T.C. Memo. 2000-233
UNITED STATES TAX COURT
VANDRA BROS. CONSTRUCTION CO., INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 15483-96. Filed August 2, 2000.
Michael J. Occhionero, for petitioner.
Joseph P. Grant, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GALE, Judge: Respondent determined a deficiency of
$405,017, and an accuracy-related penalty under section 6662(a)
in the amount of $81,003.40, for petitioner’s 1992 taxable year.
Unless otherwise noted, all section references are to the
Internal Revenue Code in effect for the year in issue.
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After a concession by respondent,1 we must decide whether
respondent abused his discretion in determining that petitioner’s
use of the cash method of accounting did not clearly reflect
income. We hold that he did.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. We
incorporate by this reference the stipulation of facts and
attached exhibits. At the time of filing the petition,
petitioner was an Ohio corporation with its principal place of
business in Oakwood Village, Ohio.
Petitioner specialized in the construction of streets,
sidewalks, curbs, and similar improvements for governmental
entities. All of petitioner’s customers were governmental and
municipal agencies, including the State of Ohio and
municipalities within the State. Petitioner’s expertise was
construction, in particular laying concrete, on public sites such
as city streets and sidewalks that required the project to be
completed with a minimal amount of disruption in traffic flow and
in compliance with governmental regulations. Petitioner provided
labor and equipment,2 but petitioner did not maintain a supply of
any of the materials that were used at a construction site,
1
Respondent concedes that petitioner is not liable for the
accuracy-related penalty.
2
Occasionally petitioner rented equipment to third parties.
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instead relying on suppliers to deliver needed materials to the
construction site at the appropriate time. Petitioner only
ordered the materials it needed for the job for the particular
day. Petitioner had no plant or other facility to store
materials and could not store materials at the construction site.
(Petitioner left no material on site overnight except,
occasionally, a negligible amount.) Concrete could not be stored
on site for an additional reason: Within a few hours of
delivery, it would harden and become useless and worthless.
Thus, petitioner tried to estimate as closely as possible the
amount of materials needed so there would not be anything left
over. Petitioner bore the cost of any wasted materials if they
were the result of an over order, or, in the case of concrete, of
it not being laid in time. If the materials were defective or,
in the case of concrete, delivered too late, the supplier was
responsible and bore the cost.
Virtually all of petitioner’s projects required laying some
concrete. Petitioner also engaged in related work, such as
preparing a site by removing existing concrete or stone.
Petitioner also installed items such as reinforcing steel, piping
for sewers and drainage, and guardrails. During the year in
issue, 67 percent of petitioner’s total materials cost was due to
concrete, 16 percent was due to stone, 6 percent was due to
reinforcing material, and the remainder was due to other
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materials. In general, petitioner subcontracted for certain
parts of projects, such as electrical work, asphalt, or
landscaping.
Bids
Petitioner’s work was generally obtained through competitive
bids. Petitioner’s bids comprised costs for labor, equipment,
and materials. In computing its bid, petitioner estimated the
cost of labor and equipment and added a markup to the cost of
labor. Further, petitioner estimated the quantity of materials,
which could include concrete, aggregate (stone and gravel),
reinforcing steel, piping for sewer and drainage, guardrail, etc.
However, petitioner did not add a markup to the cost of materials
but rather included the cost of the materials, as quoted by the
supplier, as an item in the bid. During the year in issue, 27
percent of petitioner’s gross revenue came from the material cost
of concrete. Petitioner would always solicit materials costs
from at least two suppliers, and sometimes three or four, and
would choose the lowest quoted cost for use in the bid. The cost
of materials was subject to slight variations due, for example,
to the distance between a supplier and the job site. However,
petitioner got a discount for early payment to suppliers, which
was not passed along to customers. Occasionally a customer
itself would supply materials (e.g., concrete), but this did not
happen during the year in issue.
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Bids were calculated by estimating the cost of each
individual job that was necessary to complete the entire project.
The bid price of most of the individual jobs was calculated on a
per-unit basis. For instance, in arriving at a total bid for the
reconstruction of a street in the City of South Euclid,
petitioner bid $28 per square yard to install 9-inch reinforced
concrete pavement, and $5 per linear foot to install 6-inch
drainage conduit, and separate amounts for numerous other items.
