T.C. Memo. 2004-185
UNITED STATES TAX COURT
HERBERT C. HAYNES, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 11304-01. Filed August 18, 2004.
Fred R. Becker and Shawn P. Travis, for petitioner.
Mary P. Hamilton, for respondent.
MEMORANDUM OPINION
VASQUEZ, Judge: Respondent determined deficiencies in
petitioner’s Federal income taxes as follows: (1) For the tax
year ending May 31, 1995 (FYE 1995), $1,269,108;1 (2) for the tax
1
All amounts are rounded to the nearest dollar. All
section references are to the Internal Revenue Code in effect for
the years in issue, and all Rule references are to the Tax Court
Rules of Practice and Procedure.
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year ending May 31, 1996 (FYE 1996), $527,216; and (3) for the
tax year ending May 31, 1997 (FYE 1997), $718,914.
After concessions,2 the issue for decision is whether
respondent abused his discretion by requiring petitioner to
change its method of accounting from the cash receipts and
disbursements method of accounting (cash method) to the accrual
method of accounting (accrual method). Subsumed in this issue is
the question of whether petitioner is required to maintain
inventories for tax purposes.
Background
The parties submitted this case fully stipulated pursuant to
Rule 122. The stipulation of facts and the attached exhibits are
incorporated herein by this reference. At the time the petition
was filed, petitioner’s principal place of business was in Winn,
Maine.
Herbert C. Haynes, Inc.
Petitioner is a closely held Maine corporation engaged in
the logging business. Petitioner was incorporated in 1963.
Before incorporation, Herbert C. Haynes, Sr. operated the logging
business as a sole proprietorship. Herbert C. Haynes, Sr.,
president and founder of petitioner, is the majority shareholder
of petitioner. He owned between 97 and 89 percent of the stock
2
The parties filed a stipulation of settled issues
resolving all other issues.
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during the years in issue. The other shareholders are Virginia
Haynes--wife of Herbert C. Haynes, Sr. --and Herbert C. Haynes,
Jr., Ginger Haynes Maxwell, and Barbara Haynes French, children
of Herbert C. Haynes, Sr. Herbert C. Haynes, Jr., is the vice
president of petitioner. He holds a degree in forestry. Ginger
Haynes Maxwell is the secretary-clerk of petitioner. Virginia
Haynes is the treasurer of petitioner.
During the years in issue, petitioner employed approximately
60 employees. Herbert C. Haynes, Sr., and his three children are
full-time employees of petitioner. Three employees of petitioner
hold degrees in forestry. Petitioner employed log purchasers,
truck drivers, mechanics, bulldozer operators, excavators, and
office staff.
Petitioner’s Woodland Ownership
During the years at issue, petitioner owned at least 26,000
acres of woodland in Maine. Additionally, Herbert C. Haynes,
Sr., individually owned approximately 13,000 acres of woodland in
Maine. Lakeville Shores, Inc., a corporation owned 100 percent
by Haynes children, and Five Islands Land Co., a corporation
owned 100 percent by Herbert C. Haynes, Sr., also owned woodland
in Maine.3 Petitioner maintains that its shareholders and the
corporations owned by petitioner and by petitioner’s shareholders
3
Haynes Oil Co. is a fully owned subsidiary of petitioner.
Winn Logging, Inc., is a corporation owned by the Haynes
children. These corporations do not own woodland.
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(collectively, related entities) owned approximately 110,000
acres of woodland in Maine and other States.
Petitioner’s Business Activities
Most of petitioner’s business activities relate to the
cutting of timber4 and transporting the resulting “wood product”5
(logs or wood) to the appropriate mills. Petitioner supervised
the cutting of timber on its own land and on land owned by
others.
Petitioner had contracts and arrangements with approximately
100 mills. Under the contracts and arrangements, petitioner
agreed to deliver logs to the mills for an agreed-upon price.
These mills were located in Maine, Vermont, New Hampshire,
Quebec, and New Brunswick.
For example, in petitioner’s contract with International
Paper Co., petitioner agreed to sell specified quantities of logs
and wood (such as pulpwood, sawtimber, poles, and piling) to
International Paper Co. for a set price. The duration of the
contract was 6 months, divided into six 1-month order intervals.
