T.C. Memo. 1997-311
UNITED STATES TAX COURT
TEBARCO MECHANICAL CORPORATION, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 153-95. Filed July 3, 1997.
Matthew J. Howard, for petitioner.
Clinton M. Fried, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
PARR, Judge: Respondent determined a deficiency in
petitioner's Federal income tax for the taxable year ending
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September 30, 1990, of $98,314, and an accuracy-related penalty
under section 66621 of $24,851.
After concessions by the parties, the issues for decision
are: (1) Whether respondent's determination that petitioner must
account for inventories and use the accrual method of accounting
(accrual method) was an abuse of discretion. We hold it was not.
(2) Whether petitioner is liable for the section 6662 accuracy-
related penalty for a substantial understatement of income tax
for 1990. We hold it is not.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulated facts and the accompanying exhibits are
incorporated into our findings by this reference. At the time
the petition in this case was filed, petitioner's principal place
of business was located in Alpharetta, Georgia. Petitioner is a
corporation owned by a sole shareholder, Terrell Barden (Barden).
Petitioner files its Federal income tax return using a fiscal
year ending September 30.
At its inception in 1983, petitioner began using the cash
method of accounting (cash method). Then, in 1987, petitioner
began keeping its books and records on the accrual method.
1
Unless otherwise noted, all section references are to the
Internal Revenue Code in effect for the taxable year 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.
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Thereafter, Michael L. Powers (Powers), petitioner's accountant,
would make annual or semi-annual adjusting entries to convert
petitioner's books to the percentage of completion method for
financial statement reporting, as required for bonding purposes,
and to the cash method of accounting for income tax purposes.
Petitioner is a mechanical contractor that provides plumbing
installation, heating, and air conditioning work for general
contractors or job site owners (customers). Petitioner's typical
jobs are for new commercial construction and its installation
sites include churches, schools, and retail complexes.
Petitioner's business is located in a 5,000-square foot building.
Of that 5,000 square feet, 2,000 square feet comprise an office
and the other 3,000 square feet comprise a warehouse. In the
warehouse petitioner stored materials, such as large piping, duct
work, plumbing materials, sheet metal, small hardware pieces, and
materials left over from various job sites. On occasion,
petitioner uses the warehouse to store materials that are
eventually going to a job site. For the taxable year in issue,
the value of the materials maintained at petitioner's warehouse
was between $10,000 and $20,000.
Petitioner procures jobs through a bid process. The factors
that went into estimating a bid price for a job included
materials, supplies, equipment, subcontracts, and labor costs
(total direct expenses). Prior to submitting a bid proposal,
petitioner increases the total direct expense by either 10 or 20
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percent to recover overhead expenses and to make a profit on the
job. The bid price submitted to the general contractor is a
lump-sum bid; the general contractor is not informed of the
various costs making up the bid. If accepted, the proposal forms
the basis of the contract between petitioner and the customer.
Once a contract is signed, petitioner orders materials
required for a particular job, such as steel piping and heating,
ventilation and air conditioning (HVAC) systems, on an as-needed
basis from various vendors. Petitioner supplies the purchase
order to the vendor, and the vendor looks to petitioner, not the
customer, for payment. Generally, when petitioner purchases
materials for a job, it has the items delivered directly from the
vendor to the job site, unless the weather or other exigent
circumstances require petitioner to ship the materials directly
to its warehouse. For instance, petitioner had a contract where
the schedule originally called for the materials to be delivered
to a job site in February. Due to inclement weather the job did
not progress as scheduled. Petitioner, however, had already
ordered the materials for the job, so the general contractor
asked petitioner to store the items at its warehouse. On another
occasion, petitioner was working during the summer at a school,
but the project could not be completed by the time the students
returned in September. Under those circumstances, petitioner
ordered the materials for the job and had the items shipped
directly to its warehouse.
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Petitioner works on several jobs at a time. Petitioner's
contracts generally provide for progress billing on the 25th day
of each month. In most cases, petitioner sends its customers a
bill once a month until a job is complete. Petitioner's vendors
allow 30 days for payment of any materials petitioner orders.
Petitioner generally tries to ship any materials ordered for a
particular job directly to the job site on or about the 20th day
of each month, so that it is not responsible for paying vendor
bills until the 20th of the following month.