The bid price for some individual jobs was calculated on a per-
item basis (for instance, $23 per each 9-foot guardrail post) or
on a lump-sum basis (for instance, $60,000 for clearing and
grubbing a certain area indicated in the project plan). The bid
calculation also included the estimated number of units or items
that the project required. However, petitioner would bill the
customer on the basis of the number of units or items actually
used on the project, not the number shown in the bid. In some
cases, petitioner was required by the customer to state
separately the cost of materials (i.e., without labor), and when
so required, petitioner did so on a per-unit or per-item basis.
Even if two jobs used the same amount of material, the amount of
the bid could have differed substantially, due to different cost
of labor and equipment. For instance, to maintain traffic flow,
petitioner might be limited in the amount of work it could
complete in one day, thus increasing costs of labor. Petitioner
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did not begin any work without a written contract for that
particular project. There were penalties if petitioner did not
comply with the contract.
When petitioner subcontracted, the subcontractor was
responsible for labor, equipment, and materials for its part of
the project. Petitioner took bids on the subcontractor work and
did not mark up the subcontractor’s bids, except to cover its own
bond costs and insurance. When petitioner subcontracted, if the
subcontractor did not pay its suppliers, those suppliers could
file liens against petitioner. Thus, petitioner took care in
selecting subcontractors, trying to ensure they could pay their
suppliers.
The construction season in general lasted from April to
November. Generally petitioner bid in the spring and finished
the projects by November or December. Occasionally work carried
over to the next year.
Governmental Regulations
Petitioner’s business was strictly regulated by its
customers. Both the State of Ohio and local governments
stationed an engineer at each construction site to inspect
materials and oversee the project. Petitioner was required to
pour concrete within 1 hour after the concrete supply truck left
the supply plant. If this condition was not met, the onsite
engineer had the right to reject the load of concrete. Further,
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the engineer inspected the concrete to make sure it was not
defective and had the right to reject it if it was. If concrete
was rejected, the party responsible assumed the loss. For
instance, if the supplier delivered defective concrete or did not
deliver the concrete to the site in time to lay it within 1 hour
of leaving the supplier’s plant, the supplier assumed the loss.
However, if petitioner failed to pour properly delivered concrete
in time, petitioner assumed the loss. The governmental entity
worked with petitioner and the supplier but ultimately held
petitioner responsible for any failure to meet contractual
obligations. Petitioner signed for the concrete after the
government’s inspector found it to be acceptable. The
government’s engineer gave permission to pour the concrete.
Thus, for instance, if permission was given and concrete was
poured, and then the concrete was damaged by rain before it
dried, the governmental entity assumed responsibility. For State
projects, the governmental regulation was so strict that
petitioner did not need to guarantee materials; if the State
allowed use of the materials, the State assumed responsibility
for defects. For city projects petitioner guaranteed some
materials, but the city would be responsible in some cases, for
instance if its engineer had advised petitioner to pour concrete
that was later damaged because of rain. During the 1990’s, 30 to
40 percent of petitioner’s work was for the State of Ohio.
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Accounting Method, Payments, and Billing
From its inception through the year in issue, petitioner
kept its books and records and reported its income using the cash
receipts and disbursements method of accounting. Prior to and
including the year in issue, petitioner’s annual gross receipts
did not exceed $5 million. Starting in 1991, petitioner prepared
financial reports using an accrual method of accounting, the
completed contract method. These financial reports were required
by petitioner’s bonding company. (Petitioner was often required
to be bonded for its work.)
Petitioner’s suppliers billed petitioner, not petitioner’s
customers, and petitioner made payment to the suppliers. If
petitioner had the money on hand, petitioner would pay when
billed. If not, petitioner would wait until the money was
available. For some projects, petitioner paid for all materials
before receiving any payment from its customer. Petitioner made
payments for its labor costs on a weekly basis. The schedule on
which petitioner billed and received payment from its
governmental entity customers was regulated by them; there was a
set schedule of payments over which petitioner had little or no
control. The State paid biweekly, whereas other governmental
entities paid monthly. Petitioner normally received payments
based on the amount of the project that was completed. On at
least one occasion during the year in issue, petitioner paid for
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all materials in 1992, but petitioner did not receive a check
from the customer until February 1993. However, the project was
completed in October 1992, and the delay in payment was beyond
petitioner’s control.