4
The parties define “timber” as standing trees containing
wood available and suitable for marketing and use. “Hardwood” is
defined as broadleaved, deciduous trees. “Softwood” is defined
as trees that have needles, such as pine, spruce, and fir.
“Stumpage” is defined as a standing tree, and “stumpage value” is
defined as the “economic value of standing trees”. “Pulpwood” is
defined as “paper wood” or “smaller timber that is chipped up and
used primarily to make paper”.
5
Once timber is cut, it becomes a “wood product”.
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International Paper Co. would issue a wood delivery order and/or
a log delivery order within 1 week of the interval to petitioner.
The order specified the species, volume, delivery points, and
other specifications for deliveries to be made each week during
the interval. International Paper Co. or its designee scaled or
weighed all wood delivered by petitioner upon delivery.
International Paper Co. had the right to refuse to accept
delivery of all or a portion of the wood if it did not meet the
specifications agreed to in the contract.
Petitioner supplied the mills with logs through various
business activities. These included: (1) Cutting timber on land
owned by petitioner or related entities; (2) cutting timber on
land owned by third parties--i.e., landowners not related to
petitioner, petitioner’s shareholders, petitioner’s subsidiaries,
or petitioner’s shareholders’ corporations (collectively,
unrelated entities); and (3) purchasing wood from unrelated
entities. Petitioner generally received payment for logs within
2 to 4 weeks of delivery.
The trees cut by petitioner grew at a rate of 3 percent per
year. It takes 30 to 50 years for these trees to reach maturity.
Petitioner’s business activities did not include the planting of
new trees. Petitioner was not in the business of operating a
nursery or sod farm. Petitioner was not in the business of
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raising or harvesting trees bearing fruit, nuts, or other crops
or ornamental trees.
1. Timber Cut on Land Owned by Petitioner or Its
Related Entities
A portion of petitioner’s business activities related to
cutting timber on land owned by petitioner or its related
entities. For this portion of petitioner’s business activity,
petitioner’s foresters examined tracts of land to cut, marked
trees to cut, and supervised cutting. The crews that cut the
trees were not employees of petitioner; they were employed by
corporations under contract to petitioner. The corporations
petitioner hired to cut the trees were either related entities
(such as Winn Logging, Inc.) or unrelated entities. Trucks and
other heavy equipment owned by or leased to petitioner
transported the cut logs to mills designated by petitioner.
2. Timber Purchase Arrangements With Unrelated Entities
A second business activity involved petitioner’s timber
purchase arrangements with unrelated entities that owned
woodland. Under these contracts, petitioner’s foresters (or the
landowner’s foresters) identified the merchantable timber and
oversaw the cutting crews. Petitioner’s trucks delivered the
logs to mills that petitioner had contractual arrangements with.
Petitioner used either one of two pricing arrangements under
these timber purchase contracts: (1) Fixed-price or lump-sum
arrangements; or (2) “pay-as-cut” or stumpage permits.
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a. Fixed-Price Arrangements
In a fixed-price or a lump-sum arrangement, petitioner paid
a fixed price or a lump sum to cut timber for a fixed period.
Petitioner assumed the risk of loss if the land produced an
insufficient yield of timber.
b. “Pay-as-Cut” Arrangements
In a pay-as-cut or stumpage permit arrangement, petitioner
paid the landowner for the timber as it was cut. Foresters
identified the timber to cut, and petitioner’s foresters oversaw
the cutting crews.
Although petitioner’s contractual arrangements for
purchasing timber varied, petitioner’s typical stumpage permit
granted petitioner the right to cut timber on a designated parcel
of land. Petitioner paid the landowner for the logs at the time
of cutting. The stumpage permit granted petitioner the right to
enter the property with labor and equipment to cut and remove the
timber. Petitioner indemnified and held harmless the landowner
from all liabilities, claims, judgments, or liens associated with
its work on the premises. Petitioner also covenanted to observe
all Federal, State, and local laws, ordinances, and regulations
relating to the cutting of forest products and the removal of all
products and related waste from the premises.