Petitioner had $2,115,291 in gross receipts for the taxable
year in issue. Petitioner's material costs2 for the taxable year
amounted to 33 percent of its gross receipts. Petitioner's cost
of good sold (COGS) was $1,835,723.3
OPINION
Issue 1. Whether It Was an Abuse of Respondent's Discretion To
Require Petitioner To Change From the Cash Method of Accounting
to an Accrual Method of Accounting
Respondent determined that the cash receipts and
disbursements method of accounting used by petitioner for income
tax purposes does not clearly reflect income. Specifically,
respondent claims that petitioner must use inventories, and
2
On its tax return for the year in issue, petitioner reported
material costs of $701,320.
3
On its tax return for the year in issue, petitioner included
the following items in its COGS computation: Material purchases,
labor, equipment, subcontractor payments, depreciation, payroll
taxes, insurance, operating expenses and other miscellaneous
expenditures.
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therefore the accrual method of accounting, because petitioner
derives a substantial portion of its income from the sale of
merchandise, maintains work-in-process at yearend, maintains a
physical inventory at its business premises, and uses the accrual
method of accounting for its books and records.
Petitioner asserts that it has no inventory, because it
never takes title in, or physical possession of, the materials it
acquires for its jobs, and thus is not required to adopt an
inventory method of accounting. Petitioner further argues that
even if we find that it does take title in the materials
acquired, it does not have to adopt an inventory method of
accounting because the sale of merchandise is not an income-
producing factor in its business. Finally, in reliance on
Knight-Ridder Newspapers, Inc. v. United States, 743 F.2d 781
(11th Cir. 1984), petitioner contends that even if the sale of
merchandise is an income-producing factor, section 1.471-1,
Income Tax Regs., does not apply because there are no substantial
fluctuations in petitioner's inventory, nor does petitioner
maintain a substantial amount of inventory at its warehouse.
The principal issue for decision is whether it was an abuse
of respondent's discretion to require petitioner to change from
the cash method, which petitioner uses for income tax reporting
purposes, to an accrual method. Subsumed in this issue is the
question of whether petitioner should be required to use
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inventories for tax purposes. To resolve these issues, we
consider sections 446 and 471 and the regulations thereunder.
Pursuant to section 446,4 the Commissioner has broad powers
to determine whether an accounting method used by a taxpayer
clearly reflects income. Commissioner v. Hansen, 360 U.S. 446,
467 (1959); Ansley-Sheppard-Burgess Co. v. Commissioner, 104 T.C.
367, 370 (1995). Courts do not interfere with the Commissioner's
determination under section 446 unless it is clearly unlawful.
Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 532 (1979);
Cole v. Commissioner, 586 F.2d 747, 749 (9th Cir. 1978), affg. 64
4
Section 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.
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T.C. 1091 (1975); Ansley-Sheppard-Burgess Co. v. Commissioner,
supra. However, the Commissioner cannot require a taxpayer to
change from an accounting method which clearly reflects its
income to an alternate method of accounting merely because the
Commissioner considers the alternate method to more clearly
reflect the taxpayer's income. Ansley-Sheppard-Burgess Co. v.
Commissioner, supra at 371.
Whether an abuse of discretion has occurred is a question of
fact. Ansley-Sheppard-Burgess Co. v. Commissioner, supra; Ford
Motor Co. v. Commissioner, 102 T.C. 87, 91-92 (1994), affd. 71
F.3d 209 (6th Cir. 1995); see Cole v. Commissioner, supra at 749.
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 America v. Commissioner, T.C. Memo. 1996-105.
Consequently, to prevail, a taxpayer must prove that the
Commissioner's determination is arbitrary, capricious, or without
sound basis in fact or law. Ansley-Sheppard-Burgess Co. v.
Commissioner, supra; Ford Motor Co. v. Commissioner, supra at 92.
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Pursuant to section 471,5 a taxpayer that has inventories is
required to use the accrual method of accounting. An exception
to this rule exists, however, where a taxpayer 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, supra at 377; see
also Knight-Ridder Newspapers, Inc. v. United States, 743 F.2d at
791-793 (11th Cir. 1984).
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, section 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.
Although not specifically defined in the Internal Revenue
Code or regulations, courts have found that the term
"merchandise", as used in section 1.471-1, Income Tax Regs., is
5
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 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.
