T.C. Memo. 2000-114
UNITED STATES TAX COURT
VON EUW & L.J. NUNES TRUCKING, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 17599-97. Filed March 31, 2000.
Lawrence T. Ullmann, for petitioner.
Peter C. Rock, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
VASQUEZ, Judge: Respondent determined a deficiency of
$111,114 in petitioner’s Federal income tax for the taxable year
ending March 31, 1995 (1994 taxable year). The issue for
decision is whether respondent abused his discretion by requiring
petitioner to change its method of accounting from the cash
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receipts and disbursements method (cash method) to the accrual
method.1
FINDINGS OF FACT
The parties submitted this case fully stipulated pursuant to
Rule 122.2 The stipulation of facts and the attached exhibits
are incorporated herein by reference. At the time the petition
was filed, petitioner’s principal place of business was in
Fremont, California.
Petitioner, a California corporation, acquires and
transports sand and gravel for its customers, various contractors
and developers operating in Northern and Central California.3
Petitioner’s customers use the sand and gravel to construct
foundations for streets, houses, and buildings (construction
projects). Most of petitioner’s customers depend on petitioner
to both acquire and transport the sand and gravel from storage
sites to the customers’ construction sites. Some of petitioner’s
customers own or acquire the sand and gravel necessary to
complete their construction projects without petitioner’s
1
In the notice of deficiency, respondent reduced
petitioner’s depreciation, truck, and advertising & promotion
deductions by $28,027, which petitioner does not contest in its
petition.
2
All section references are to the Internal Revenue Code
in effect for the year in issue, and all Rule references are to
the Tax Court Rules of Practice and Procedure.
3
The phrase “sand and gravel” refers to both “sand and
gravel” and “sand or gravel”.
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assistance. These customers hire petitioner only for its
transportation services.4
Usually, a customer contacts petitioner to order sand and
gravel (measured by weight in tons) 1 day before the sand and
gravel are needed at the construction site (the order date). On
the order date, petitioner informs the customer of petitioner’s
total charge for acquiring and transporting the sand and gravel
(contract amount). Petitioner calculates the contract amount by
multiplying petitioner’s charge for acquiring and transporting 1
ton of sand and gravel times the number of tons of sand and
gravel ordered by the customer. Petitioner’s charge for
acquiring and transporting 1 ton of sand and gravel consists of
four amounts: (1) Petitioner’s costs in acquiring the sand and
gravel, (2) petitioner’s profit for acquiring the sand and gravel
(approximately 20 to 25 percent of petitioner’s costs in
acquiring the sand and gravel), (3) petitioner’s costs in
transporting the sand and gravel from the storage site to the
construction site (and petitioner’s related profit for
transporting the sand and gravel), and (4) a sales tax levied on
amounts (1) through (3).
Petitioner, however, does not provide the customer an
itemized description of the separate amounts constituting the
4
The record does not reflect what revenues and expenses
relate to customers using petitioner solely for transportation
services.
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contract amount. If a customer requests only that petitioner
transport the sand and gravel, petitioner charges the customer
petitioner’s costs for transporting the sand and gravel and
petitioner’s related profit for transporting the sand and gravel.
Petitioner acquires the sand and gravel from various
suppliers. During petitioner’s 1994 taxable year, 20 different
entities (20 suppliers) provided petitioner with 60 percent
(evaluated by weight in tons) of its sand and gravel needs, while
the Unimin Corp. (Unimin) supplied petitioner with the remaining
40 percent.
Unimin processes and sells a high grade of sand used
primarily in the production of wine bottles. Processing this
high grade of sand produces a byproduct consisting of water and a
lower grade of sand, known as Byron sand. After the water is
removed from the byproduct, the Byron sand can be used by
petitioner’s customers. Because petitioner must provide and
maintain all the equipment and personnel necessary to filter,
gather, and remove the Byron sand from Unimin’s processing plant,
Unimin charges petitioner a lower amount than what the 20
suppliers charge for the same grade of sand. When petitioner
computes the cost to acquire 1 ton of the Byron sand, petitioner
includes its costs in filtering, gathering, and removing the
Byron sand from Unimin’s processing plant as well as the amount
that Unimin charges petitioner for the Byron sand.
