equip. Co. v.
Commissioner, 78 T.C. 1029, 1050 (1982). Furthermore, this Court
has held that the Commissioner cannot require a taxpayer to
change from an accounting method which clearly reflects income to
an alternate method of accounting merely because the Commissioner
considers the alternate method to more clearly reflect the
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taxpayer's income. Molsen v. Commissioner, 85 T.C. 485, 498
(1985); Peninsula Steel Prods. & Equip. Co. v. Commissioner,
supra at 1045; Bay State Gas Co. v. Commissioner, 75 T.C. 410,
422 (1980), affd. 689 F.2d 1 (1st Cir. 1982).
Section 446 specifically authorizes a taxpayer to use the
cash receipts and disbursements method of accounting (cash
method) to compute taxable income, provided it is the method of
accounting the taxpayer regularly uses to compute his income in
keeping his books, and it clearly reflects income. Sec. 446(a),
(b) and (c)(1).
Generally, under the cash method of accounting, an item of
income or expense is reported when received or paid without
regard to the economic events giving rise to the item. On the
other hand, under the accrual method of accounting, an item of
income or expense generally is reported for the accounting period
during which all the events have occurred which fix the
taxpayer's right to receive the item of income or which establish
the fact of liability giving rise to the deduction, and the
amount thereof can be determined with reasonable accuracy.
Hallmark Cards, Inc. v. Commissioner, supra at 32; secs. 1.446-
1(c)(1)(ii), 1.451-1(a), Income Tax Regs. Thus, each method
properly applied to the same facts may yield different results.
This Court is aware that "By definition, the cash method may
result in mismatching between expenses and income where expenses
are paid in a year prior to the receipt of the related income."
RLC Indus. Co. v. Commissioner, 98 T.C. 457, 493 n.29 (1992),
- 27 -
affd. 58 F.3d 413 (9th Cir. 1995). However, mismatches between
expenses and income will over time tend to cancel out provided no
attempt is made to unreasonably prepay expenses or purchase
supplies in advance. Van Raden v. Commissioner, 71 T.C. 1083,
1104 (1979), affd. 650 F.2d 1046 (9th Cir. 1981). Respondent did
not contend that petitioner attempted to unreasonably prepay
expenses or purchase supplies in advance. In fact, petitioner
paid its suppliers only after receiving payment from its
clients.15 Therefore, in this case, income and expenses were not
mismatched.16
Furthermore, respondent's determination that petitioner's
use of the accrual method of accounting would increase its income
tax liability for taxable years 1989 and 1990 by $111,613 and
$775, respectively, is not, per se, indicative that petitioner's
use of the cash method failed to clearly reflect income. RLC
15
Petitioner is billed by the asphalt supplier, and that
invoice is due within 30 days. When a job is complete,
petitioner bills its client and creates an account receivable.
Petitioner pays the invoice when the client pays petitioner.
Thus, we can conclude that if petitioner pays its supplier's
invoices on time, then petitioner receives payment from its
customers within 30 days of completing the paving job.
16
The accrual method requires a taxpayer to recognize
income in the taxable year when all the events have occurred that
fix the right to receive the income and the amount can be
determined with reasonable accuracy (the "all-events test"),
secs. 1.446-1(c)(1)(ii)(A), 1.451-1(a), Income Tax Regs., rather
than when the taxpayer actually receives payment. Accordingly,
under the accrual method petitioner would be required to
recognize income when petitioner completes each paving job; i.e.,
approximately 30 days earlier than when it recognizes income
under the cash method.
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Indus. Co. v. Commissioner, supra at 503. The best method is not
necessarily the one that produces the most tax in a particular
year. Id.
Respondent's final argument is that if petitioner is to
establish that respondent has abused her discretion, petitioner
must demonstrate substantially identical results between
petitioner's method and the method selected by respondent. We
disagree. We have found that petitioner does not have any
inventories. Respondent's contention that we must apply the
substantial-identity-of-results test17 in cases where the
taxpayer is not required to maintain an inventory is without
support in the case law. Ansley-Sheppard-Burgess Co. v.
17
The substantial-identity-of-results test is a judicial
creation; the test was first articulated in Wilkinson-Beane, Inc.
v. Commissioner, 420 F.2d 352 (1st Cir. 1970). In that case, 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 determined by the method it used and the
method selected by the Commissioner was negligible. The court
found that where the Commissioner has determined that the
accounting method used by a taxpayer does not clearly reflect
income, in order to prevail, "the taxpayer must demonstrate
substantial identity of results between his method and the method
selected by the Commissioner." Id. at 356.
In Ansley-Sheppard-Burgess Co. v. Commissioner, 104 T.C.
367, 377 (1995), we held that a taxpayer that is required to use
the inventory method of accounting must meet the substantial-
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.
However, respondent's contention that we must apply the
substantial-identity-of-results test in cases where the taxpayer
is not required to use an inventory is without support in case
law. Id.
- 29 -
Commissioner, 104 T.C. at 377; Austin v. Commissioner, T.C. Memo.
1997-157. Thus, petitioner is not required to show a substantial
identity of results for this Court to find that respondent abused
her discretion in changing petitioner's method of accounting.
Respondent required petitioner to change from an accounting
method which clearly reflects income to an alternate method of
accounting merely because respondent considers the alternate
method to more clearly reflect its income. We previously have
held that to do so exceeds the bounds of her discretion.
On the basis of the facts of the instant case--including the
fact that petitioner has consistently used the cash method of
accounting without any evidence that it attempted to prepay
expenses unreasonably or purchase supplies in advance, does not
have inventories and is not required to use an inventory method
of accounting, and is not otherwise required by the Code or
regulations to use the accrual method of accounting--we hold that
respondent's determination that petitioner's use of the cash
method of accounting did not produce a clear reflection of income
was an abuse of discretion.
To reflect the foregoing,
Decision will be entered
for petitioner.