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defined as an item acquired and held for sale. Wilkinson-Beane,
Inc. v. Commissioner, 420 F.2d 352, 354-355 (1st Cir. 1970),
affg. T.C. Memo. 1969-79; Galedrige Const., Inc. v. Commissioner,
T.C. Memo. 1997-240; Honeywell Inc. v. Commissioner, T.C. Memo.
1992-453, affd. without published opinion 27 F.3d 571 (8th Cir.
1994). Whether an item was acquired and held for sale is
governed by the substance of the transaction and not its form.
Galedrige v. Commissioner, supra; Honeywell Inc. v. Commissioner,
supra. Thus, in deciding whether the materials petitioner
acquires to perform its installation contracts are merchandise,
we examine the facts and circumstances of the case. Wilkinson-
Beane, Inc. v. Commissioner, supra; Galedrige 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.
Material Purchases and Warehouse Items are Merchandise
Petitioner asserts that it was an abuse of respondent's
discretion to place petitioner on an accrual method of accounting
for income tax reporting purposes, because petitioner does not
have merchandise held for sale in its business, and therefore it
does not have to use inventories. In support of this contention,
petitioner argues that while the section 1.471-1, Income Tax
Regs. does not define inventory, it imposes one critical
requirement before a taxpayer is permitted to include an item of
merchandise in inventory, that requirement being the vesting of
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title. Petitioner relies on the following language to support
its position that it does not have to include the materials it
acquires in inventory. Section 1.471-1, Income Tax Regs.,
provides in pertinent part:
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, * * * title to which has passed to the
purchaser. A purchaser should include in inventory
merchandise purchased, * * * title to which has passed to
him, although such merchandise is in transit or for other
reasons had not been reduced to physical possession, but
should not include goods ordered for future delivery,
transfer of title to which had not yet been effected.
[Emphasis added].
Specifically, petitioner asserts that under Georgia law6,
title to the job site materials remains in the vendor until
delivery, and at delivery vests in the job site owner.
Petitioner claims that in essence, it was a broker or agent for
its customers, in that it merely coordinated the purchase, sale,
and delivery of materials to the job site for a fee. Thus,
petitioner contends that title passed directly from its vendors
to its customers at the point of shipment, here the job site. To
support its position that as a broker, it is not required to
6
Ga. Code. Ann. sec. 11-2-401(2) (1994) provides in pertinent
part:
Unless otherwise explicitly agreed title passes to the buyer at
the time and place at which the seller completes his
performance with reference to physical delivery of the goods
* * *
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maintain inventories, petitioner relies heavily on Simon v.
Commissioner, 176 F.2d 230 (2d Cir. 1949) (buyer and seller of
paper box-board maintained no inventory, and was not engaged in
business of "merchandising" requiring use of accrual method in
computing income for Federal income tax purposes), and stresses
the fact that generally it does not take physical possession of
any materials it orders. Petitioner further argues that its
practices are consistent with industry customs in that other
subcontractors never take title to assigned materials, which they
provide to their customers for a particular job.
We find petitioner's argument without merit; not only does
it lack factual support in the record, but it fails to provide a
defense for petitioner's refusal to account for inventories.
Petitioner argues in a circular fashion that pursuant to section
1.471-1, Income Tax Regs., it need not maintain inventories,
because it never had merchandise held for sale as all materials
it acquires are instantaneously applied to a contract,
segregated, and sold. Under the facts discussed herein, however,
petitioner, in any given transaction, acts as both the buyer
pursuant to its contract with the vendor, and the seller pursuant
to its contract with the general contractor. In relying on
section 1.471-1, Income Tax Regs., and Ga. Code Ann. sec. 11-2-
401, however, petitioner fails to address this critical fact.
Moreover, we note that petitioner could have changed the nature
of its position as one of "buyer" by describing in the contracts
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with its customers exactly when, where, and to whom title to the
materials was to pass. See Miami Purchasing Service Corp. v.
Commissioner, 76 T.C. 818, 830 (1981) (the taxpayer, when
negotiating with customers over sales terms could have insisted
on a clear contractual statement of where title was to pass).