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Petitioner owns 20 hauling trucks which it uses to transport
the sand and gravel. If petitioner’s customers order amounts of
sand and gravel exceeding petitioner’s transportation
capabilities, petitioner hires third parties to meet customer
demand.
On the delivery date, petitioner’s employees travel to the
supplier’s storage site, load the sand and gravel purchased onto
petitioner’s trucks, and transport the sand and gravel to the
customer’s construction site.5 As to the Byron sand, once
petitioner’s employees load it onto petitioner’s trucks and
Unimin creates a “weighmaster certificate”, Unimin considers the
Byron sand to be petitioner’s property. Because petitioner
acquires and delivers the sand and gravel to its customers during
the same business day, petitioner does not possess any sand and
gravel at the beginning or end of its business day.
On petitioner’s 1994 Federal corporate income tax return
(1994 tax return), petitioner described its business activity as
“sales” and its product as “construction materials”. Petitioner
maintained its books and records on the accrual method of
accounting and reported its income for Federal tax purposes on
the cash method. On its 1994 tax return, petitioner reported
gross receipts of $3,483,206 and cost of goods sold of
5
Petitioner’s employees perform similar tasks for
customers who only request petitioner to transport (and not
acquire) sand and gravel.
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$1,867,497. In computing its cost of goods sold, petitioner
reported $1,080,774 of “purchases”, $786,723 of “cost of labor”,
and no beginning or ending inventories. In addition to its cost
of goods sold, petitioner separately deducted its expenses
related to the filtering, gathering, and removing of the Byron
sand at the Unimin processing plant.
As of March 31, 1995, petitioner had accounts receivable of
$426,389 and accounts payable of $143,846.
In the notice of deficiency, respondent determined that
petitioner’s use of the cash method of accounting did not clearly
reflect income. Respondent, therefore, changed petitioner’s
method of accounting to the accrual method. Further, with regard
to the change in accounting method and petitioner’s concessions,
respondent made a section 481(a) adjustment and determined a
deficiency of $111,114 in petitioner’s tax liability for its 1994
taxable year.
OPINION
The principal issue for decision is whether respondent
abused his discretion by requiring petitioner to change from the
cash method to the accrual method of accounting. Subsumed in
this issue is the question of whether petitioner should be
required to use inventories for tax purposes.
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Under section 446,6 the Commissioner has broad powers to
determine whether an accounting method used by a taxpayer clearly
reflects income. See 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.
See 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 T.C. 1091 (1975); Ansley-Sheppard-Burgess Co., supra at
370.
Whether respondent abused his discretion is a question of
6
Sec. 446 provides in pertinent part:
(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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fact. See Ansley-Sheppard-Burgess Co. v. Commissioner, supra at
371; Ford Motor Co. v. Commissioner, 102 T.C. 87, 91-92, affd. 71
F.3d 209 (6th Cir. 1995). 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. See Ansley-Sheppard-Burgess Co. v.
Commissioner, supra at 371. Consequently, to prevail, a taxpayer
must prove that the Commissioner’s determination is arbitrary,
capricious, or without sound basis in fact or law. See Ansley-
Sheppard-Burgess Co. v. Commissioner, supra at 371; Ford Motor
Co., supra at 92.
To resolve this dispute, we consider sections 446 and 471
and the regulations thereunder. Under section 446(a), a taxpayer
computes taxable income based on the method of accounting
utilized by the taxpayer in keeping its books. Section 446(c)
describes the various accounting methods that a taxpayer may use
in computing taxable income, including the cash and accrual
methods.
Section 1.446-1(c)(2)(i), Income Tax Regs., provides that a
taxpayer who is required to use inventories must also use the
accrual method of accounting with regard to purchases and sales.
Under section 471 and section 1.471-1, Income Tax Regs., a
taxpayer must account for inventories if the production,
purchase, or sale of merchandise is an income-producing factor in
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the taxpayer’s business and the taxpayer has acquired title to
the merchandise.
We consider the facts and circumstances of each case in
deciding whether material is merchandise that is an income-
producing factor. See Honeywell, Inc. v. Commissioner, T.C.