Petitioner obtained stumpage permits from major timber
landowners such as J.M. Huber Corp., Great Northern Paper Co.,
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and International Paper Co., and from smaller landowners. For
stumpage permits with major timber landowners, the landowner’s
foresters identified the trees to be cut. For stumpage permits
with smaller landowners, petitioner’s foresters identified the
trees to be cut.
3. Financing Arrangements
As another business activity, petitioner entered into
purchase financing arrangements with unrelated entities. Under
these arrangements, petitioner lent the unrelated entity funds to
purchase woodland. The unrelated entity paid interest to
petitioner, gave petitioner a security interest in the land and
logs, and sold the logs to petitioner. Petitioner’s foresters or
log buyers surveyed the property and identified and priced the
marketable timber. In some arrangements, petitioner hired
cutting crews. In other instances, petitioner merely identified
and purchased the marketable timber and then sold and delivered
it to the mill.
4. Cutting Agreements With Unrelated Landowners
Petitioner also derived revenue from cutting agreements with
unrelated landowners. Under these cutting agreements, a
landowner hired petitioner to cut and transport timber to the
mills designated by the landowner. The landowner paid petitioner
a fixed rate per unit delivered.
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5. Purchased Wood
Another business activity petitioner engaged in involved
logs that petitioner purchased and then resold. Petitioner had
no involvement in the cutting of the logs under this business
activity. Petitioner purchased the cut logs from an unrelated
entity. The unrelated entity delivered the logs to mills
petitioner designated. The mills purchased the logs from
petitioner under an existing contract petitioner had with the
mill. The mill paid petitioner for the logs. Petitioner then
paid the unrelated entity for the logs, at a price less than what
the mill paid petitioner.
6. Petitioner’s Estimated Costs From Its Business
Activities
The parties stipulated the following:
Because of the scope of petitioner’s activities
and the entrepreneurial nature of the industry, it is
impossible to describe a single business model.
Further, the extent of petitioner’s activities * * *
will vary from year [to year] and involve many unique
transactions.
Petitioner estimates the direct costs associated with the
various business activities as follows:
Business Activity FYE 1995 FYE 1996 FYE 1997
Trees from petitioner’s land $12,333,559 $12,136,789 $9,050,143
Trees from related party land 24,667,118 24,273,578 22,647,858
Trees from unrelated party land 12,333,559 12,136,789 13,588,715
Subtotal 49,334,236 48,547,156 45,286,716
Purchased wood 23,099,969 18,079,103 28,757,169
Total 72,434,205 66,626,259 74,043,885
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As a percentage, petitioner estimates the direct costs associated
with the various business activities as follows:
Business Activity FYE 1995 FYE 1996 FYE 1997
Trees from petitioner’s land 17% 18% 12%
Trees from related party land 34 36 31
Trees from unrelated party land 17 18 18
Subtotal 68 73 61
Purchased wood 32 27 39
Total 100 100 100
Financial Accounting
The firm of Haverlock, Estey & Curran prepared petitioner’s
financial statements for FYE 1995, FYE 1996, and FYE 1997. The
financial statements note, in the first footnote, that “The
company * * * is on the cash basis of accounting for financial
statement and tax reporting. Consequently, accounts payable,
receivable and inventory are not recognized in these statements.
The estimated figures for each * * * are as follows:”
FYE 1995 FYE 1996 FYE 1997
Accounts receivable $1,576,000 $3,200,000 $3,500,000
Accounts payable --— --— ---
Inventory1 (cost, FIFO) 1,862,892 1,477,361 1,862,892
1
The parties agree that if respondent prevails and petitioner is
required to maintain inventories, the closing inventory figures
are as follows: (1) For FYE 1995, $1,862,892; (2) for FYE 1996,
$610,950; and (3) for FYE 1997, $587,334.
Income Tax Returns
On petitioner’s Forms 1120, U.S. Corporation Income Tax
Return, for the years at issue, petitioner listed its business
activity as “wood operator” and its product or service as
“pulpwood and logs”. Since its inception, and including the
years at issue, petitioner has maintained its books and records
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and filed its Federal income tax returns using the cash method.
For FYE 1995, petitioner had gross receipts of $82,693,253 and
cost of operations of $78,340,960. For FYE 1996, petitioner had
gross receipts of $76,677,330 and cost of operations of
$72,745,121. For FYE 1997, petitioner had gross receipts of
$86,123,392 and cost of operations of $81,561,495.