Had petitioner set out such terms pursuant to its contracts, and
had it consistently acted in accordance with such contracts,
"such provisions would have furnished clear evidence of the
parties' intention and governed the passage of title". Epic
Metals Corp. v. Commissioner, T.C. Memo. 1984-322, affd. without
published opinion 770 F.2d 1069 (3d Cir. 1985). However, based
on the evidence submitted at trial, we find that petitioner's
contracts do not by their terms prevent petitioner from taking
title to the materials shipped directly to a job site from
petitioner's vendors to its customers.
Moreover, petitioner's assertion that many of its material
acquisitions are identified with specific customers' construction
jobs, does not negate the fact that it purchases materials from
vendors and then sells the ordered materials to its customers.
J.P. Sheahan Associates v. Commissioner, T.C. Memo. 1992-239.
More importantly, that title in the merchandise may not repose in
petitioner for a long period of time does not negate the fact
that petitioner acquires merchandise for sale in its business.
We note that possession of title is a factor in determining when
a sale occurs together with all surrounding circumstances.
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Hallmark Cards, Inc. v. Commissioner, 90 T.C. 26 (1988).
Furthermore, it is title, rather than physical possession that
determines whether merchandise should be included in inventory.
Epic Metals Corp. v. Commissioner, T.C. Memo. 1984-322; see also
Hoffman v. Commissioner, T.C. Memo. 1989-154 (taxpayer's S
corporation required to accrue income from sale of ski equipment,
even though equipment had not yet been manufactured and it never
took possession); Middlebrooks v. Commissioner, T.C. Memo. 1975-
275 (magazines were considered inventory, even where publisher
held title to them only briefly).
In Middlebrooks, we noted that, aside from consideration of
the technical passage of title, the taxpayer exercised control
and ownership rights over the magazines after they had been
printed in that they were shipped in the taxpayer's name and at
his own expense. Similar to the taxpayer in Middlebrooks, the
petitioner in the instant case also has the benefits and burdens
of ownership. Here, petitioner marks up the cost of the
materials between 10 and 20 percent, acquires the materials in
its name, and the vendors look to petitioner, not the general
contractor or owner, for payment. Petitioner's argument is
further weakened by its admission that it sometimes accepts
delivery and retains possession of the merchandise it acquires.
Finally, we note that petitioner's reliance on Simon v.
Commissioner, supra, is misplaced. The facts in Simon, are
clearly distinguishable from the facts in the instant case. In
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Simon, the Court of Appeals for the Second Circuit noted that one
of the conclusive facts in finding the taxpayer did not maintain
inventories was that the taxpayer had no stock or merchandise on
hand and no warehouse or storeroom for merchandise. Simon v.
Commissioner, supra at 232. Here, as discussed below, we find as
fact that petitioner did indeed have stock on hand and a
warehouse where it stored materials.
In addition to the above-described materials petitioner
acquired in its business, respondent alleges that petitioner had
a warehouse where it stored materials such as large piping, duct
work, plumbing materials, sheet metal, small hardware pieces, and
materials left over from various job sites. Petitioner admits
that its office contains a large warehouse where it keeps
materials such as scraps from old jobs, doors, and some duct
work. Moreover, petitioner concedes that if it does maintain the
"warehouse inventory" as alleged by respondent, "then there is no
question that it will have title to it." Petitioner contends
however, both at trial and on brief, that the warehouse space was
shared by petitioner and two corporations run by the brothers of
petitioner's president. At trial, Barden, petitioner's
president, testified that his brother, Howell, who owned General
Mechanical Corporation (General Mechanical), had shut down his
company after being in business for 20 years. Barden claimed
that all of the material from General Mechanical's shop was
brought to petitioner's warehouse and stored there by Howell.
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Barden also testified that his other brother, Tim, who runs
Tebarco Door and Metal Services (Tebarco Door), stored his
material in the warehouse as well.