Memo. 1992-453, affd. without published opinion 27 F.3d 571 (8th
Cir. 1994); Wilkinson-Beane, Inc. v. Commissioner, T.C. Memo.
1969-79, affd. 420 F.2d 352 (1st Cir. 1970). Although not
specifically defined in the Internal Revenue Code or the
regulations, courts have ruled 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.
Respondent contends that, because the sand and gravel is
merchandise which is an income-producing factor in petitioner’s
business, petitioner must account for inventories and report its
taxable income under the accrual method of accounting.
Petitioner broadly argues that it does not have to account
for inventories under section 471 and section 1.471-1, Income Tax
Regs., because (1) its business consists of “procuring and
delivering * * * not acquiring and holding sand and gravel for
sale to customers”; therefore, the sand and gravel should not be
considered merchandise, and (2) even if the sand and gravel is
considered merchandise, the procurement of the sand and gravel is
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not an income-producing factor in petitioner’s business.
Petitioner makes several arguments regarding why the sand
and gravel should not be considered merchandise (i.e., items
acquired and held for sale). On brief, petitioner positions
itself as a service provider rather than as a seller of goods.
Petitioner argues that to perform its primary business activity
of delivering sand and gravel, petitioner merely accommodates its
customers by also procuring sand and gravel. Further, petitioner
asserts that, because it does not have any sand and gravel on
hand at the beginning or end of the business day (due to the fact
that on the same day it procures and delivers the exact amount of
sand and gravel requested by its customers), it does not hold the
sand and gravel for sale. Petitioner also argues that it does
not mark up the cost of the sand and gravel and that “it makes
the same profit whether it procures and delivers the requested
[sand and gravel], or simply delivers [the] sand and gravel which
the [customer] already owns or has purchased separately”.7
We reject petitioner’s contentions. When petitioner
transports the sand and gravel that a customer already owns or
has acquired, petitioner does not realize the profit associated
with acquiring sand and gravel for a customer. Based on the
7
Petitioner argues that because it designates the profit
it earns on the “procurement” of sand and gravel as a separate
element of its charge for acquiring and transporting 1 ton of
sand and gravel, petitioner does not mark up the sand and gravel.
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record, petitioner generates more profits if it both acquires and
transports sand and gravel for its customer rather than solely
acting as a transporter. Further, although not labeled by
petitioner as a markup in its business records, petitioner’s
profit for acquiring the sand and gravel is nevertheless a markup
since, in substance, the profit is based on a percentage of the
underlying cost of the sand and gravel. Furthermore, petitioner,
on its tax return, listed its business activity as the selling of
construction materials.
In RACMP Enters., Inc. v. Commissioner, 114 T.C. ___ (2000),
we recently held that respondent abused his discretion in placing
a construction contractor on the accrual method for Federal
income tax purposes. In that case, we concluded that the
material provided by the contractor to its customer, pursuant to
a construction contract for concrete foundations, driveways, and
walkways, was not merchandise within the meaning of section
1.471-1, Income Tax Regs. See id. In reaching that conclusion,
we viewed the construction contract as a service contract,
finding that the materials were indispensable to and inseparable
from the provision of that service and that the materials lost
their separate identity during the construction activity. See
id.; see also Osteopathic Med. Oncology & Hematology, P.C. v.
Commissioner, 113 T.C. 376 (1999) (wherein drugs used as part of
chemotherapy treatments were not considered merchandise because
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their use was an indispensable and inseparable part of the
rendering of services).
This is not such a case. Petitioner primarily sells a
product, the sand and gravel, and incidentally provides a
service, the transportation of the sand and gravel. Because
petitioner can generate profits from solely transporting the sand
and gravel, we do not view the sand and gravel as indispensable
to and inseparable from the provision of a service.8 Further,
because petitioner does not consume, alter, or add to the sand
and gravel, petitioner does not cause the sand and gravel to lose
its separate identity. As the evidence shows that petitioner is
a seller of sand and gravel, we conclude that the sand and gravel
is merchandise.