Discussion
I. Evidentiary Issue
Attached to petitioner’s opening brief are exhibits which
were not included in the stipulation of facts and exhibits
submitted pursuant to Rule 122. Petitioner’s requests for
findings of fact and argument refer to these exhibits.
The submission of a case without trial under Rule 122(a)
does not alter the requirements otherwise applicable to adducing
proof. Rule 122(b). Statements in briefs do not constitute
evidence. Rule 143(b); Evans v. Commissioner, 48 T.C. 704, 709
(1967), affd. per curiam 413 F.2d 1047 (9th Cir. 1969); Chapman
v. Commissioner, T.C. Memo. 1997-147; Berglund v. Commissioner,
T.C. Memo. 1995-536. Accordingly, the additional exhibits
attached to petitioner’s briefs are not part of the record and
will not be considered by the Court.
II. Burden of Proof
Petitioner appears to argue that respondent bears the burden
of proof on the issue of whether petitioner must maintain
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inventories. Petitioner argues that this issue is a “new matter”
not contained in the notice of deficiency. Our resolution of
this case does not depend on which party bears the burden of
proof. Nonetheless, for the sake of completeness, we will
address this issue.
Petitioner bears the burden of establishing that
respondent’s determinations of deficiencies, as contained in the
statutory notice of deficiency, are incorrect. See Rule 142(a);6
Welch v. Helvering, 290 U.S. 111 (1933).
The notice of deficiency states:
Schedule A-1
Explanation of Adjustments
a. Change of Accounting Method 5/31/95 $1,576,300.00
5/31/96 $1,623,700.00
5/31/97 $300,000.00
The cash receipts and disbursements method of accounting you
used to keep your books and records does not clearly reflect
income; but the accrual method of accounting clearly reflects your
income. Therefore, your taxable income is increased
$1,576,300.00, $1,623,700.00 and $300,000.00 for 5/31/95, 5/31/96
and 5/31/97, respectively.
b. Cost of Sales 5/31/95 $1,862,892.00
5/31/96 ($1,862,892.00)
5/31/97 ($1,477,361.00)
Since you are being required to use the accrual method of
accounting, the values of your opening and closing inventories for
the tax year ending 5/31/95 is $0.00 and $1,862,892.00. For the
tax year ending 5/31/96, your opening and closing inventories are
$1,862,892 and $1,477,361.00. For the tax year ending 5/31/97,
your opening and closing inventories are $1,477,361.00 and
$2,419,747.
6
The examination in this case commenced before July 22,
1998. Accordingly, sec. 7491 is inapplicable. See Warbelow’s
Air Ventures, Inc. v. Commissioner, 118 T.C. 579, 582 n.8,
(2002), affd. 80 Fed. Appx. 16 (9th Cir. 2003).
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c. Cost of Sales 5/31/96 $1,477,361.00
5/31/97 $2,419,747.00
Since you are being required to use the accrual method of
accounting, the values of your opening and closing inventories for
the tax year ending 5/31/95 is $0.00 and $1,862,892.00. For the
tax year ending 5/31/96, your opening and closing inventories are
$1,862,892 and $1,477,361.00. For the tax year ending 5/31/97,
your opening and closing inventories are $1,477,361.00 and
$2,419,747.
[Emphasis added.]
The language regarding the adjustments to the cost of sales
specifically refers to the value of petitioner’s inventories.
We find respondent determined in the notice of deficiency that
petitioner is required to maintain inventories. This is not a
new issue.
III. Whether Petitioner’s Accounting Method Clearly Reflects
Income
A. Applicable Law
Respondent asserts that the cash method does not clearly
reflect petitioner’s income. Under section 446,7 the
7
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--
(continued...)
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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. v. Commissioner, supra
at 370.
Whether respondent abused his discretion is a question of
fact. See Ansley-Sheppard-Burgess Co. v. Commissioner, supra at
371; Ford Motor Co. v. Commissioner, 102 T.C. 87, 91-92 (1994),
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.
7
(...continued)
(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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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 id.; Ford Motor Co. v. Commissioner, 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 on the basis of the method of
accounting it uses 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 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 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 an item 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
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Cir. 1994); Wilkinson-Beane, Inc. v. Commissioner, T.C. Memo.