At trial, Vicki Byers (Byers), a revenue agent, who
conducted an onsite audit of petitioner's business testified that
while touring the warehouse with Barden she and another agent
discussed the approximate value of the inventory in petitioner's
warehouse. Although Barden valued the inventory at somewhere
between $10,000 and $20,000, he at no time indicated to Byers
that some of the material belonged to his brothers. Given that
petitioner was being audited, we believe that if the materials in
the warehouse belonged to anyone other than petitioner, Barden
would have informed the agent of that fact. Barden's failure to
do so leads us to believe that the materials in the warehouse did
indeed belong to petitioner. Furthermore, Barden's brothers were
not called to testify regarding the inventory maintained in
petitioner's warehouse, nor did petitioner call anyone who worked
at either General Mechanical or Tebarco Door to corroborate the
validity of Barden's testimony. We note that the absence of
testimonial evidence may lead the finder of fact to infer that
such evidence, if presented at trial, subject to respondent's
cross-examination, would not have been favorable to petitioner.
McKay v. Commissioner, 89 T.C. 1063, 1069 (1987), affd. 886 F.2d
1237 (9th Cir. 1989); Wichita Terminal Elevator Co. v.
Commissioner, 6 T.C. 1158, 1165 (1946), affd. 162 F.2d 513 (10th
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Cir. 1947). This is especially true where, as here, the party
failing to produce such evidence has the burden of proof. Id. at
1165.
Moreover, numerous invoices found in petitioner's books and
records clearly establish that petitioner stored materials in its
warehouse, which it used to complete its work at various job
sites. At trial, petitioner objected on the grounds of hearsay
to the inclusion in the record of numerous exhibits placed in the
stipulation by respondent. We received the exhibits subject to
oral reservation. The exhibits referred to and included in the
stipulation were petitioner's business records produced pursuant
to respondent's subpoena duces tecum. On brief, petitioner
withdrew its objections to all of the exhibits except the
following: 72-BT, 73-BU, 84-CF, 85-CG, and 86-CH.
Petitioner contends that respondent is using hearsay
statements from several of the exhibits to prove that petitioner
maintains a warehouse full of materials, and that petitioner sold
such materials from its warehouse to customers. Petitioner
admits that the stipulated exhibits, which are composed mostly of
petitioner's purchase orders, are not inherently untrustworthy.
Rather, petitioner contends that they are merely untrustworthy
when offered by respondent to prove matters that are collateral
to the material information conveyed by the documents.
Furthermore, petitioner argues that its "control over the
stipulated business records does not negate the hearsay that is
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found therein, nor does it establish as fact respondent's
interpretations of the hearsay statements."
The business record exception to the hearsay rule expressly
authorizes the introduction of the exhibits into the record.
Fed. R. Evid. 803(6).7 The exhibits were all maintained in
petitioner's files and were maintained in the ordinary course of
business. The fact that notations, terms, and directives may be
contained in the business records, which express certain acts,
events, conditions, or opinions, does not per se render the
records inadmissible.
Petitioner does not dispute the material facts contained
within the invoices, but asserts that there are certain
notations, terms, and directives found within some of the
documents in issue, e.g., invoices which show that materials used
by petitioner on a particular job either are being shipped to, or
picked up from, "the shop." Petitioner argues that if the
7
Fed. R. Evid. 803 provides in pertinent part:
The following are not excluded by the hearsay rule, even
though the declarant is available as a witness:
* * * * * * *
(6). Records of regularly conducted activity.--A * * *
record, * * * in any form, of acts, events, conditions,
opinions, or diagnoses, made at or near the time by, or from
information transmitted by, a person with knowledge, if kept
in the course of a regularly conducted business activity,
and if it was the regular practice of that business activity
to make the * * * record * * *, all as shown by the
testimony of the custodian or other qualified witness,
unless the source of information or the method or
circumstances of preparation indicate lack of
trustworthiness. * * *
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declarants of the statements had been able to testify as to the
statements' meanings, it would be clear that they were taken out
of context and that any reference to "the shop" was not a
reference to petitioner's shop, but to the shop at the job site.
Petitioner had the opportunity to present evidence or witnesses
at trial to explain any ambiguity in the statements found in
petitioner's business records. Petitioner's failure to do so
leads us to believe that the presentation of such evidence would
have been unfavorable to petitioner. McKay v. Commissioner,
supra; Wichita Terminal Elevator Co. v. Commissioner, supra.
Based on the entire record, we find that petitioner's
subcontracting installation transactions involved a sale of a
service and merchandise. The materials petitioner acquires and
assigns to particular jobs, as well as the materials petitioner
maintains in its warehouse are the merchandise sold in these
transactions.