Petitioner additionally argues that even if we conclude that
the sand and gravel is merchandise, petitioner does not have to
maintain inventories because the sand and gravel is not an
income-producing factor in petitioner’s business. In evaluating
whether merchandise is an income-producing factor in a taxpayer’s
business, we must compare the cost of the merchandise to the
taxpayer’s gross receipts computed under the cash method of
8
With regard to revenues and expenses generated as a
result of customers requesting only transportation services,
petitioner has not argued in the alternative that they should be
placed on a hybrid method of accounting. In any respect,
petitioner has not presented any evidence with regard to those
revenues and expenses, and therefore it cannot meet its burden of
proof.
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accounting. See Wilkinson-Beane, Inc. v. Commissioner, supra.
In Wilkinson-Beane, Inc., we held that merchandise, the cost of
which (in different taxable years) constituted 14.7 percent and
15.4 percent of the taxpayer’s gross receipts, was an income-
producing factor in the taxpayer’s business. See also Knight-
Ridder Newspapers, Inc. v. United States, 743 F.2d 781, 791 (11th
Cir. 1984) (wherein newspapers, the cost of which constituted
17.6 percent of the taxpayer’s total revenues, were considered an
income-producing factor).
For its 1994 taxable year, petitioner reported cost of goods
sold in the amount of $1,867,497. Petitioner argues that
$786,723 of the $1,867,497 amount relates to petitioner’s
transportation activities, thereby leaving $1,080,774 for the
cost associated with petitioner’s acquisition of the sand and
gravel. Assuming arguendo that petitioner’s figures are correct,
because the cost of the sand and gravel constitutes at least 31
percent of petitioner’s gross receipts ($1,080,774 ÷ $3,483,206),
we conclude that the sand and gravel is an income-producing
factor in petitioner’s business.9
On brief, petitioner does not address whether it acquires
9
Petitioner does not include in cost of goods sold the
costs involved in filtering, gathering, and removing the Byron
sand from Unimin’s processing plant. These costs would
significantly increase the cost of goods sold and the percentage
that cost of goods sold would constitute of petitioner’s gross
receipts.
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title to the sand and gravel. Petitioner and respondent
stipulate that after petitioner loads the Byron sand onto its
trucks for delivery and Unimin creates a “weighmaster
certificate”, Unimin considers the Byron sand to be petitioner’s
property. We interpret that stipulation to mean that title to
the Byron sand passes from Unimin to petitioner at that point in
time.
The record does not reflect whether petitioner acquires
title to the sand and gravel that petitioner purchases from the
20 suppliers. In Addison Distrib., Inc., T.C. Memo. 1998-289, we
described a taxpayer as both a “buyer pursuant to its contract
with [a] vendor or subcontractor and [as a] seller pursuant to
its contract with its customers”. Citing California Commercial
Code section 2106 (West 1964), which provides that “a ‘sale’
consists in the passing of title from the seller to the buyer for
a price”, we concluded that the taxpayer had acquired title to
goods which were purchased from the vendor or subcontractor for
eventual sale to the taxpayer’s customers. See id. In light of
California Commercial Code section 2106, our characterization of
petitioner as a seller of sand and gravel, and petitioner’s
failure to dispute the transfer of title, we see no reason to
treat petitioner’s contractual and legal relationship with the 20
suppliers differently from petitioner’s business dealings with
Unimin. We therefore conclude that petitioner acquires title to
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the sand and gravel.
Because we hold that the sand and gravel is merchandise
which is an income-producing factor in petitioner’s business and
that petitioner acquires title to the sand and gravel, petitioner
must maintain inventories. Pursuant to section 1.446-1(c)(2)(i),
Income Tax Regs., petitioner would therefore have to report its
taxable income on the accrual method of accounting unless an
exception applies. A taxpayer demonstrating a substantial
identity of results between the taxpayer’s method of accounting
and the method of accounting selected by the Commissioner may
compute taxable income under its method of accounting. See
Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d 352, 356 (1st
Cir. 1970), affg. T.C. Memo. 1969-79. On brief, petitioner
concedes that it does not meet the substantial identity of
results test. We, therefore, hold that respondent did not abuse
his discretion under section 446 when respondent required
petitioner to compute its taxable income based on the accrual
method of accounting.
In reaching all our holdings herein, we have considered all
arguments made by the parties, and, to the extent not mentioned
above, we find them to be irrelevant or without merit.
To reflect the foregoing,
Decision will be entered
for respondent.