1969-79, affd. 420 F.2d 352 (1st Cir. 1970).
B. Whether Petitioner Must Maintain Inventory
Respondent contends that, because the logs and wood are
merchandise that is an income-producing factor in petitioner’s
business, petitioner must maintain inventories and report its
taxable income under the accrual method.
Petitioner failed to respond in its reply brief to
respondent’s arguments regarding this issue. In its opening
brief petitioner argues that the purchased wood is not inventory
because petitioner does not possess title to it. Petitioner’s
only statement on this issue is:
It seems reasonably far-fetched to contend that a
person that harvests trees on land not owned by
Petitioner and delivers them to a mill under
Petitioner’s contract, which Petitioner first learns
about when it is presented a scale slip, somehow
resulted in Petitioner receiving title to a log that is
probably pulp before Petitioner’s obligation to pay
arises. Indeed, we are unsure what this inventory
argument truly brings to the clear reflection of
anything since the “inventory” seems to be sold before
it is received and the Petitioner never has the risk of
loss or the benefits and burdens of ownership.
For the reasons stated below, we agree with respondent that
petitioner maintains inventory and must use the accrual method.
1. Purchase, Production, or Sale
It is undisputed that petitioner purchases the purchased
wood. Petitioner then resells the purchased wood to the mills.
Additionally, in evaluating the substance of the transactions,
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we believe petitioner bought wood in its other business
activities as well. Petitioner’s activities related to cutting
wood on land owned by unrelated entities, under the numerous
business activities such as the fixed price arrangements and
pay-as-cut arrangements, are also forms of purchasing wood
products for resale. Petitioner “bought” the timber (standing
trees) on the unrelated entity’s land, supervised cutting of the
timber, removed the logs using its own equipment and trucks, and
delivered the logs to the mills.
2. Merchandise
The logs and other wood products are merchandise to
petitioner. 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. 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 business at hand. Wilkinson-Beane, Inc.
v. Commissioner, supra; Thompson Elec., Inc. v. Commissioner,
T.C. Memo. 1995-292; Honeywell, Inc. v. Commissioner, supra;
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J.P. Sheahan Associates v. Commissioner, T.C. Memo. 1992-239.
Possession of title to goods, even if only for an instant, is
sufficient to require a taxpayer to inventory the goods.
Addison Distrib. Inc. v. Commissioner, T.C. Memo. 1998-289;
Middlebrooks v. Commissioner, T.C. Memo. 1975-275; see also sec.
1.471-1, Income Tax Regs.
Petitioner stipulated that it acquired the purchased wood.
Petitioner stipulated that it sold the purchased wood it
acquired. We have also found that petitioner bought and sold
the wood it cut on land owned by unrelated entities. The terms
of a typical contract between petitioner and a mill state:
For the period and upon the terms and conditions
hereinafter set forth, SELLER undertakes and agrees to
sell and deliver unto PURCHASER, and PURCHASER
undertakes and agrees to purchase and accept from
SELLER, those certain quantities of pulpwood,
sawtimber, poles and piling (herein called “wood”) as
are hereinafter more particularly set forth and
described.
Petitioner obtains title to the wood before it sells it to
the mills. See Me. Rev. Stat. Ann. tit. 11, sec. 2-401 (West
1995) (passage of title). For petitioner to purchase and resell
the wood, title had to pass from the logger who cut the wood to
petitioner and then from petitioner to the mill. See also
Tebarco Mech. Corp. v. Commissioner, T.C. Memo. 1997-311.
Petitioner’s income tax returns indicate that its product
or service was “pulpwood and logs”. The logs are not consumed
by petitioner in its business. Petitioner has not asserted that
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it is in a service business or that the logs are incidental to
its business activity. To the contrary, petitioner is in the
business of buying and selling logs.
The substance of the transactions demonstrates that
petitioner acquired logs and wood and held them for sale.
3. Income-Producing Factor
In evaluating whether merchandise is an income-producing
factor in a taxpayer’s business, we compare the cost of the
merchandise to the taxpayer’s gross receipts computed under the
cash method. See Wilkinson-Beane, Inc. v. Commissioner, supra.
In Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d 352 (1st Cir.
1970), the Court of Appeals affirmed our holding 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 a significant income-producing factor in the
taxpayer’s business. See also Knight-Ridder Newspapers, Inc. v.
United States, 743 F.2d 781, 790 (11th Cir. 1984) (wherein
newspapers, the cost of which constituted 17.6 percent of the
taxpayer’s total revenues, were considered a material income-
producing factor).
Here, the cost of the purchased wood was stipulated by the
parties as $23,099,069, which is 28 percent of petitioner’s
gross receipts for FYE 1995; $18,079,103, which is 23.6 percent
of petitioner’s gross receipts for FYE 1996; and $28,757,169,
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which is 33 percent of petitioner’s gross receipts for FYE 1997.
The business activity related to purchased wood was a
substantial income-producing factor to petitioner.
Considering the cost of the purchased wood plus the
business activities of cutting trees on land owned by unrelated
entities, the cost of the wood that petitioner purchased was 43
percent of the gross receipts for FYE 1995 ($23,099,969 +
$12,333,559), 39 percent of the gross receipts for FYE 1996
($18,079,103 + $12,136,789), and 49 percent of the gross
receipts for FYE 1997 ($28,757,169 + $13,588,715).
Considering wood that petitioner purchased from related
entities, these percentages are even higher.
Accordingly, petitioner must maintain inventories and use
the accrual method to account for purchases and sales.
Petitioner’s use of the cash method does not clearly reflect its
sales income.
IV. Other Arguments Raised by Petitioner
Petitioner claims that it is a grower and harvester of
trees. Petitioner argues that “the Code literally, explicitly,
and intentionally permits a company that ‘harvests’ timber to
use the cash method of accounting” and that respondent cannot
force petitioner to change an accounting method specifically
authorized by the Internal Revenue Code. Petitioner cites
sections 447 and 448 in support of this argument.
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A. Section 447--Method of Accounting for Corporations
Engaged in Farming
Section 447 provides that taxable income from farming of a
corporation engaged in the trade or business of farming “shall
be computed on an accrual method of accounting”. Sec. 447(a).
Section 447, however, does not apply to the trade or business of
harvesting trees that are not fruit or nut trees. Id. We agree
with petitioner that section 447 does not require petitioner’s
use of the accrual method.
We disagree, however, that section 447 “literally,
explicitly, and intentionally” permits petitioner’s use of the
cash method under the facts and circumstances presented.
Section 447 sets forth conditions that require use of the
accrual method, not authorization to use the cash method.
B. Section 448–Whether Petitioner Is a
“Farming Business”
Section 448 provides that a C corporation shall not compute
its taxable income using the cash method. Sec. 448(a)(1). An
exception exists for C corporations engaged in a “farming
business.” Sec. 448(b)(1). “Farming business” includes “the
raising, harvesting, or growing” of timber. Secs. 448(d)(1)(B),
263A(c)(5). Timber includes “trees raised, harvested, or grown
by the taxpayer” other than trees that bear fruit or nuts, and
other than trees in a nursery. Sec. 263A(c)(5), (e)(4).
Petitioner contends that it should be allowed to use the
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cash method because section 448 does not bar it. “The fact that
section 448 does not preclude petitioner from using the cash
method does not authorize it if * * * the cash method does not
clearly reflect income.” Thompson Elec., Inc. v. Commissioner,
T.C. Memo. 1995-292. When a taxpayer has inventories, the
taxpayer may not use the cash method, even though so permitted
under section 448, if the cash method does not clearly reflect
its income. See id.
Indeed, the regulations under section 448 emphasize that
other sections may limit a taxpayer’s entitlement to use the
cash method.
Nothing in section 448 shall have any effect on the
application of any other provision of law that would
otherwise limit the use of the cash method, and no
inference shall be drawn from section 448 with respect
to the application of any such provision. For example,
nothing in section 448 affects * * * the requirement of
§ 1.446-1(c)(2) that an accrual method be used with
regard to purchases and sales of inventory. Similarly,
nothing in section 448 affects the authority of the
Commissioner under section 446(b) to require the use of
an accounting method that clearly reflects income
* * *. For example, a taxpayer using the cash method
may be required to change to an accrual method of
accounting under section 446(b) because such method
clearly reflects that taxpayer’s income, even though
the taxpayer is not prohibited by section 448 from
using the cash method. * * * [Sec. 1.448-1T(c),
Temporary Income Tax Regs., 52 Fed. Reg. 22767 (June
12, 1987).]