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Sale of Merchandise Is an Income-Producing Factor
For merchandise to be classified as inventory under section
1.471-1, Income Tax Regs., it must also be an "income-producing
factor". Whether merchandise is an income-producing factor
depends on the facts and circumstances of the case. Thompson
Elec., Inc. v. Commissioner, T.C. Memo. 1995-292; Wilkinson-
Beane, Inc. v. Commissioner, T.C. Memo. 1969-79. If the cost of
the merchandise is substantial compared to the taxpayer's
receipts, the merchandise is an income-producing factor. Knight-
Ridder Newspapers, Inc. v. United States, 743 F.2d at 790 (11th
Cir. 1984) (the cost of newsprint and ink constituted 17.6
percent of total cash receipts); Wilkinson-Beane, Inc. v.
Commissioner, 420 F.2d at 355 (for 1963 and 1965 respectively,
the cost of caskets constituted 15.4 percent and 14.7 percent of
cash basis receipts); Thompson Elec., Inc. v. Commissioner, supra
(materials varied from 37 to 44 percent of its cash basis gross
receipts).
In this case, the facts indicate that the materials acquired
by petitioner and assigned to particular job sites, as well as
materials kept at petitioner's warehouse, were sold to its
customers as part of the subcontracting installation transaction.
The price of such materials was one of six factors making up the
price of the installation transaction; the other factors were
equipment and supply cost, labor cost, subcontractor cost, and an
overhead/profit allocation. Petitioner's materials amounted to
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38 percent of its COGS for 1990. Since most of the components of
petitioner's COGS are the same components that go into preparing
its estimated direct expenses, a similar relationship would, and
does, appear as direct expenses in petitioner's bid estimate.
The direct expenses plus an overhead/profit allocation of 10 to
20 percent are included in petitioner's bid price. The cost of
the materials acquired by petitioner bears a direct relationship
to the price charged for the subcontracting installation
transaction. In fact, the cost of the materials is the most
significant factor used by petitioner in computing its bid.
Thus, we find that the price charged for the subcontracting
installation transaction was directly related to the cost of the
material purchases. Wilkinson-Beane, Inc. v. Commissioner, T.C.
Memo. 1969-79. That petitioner acquired the materials from a
vendor only after it obtained a signed contract from a customer
indicates that petitioner sold the materials as part of the
subcontracting installation transaction. Cf. Honeywell Inc. v.
Commissioner, T.C. Memo. 1992-453 (fee established before
taxpayer knew the parts that would be used; thus, there was no
direct relationship between the amount charged to maintain the
computers and the cost of the parts).
Moreover, the cost of petitioner's material purchases for
the taxable year in issue represented approximately 33 percent of
its gross receipts. This amount clearly establishes that the
materials were an income-producing factor for petitioner.
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Knight-Ridder Newspapers, Inc. v. United States, supra (sale of
newspapers was a material income-producing factor where the cost
of raw materials for such newspapers was 17.6 percent of total
revenues); Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d at 355
(for 1963 and 1965, the cost of caskets constituting 15.4 percent
and 14.7 percent, respectively of the taxpayer's cash basis
receipts was a substantial income-producing factor).
Since petitioner's materials are both merchandise and an
income-producing factor, section 1.471-1, Income Tax Reg., is
applicable. Respondent determined, pursuant to section 1.446-
1(c)(2)(i), Income Tax Regs.,8 that this conclusion requires
petitioner to use the accrual method of accounting. Petitioner
argues that section 1.446-1(c)(2)(ii), Income Tax Regs., allows
respondent to authorize petitioner's use of the cash method,
8
Sec. 1.446-1(c)(2), Income Tax Regs., provides:
(2) Special rules. (i) In any case in which it is necessary
to use an inventory the accrual method of accounting must be
used with regard to purchases and sales unless otherwise
authorized under subdivision (ii) of this subparagraph.
(ii) * * * The Commissioner may authorize a taxpayer to
adopt or change to a method of accounting permitted by this
chapter although the method is not specifically described in
this part if, in the opinion of the Commissioner, income
is clearly reflected by the use of such method. Further,
the Commissioner may authorize a taxpayer to continue the
use of a method of accounting consistently used by the
taxpayer, even though not specifically authorized by the
regulations in this part, if, in the opinion of the
Commissioner, income is clearly reflected by the use of such
method. * * *
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notwithstanding a finding that petitioner has inventory, and that
respondent's failure to authorize the use of the cash method is
an abuse of discretion.