Petitioner made no attempt to defer income to a later year,
and there were no prepayments of expenses. Business decisions
were made on the basis of the cash method financial records, even
though the completed contract records were available.
In the notice of deficiency, respondent determined that
petitioner was required to use an accrual method of accounting.
By amendment to answer and stipulation of the parties, the
parties agree that if petitioner was not entitled to use the cash
method of accounting, then petitioner will elect to use, and
respondent will allow the use of, the completed contract method
of accounting.3
3
The parties further stipulate that under the completed
contract method of accounting, petitioner’s income for the
taxable year 1992 would be $433,862, which would result in a
current year adjustment of $385,755 (after consideration of
$48,107 in income reported on the cash basis) and adjustment
required to be taken into account in 1992 under sec. 481 of
$1,005,077. Thus, the total increase in petitioner’s taxable
income for 1992 would be $1,390,832.
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OPINION
We must decide whether respondent’s determination that
petitioner’s use of the cash method of accounting did not clearly
reflect income was an abuse of respondent’s discretion. We hold
that it was.
In order to require a taxpayer to change its method of
accounting, the Commissioner must determine that the method used
by the taxpayer does not clearly reflect income. See sec.
446(b); Hallmark Cards, Inc. v. Commissioner, 90 T.C. 26, 31
(1988). While the Commissioner’s discretion is broad, see Thor
Power Tool Co. v. Commissioner, 439 U.S. 522, 532-533 (1979), it
is not absolute, see Hallmark Cards, Inc. v. Commissioner, supra,
and we find an abuse of discretion when the Commissioner’s
determination is without sound basis in fact or law. See Ansley-
Sheppard-Burgess Co. v. Commissioner, 104 T.C. 367, 371 (1995).
In RACMP Enters., Inc. v. Commissioner, 114 T.C. 211 (2000),
we addressed these issues in a factual context indistinguishable
from the instant case. In that case, we provided as follows:
Whether * * * [the taxpayer] is required to report
its income on the accrual method of accounting instead
of the cash method depends on whether * * * [the
taxpayer] is in the business of selling merchandise to
customers in addition to providing service or whether
the material provided by * * * [the taxpayer] is a
supply that is incidental to the provision of the
contracted service. [Id. at 220; citations omitted.]
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In that case we found that the taxpayer, a company engaged in the
laying of concrete and the installation of related items, such as
sand, rock, wire mesh, and rebar, did not sell merchandise to its
customers. Rather, relying on Osteopathic Med. Oncology &
Hematology, P.C. v. Commissioner, 113 T.C. 376 (1999), we found
that the concrete and related materials were supplies consumed by
the taxpayer. In Osteopathic Med. Oncology & Hematology, P.C.,
we held that chemotherapy drugs furnished by a healthcare
provider in treating cancer patients were supplies rather than
merchandise because the taxpayer was a service provider and the
drugs were an “integral and inseparable part of its service.”
Id. at 384. Similarly, in RACMP Enters., Inc. v. Commissioner,
supra, we held that the taxpayer was a service provider, and we
found that the materials used in construction were not
merchandise because they were “indispensable and inseparable from
the service provided by” the taxpayer. Id. at 228. In
conclusion, we held that because the taxpayer did not produce or
sell merchandise, the taxpayer could not be required to use
inventory accounting. See id. at 229.
In the instant case, the concrete, stone, reinforcing steel,
and other items (collectively, the materials) used by petitioner
were not merchandise for the same reasons stated in RACMP
Enters., Inc.: First, the materials lost their separate identity
when used in a construction project. Second, petitioner did not
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contract to sell the materials but rather contracted to provide
finished walkways, repaired streets, and the like. Third, the
construction projects that petitioner engaged in were
improvements to real property. Fourth, petitioner did not leave
any of the materials on the construction site, or store them for
use for a later project. See id. at 228-231. Given our recent
holding in RACMP Enters., Inc., and the indistinguishable facts
of the instant case, we hold that petitioner was not engaged in
the production or sale of merchandise. Therefore, petitioner
cannot be required to use inventories, and the Commissioner
abused his discretion in requiring petitioner to change from the
cash method of accounting.
To reflect the foregoing,
Decision will be entered
for petitioner.