We have found that petitioner must maintain inventories.
Accordingly, the cash method does not clearly reflect
petitioner’s income. Section 448 does not “literally,
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explicitly, and intentionally” permit petitioner’s use of the
cash method.
C. Section 1.471-6(a), Income Tax Regs.--Whether
Petitioner Is a “Farmer”
Petitioner cites various cases in which we held that the
taxpayers were farmers and thus were entitled to use the cash
method. In Maple Leaf Farms, Inc. v. Commissioner, 64 T.C. 438
(1975), we held that a duck grower was entitled to use the cash
method under section 1.471-6(a), Income Tax Regs. We looked to
other sections to determine whether the duck grower was a
“farmer” and whether the place where the duck growing process
occurred was a “farm” for purposes of section 1.471-6(a), Income
Tax Regs. Id. at 447 (citing sections 175(c)(2), 180(b),
182(c), and 6420(c)(2) and (3) and sections 1.61-4(d), 1.175-3,
1.180-1(b), and 1.182-2, Income Tax Regs.). In Maple Leaf
Farms, Inc., the facts evidenced that the taxpayer was
integrally involved in the process of growing ducks it raised on
its own property and in the process of growing ducks it supplied
to independent growers. Id. The taxpayer also bore a
substantial risk of loss. Id. at 448. Thus, the taxpayer’s
“participation in the activities of its growers was sufficient
to constitute it a ‘farmer’ and accordingly it may use the cash
receipts and disbursements method of accounting in respect of
its ducks.” Id. at 452; see also sec. 1.471-6(a), Income Tax
Regs.
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In Hi-Plains Enters., Inc. v. Commissioner, 60 T.C. 158
(1973), affd. 496 F.2d 520 (10th Cir. 1974), and Cameron v.
Commissioner, T.C. Memo. 1982-259, two cases decided before the
enactment of section 447, we held that taxpayers who operated
commercial feedlots were “farmers” and the feedlot was a “farm”
under the Internal Revenue Code. The taxpayers were permitted
to use the cash method pursuant to section 1.471-6(a), Income
Tax Regs.
The facts of the aforementioned farming cases are
distinguishable from the facts of this case. In the farming
cases, the taxpayers engaged in the business activity of
farming, as defined in sections 175(c)(2), 180(b), 182(c), and
6420(c)(2) and (3) and sections 1.61-4(d), 1.175-3, 1.180-1(b),
and 1.182-2, Income Tax Regs. Section 1.471-6(a), Income Tax
Regs., permits taxpayers who meet the definition under these
sections to use the cash method. See Maple Leaf Farms, Inc. v.
Commissioner, supra at 447.
Unlike the taxpayers in Maple Leaf Farms, Inc., Hi-Plains
Enters., Inc., and Cameron, petitioner does not operate a
“farm”, and its business activities do not meet the definition
of “the business of farming” or “farming” under these sections.
For example, in section 175(c)(2), which the Court cited in
Maple Leaf Farms, Inc., “land used in farming” means “land used
* * * by the taxpayer or his tenant for the production of crops,
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fruits, or other agricultural products, or for the sustenance of
livestock.” Under the facts of this case, petitioner does not
use the woodland it owns to produce crops, fruits, or other
agricultural products. Likewise, in sections 1.182-2 and 1.175-
3, Income Tax Regs., “A taxpayer is engaged in the business of
farming if he cultivates, operates, or manages a farm for gain
or profit * * * A taxpayer engaged in forestry or the growing of
timber is not thereby engaged in the business of farming.”8
Indeed, these regulations specifically exclude petitioner from
the definition of “business of farming” for purposes of those
sections.
Petitioner engages in a variety of business activities.
Petitioner’s business activities do not qualify petitioner as a
“farmer” for purposes of section 1.471-6(a), Income Tax Regs.