In general, where a taxpayer has been required to maintain
inventories, it has been held that the taxpayer must use the
accrual method of accounting in accordance with the mandate of
section 1.446-1(c)(2)(i), Income Tax Regs. Herberger v.
Commissioner, 195 F.2d 293, 295 (9th Cir. 1952). However, the
courts have developed, in the context of accounting for
inventory, a substantial-identity-of-results test for determining
whether respondent abused his discretion in not affording the
taxpayer the opportunity to continue to use the cash method of
accounting under section 1.446-1(c)(2)(ii), Income Tax Regs.
Asphalt Prods. Co. v. Commissioner, 796 F.2d 843, 849 (6th Cir.
1986), affg. on this issue Akers v. Commissioner, T.C. Memo.
1984-208; Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d at 356;
Ansley-Sheppard-Burgess Co. v. Commissioner, 104 T.C. at 377
(1995); Thompson Elec., Inc. v. Commissioner, T.C. Memo. 1995-
292; J. P. Sheahan Associates, Inc. v. Commissioner, T.C. Memo.
1992-239; Surtronics, Inc. v. Commissioner, T.C. Memo. 1985-277.
Whether the result under the cash method is substantially
identical with that under the accrual method is a question of
fact. E.g., Asphalt Prods. Co. v. Commissioner, supra;
Wilkinson-Beane, Inc. v. Commissioner, supra; Thompson Elec.,
Inc. v. Commissioner, supra.
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In Asphalt Prods. Co. v. Commissioner, supra at 849, the
court noted that an insignificant increase in inventories may be
grounds for finding an abuse of discretion by the Commissioner.
However, the court found no such abuse of discretion in that case
given the size of the taxpayer's receivables combined with its
failure to account for inventories. Id. See also Thompson
Elec., Inc. v. Commissioner, supra (cash method did not produce
substantial identity of results where for 1988 and 1989,
petitioner's taxable income computed under the cash method was
$138,418 and $135,958, respectively, while taxable income
computed under the accrual method was $331,925 and $289,039,
respectively); Surtronics, Inc. v. Commissioner, supra (cash
method did not produce substantially identical results to the
accrual method, where the difference in net income for the period
involved was $198,000).
For fiscal year 1990, petitioner's taxable income under the
cash method of accounting was $54,128. Petitioner's taxable
income under the accrual method of accounting would be $328,549.
Thus, petitioner's taxable income under the accrual method
increased by $274,421 for the taxable year in issue. This
difference is not inconsequential; the two methods do not produce
substantially identical results. Thompson Elec., Inc. v.
Commissioner, supra; J. P. Sheahan Associates, Inc. v.
Commissioner, supra.
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The same result obtains if we examine the differences in
gross receipts computed under the accrual method and the cash
method. For fiscal year 1990 petitioner's gross receipts under
the cash method of accounting were $2,115,291. Petitioner's
gross receipts under the accrual method of accounting would be
$2,465,060. Thus, petitioner's gross receipts under the accrual
method increased by $349,769. Petitioner's use of the cash
method does not produce results that are substantially identical
to the computation of either taxable income or gross receipts
under the accrual method. Thus, we hold that respondent did not
commit an abuse of discretion in precluding petitioner from
continuing to use the cash method of accounting for income tax
reporting purposes.9
9
Petitioner, in reliance on Knight-Ridder Newspapers, Inc. v.
United States, 743 F.2d 781 (11th Cir. 1984), asserts that it is
not required to use the accrual method, because it does not
maintain inventory at its warehouse. In Knight-Ridder, the Court
of Appeals for the Eleventh Circuit stated that "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 sec. 1.471-1,
[Income Tax Regs]." Id. at 791 In addition to the $701,320 cost
of petitioner's material purchases during the year in issue,
petitioner maintained a warehouse with materials valued somewhere
between $10,000 to $20,000. We find that such inventory is
substantial in comparison to petitioner's reported taxable income
of $54,128. We note, that petitioner's books and records were
insufficient to establish whether there was a substantial
fluctuation in its inventory account during the year in issue,
however, because we have found that petitioner maintains
substantial inventory at its warehouse we need not address the
fluctuation issue.