Further, some of petitioner’s business activities specifically
require it to maintain inventories. Thus, section 1.471-6(a),
Income Tax Regs., does not permit petitioner’s use of the cash
method under the facts and circumstances presented herein.
8
We note that the other sections cited in Maple Leaf
Farms, Inc. v. Commissioner, 64 T.C. 438 (1975), provide similar
definitions for “farming” and “the business of farming”.
Petitioner does not meet these definitions either. See secs.
180(b), 6420(c)(2) and (3); secs. 1.61-4(d), 1.180-1(b), Income
Tax Regs.
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D. Use of Both Cash and Accrual Methods
Petitioner argues that it should be permitted to use the
cash method for the business activity of cutting trees on its
own land. “Where a taxpayer has two or more separate and
distinct trades or businesses, a different method of accounting
may be used for each trade or business, provided the method used
for each trade or business clearly reflects the income of that
particular trade or business.” Sec. 1.446-1(d)(1), Income Tax
Regs. “No trade or business will be considered separate and
distinct * * * unless a complete and separable set of books and
records is kept for such trade or business.” Sec. 1.446-
1(d)(2), Income Tax Regs.
Petitioner does not maintain separate businesses or
separate books and records for its various business activities.
Indeed, petitioner stipulated: “Because of the scope of
petitioner’s activities and the entrepreneurial nature of the
industry, it is impossible to describe a single business model.
Further, the extent of petitioner’s activities * * * will vary
from year [to year] and involve many unique transactions.”
Petitioner engages in various business activities. In
Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d at 355, the
Court of Appeals for the First Circuit, the court to which an
appeal of this case would lie, held that the taxpayer had to use
the accrual method where its business involved providing funeral
- 27 -
services and supplying caskets for the funeral services. In
Knight-Ridder Newspapers, Inc. v. United States, 743 F.2d at
790, the Court of Appeals for the Eleventh Circuit held that a
newspaper that provided the service of presenting information to
its readers had to use the accrual method where the cost of
newsprint and ink was 17.6 percent of the total cash receipts.
In Ward AG Prods. v. Commissioner, T.C. Memo. 1998-84, affd.
without published opinion 216 F.3d 1090 (11th Cir. 2000), we
held that a taxpayer who operated a business that sold farming
seed, fertilizer, and equipment and provided certain services to
farmers was not a farming business and had to maintain
inventories and use the accrual method.
Some of petitioner’s business activities involve no growing
of trees, no harvesting of trees, and no ownership of the land
on which the trees are grown. Other business activities involve
a combination of the above. The business activities related to
buying and selling wood generate merchandise for petitioner.
The merchandise is an income-producing factor to petitioner.
Thus, the facts and circumstances of this case are analogous to
those described in Wilkinson-Beane, Inc. and Knight Ridder
Newspapers.
Petitioner must use the accrual method of accounting for
all of its business activities. See Thompson Elec., Inc. v.
Commissioner, T.C. Memo. 1995-292.
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In reaching all of 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.9
Decision will be entered
under Rule 155.
9
We note that secs. 611 and 631 and the regulations
thereunder contain special rules of accounting for the timber
industry. See secs. 611, 631; sec. 1.611-3, Income Tax Regs.
(relating to cost depletion of timber), sec. 1.631-1, Income Tax
Regs. (creating an election to consider the cutting of timber as
a sale or exchange); see also RLC Indus. Co. v. Commissioner, 98
T.C. 457 (1992) (analyzing taxpayer’s method of computing timber
depletion under sec. 611), affd. 58 F.3d 413 (9th Cir. 1995).
Neither party argued in its briefs that these code sections
are dispositive of the issues presented in this case.
Additionally, neither party addressed the interplay of these code
sections with secs. 447 and 448, or the rules regarding inventory
in the regulations under secs. 611 and 631. Accordingly, we will
not address these issues.
We note that while petitioner mentioned sec. 631(a) in
passing in its reply brief, petitioner did not raise the
aforementioned issues. Furthermore, we will not consider issues
that are raised for the first time in a reply brief. See Foil v.
Commissioner, 92 T.C. 376, 418 (1989), affd. 920 F.2d 1196 (5th
Cir. 1990); Markwardt v. Commissioner, 64 T.C. 989, 997 (1975).