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We have concluded that the materials petitioner purchased
and the materials maintained at its warehouse were merchandise
that were an income-producing factor and that petitioner is
required to use inventories. Sec. 1.471-1, Income Tax Regs.
Furthermore, we have found that respondent did not commit an
abuse of discretion in not allowing petitioner to continue to use
the cash method of accounting. Sec. 1.446-1(c)(2)(i), Income Tax
Regs. Thus, we must now decide whether petitioner is liable for
the section 6662 accuracy-related penalty for a substantial
understatement of income for 1990.
Issue 2. Whether Petitioner Is Liable for the Section 6662
Accuracy-Related Penalty
Respondent determined that petitioner was liable for an
accuracy-related penalty pursuant to section 6662 for fiscal year
1990. Respondent asserts that the section 6662(a) penalty for
1990 is due to a substantial understatement of tax. Petitioner
asserts that it is not liable for the section 6662 penalty
because it relied on its accountant in using the cash method of
accounting.
Section 6662(a) imposes a penalty in an amount equal to 20
percent of the portion of the underpayment of tax attributable to
one or more of the items set forth in subsection (b). The
accuracy-related penalty does not apply with respect to any
portion of the underpayment if it is shown that there was
reasonable cause for such portion and that the taxpayer acted in
- 27 -
good faith with respect to such portion. Sec. 6664(c)(1). The
determination of whether a taxpayer acted with reasonable cause
and in good faith is made on a case-by-case basis, taking into
account all the pertinent facts and circumstances. Sec. 1.6664-
4(b)(1), Income Tax Regs. The most important factor is the
extent of the taxpayer's effort to assess its proper tax
liability for the year. Id.
Petitioner contends that the accuracy-related penalty is
inappropriate in this case, because it relied on its certified
public accountant, Michael Powers, to prepare its tax return
accurately. Generally, the duty of filing accurate returns
cannot be avoided by placing the responsibility on a tax return
preparer. Metra Chem Corp. v. Commissioner, 88 T.C. 654, 662
(1987). However, reliance on a qualified adviser may demonstrate
reasonable cause and good faith if the evidence shows that the
taxpayer relied on a competent tax adviser and provided the
adviser with all necessary and relevant information. Jackson v.
Commissioner, 86 T.C. 492, 539-540 (1986), affd. 864 F.2d 1521
(10th Cir. 1989); Daugherty v. Commissioner, 78 T.C. 623, 641
(1982); Magill v. Commissioner, 70 T.C. 465, 479 (1978), affd.
651 F.2d 1233 (6th Cir. 1981); Pessin v. Commissioner, 59 T.C.
473, 489 (1972).
At trial, Powers testified that he had prepared petitioner's
tax returns from the time of its inception in 1983, and that
subcontractors similar to petitioner comprised approximately 50
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percent of his clientele. Powers spent 8 to 12 days a year
actually at petitioner's place of business. As petitioner's
accountant, Powers' duties involved preparing semi-annual
financial statements and annual tax returns for petitioner,
hiring and training petitioner's accounting personnel, and
solving any accounting problems that petitioner may incur
throughout the year. Powers claimed that to his understanding, a
mechanical contractor is a service provider. Moreover, Powers
testified that petitioner did not have inventory, because it
acted merely as an agent when it ordered materials pursuant to a
particular contract.
There is nothing in the record to indicate that petitioner
withheld any relevant information from Powers. We note that
Powers testified that he did not take a physical inventory of
petitioner's warehouse. That fact alone, however, does not
establish that petitioner failed to provide Powers with all the
necessary and relevant information he needed to prepare
petitioner's tax returns. Powers spent time at petitioner's
offices, he actually viewed petitioner's warehouse, and he
admitted that it was ultimately his decision, and not
petitioner's, to define what inventory is.
Thus, given the facts discussed herein we find that
petitioner relied in good faith on the advice of its accountant
in filing its returns on the cash method. Accordingly, we hold
- 29 -
that petitioner is not liable for the accuracy-related penalty
under section 6662(a) for the fiscal year 1990.
To reflect the foregoing,
Decision will be entered
for respondent as to the
deficiency, and for petitioner as
to the accuracy-related penalty.