RACMP Enterprises, Inc. v. Commissioner , 114 T.C. No. 16 ( 2000 )

114 T.C. No. 16
UNITED STATES TAX COURT
RACMP ENTERPRISES, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 23954-97. Filed March 30, 2000.
P is a construction contractor that enters into
contracts to construct, place, and finish concrete
foundations, driveways, and walkways for real property
developers. P uses the cash method to recognize income
and to expense the cost of concrete and other
materials. R determined that the material P uses in
providing service to its clients is "merchandise" under
sec. 1.471-1, Income Tax Regs., and that P must report
its income on the accrual method of accounting.
Held: P's contract to provide labor and material
to a real property developer is a contract to provide
service, and the material is an indispensable and
inseparable part of the provision of that service. See
Osteopathic Med. Oncology & Hematology, P.C. v.
Commissioner, 113 T.C. 376, 384 (1999).
Held, further, material that is provided by a
construction contractor according to the terms of a
contract that requires the provision of labor and
material, and which, when combined with other tangible
personal property, loses its separate identity to
become an integral and inseparable part of a building
or other real property, is not merchandise within the
- 2 -
meaning of sec. 1.471-1, Income Tax Regs.
Held, further, under the facts of this case, R abused
his discretion in determining that P must use the
accrual method of accounting to report its income for
Federal income tax purposes.
Kevin P. Courtney, for petitioner.
Steven Walker, for respondent.
PARR, Judge:* Respondent determined an $82,577 income tax
deficiency for petitioner's tax year ended August 31, 1994, and a
section 66621 accuracy-related penalty of $16,515.
The issues for determination are: (1) Whether the material
provided by petitioner in accordance with its contract to
construct and place concrete foundations, driveways, and walkways
is merchandise within the meaning of section 1.471-1, Income Tax
Regs. We hold it is not. (2) Whether respondent abused his
discretion in determining that petitioner's use of the cash
method of accounting did not clearly reflect its income. We hold
he did. (3) Whether petitioner is liable for an accuracy-related
penalty. Because of our disposition of the preceding issues, we
need not address this issue.
*
This case was reassigned to Judge Carolyn Miller Parr by
order of the Chief Judge.
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the year at issue.
- 3 -
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulations of facts and the attached exhibits are
incorporated herein by this reference. At the time the petition
in this case was filed, petitioner was a California corporation
with its principal place of business in Gilroy, California, where
it had a small office and an equipment yard.
Petitioner is a licensed contractor in the State of
California, holding a class C-8 license to construct, place, and
finish concrete foundations and flatwork. The term "flatwork"
means driveways and walkways.
Petitioner used concrete, sand, drain rock, and various
hardware items (wire mesh, rebar, anchor bolts and rods,
holddowns, P.A. straps, column bases, post bases, and drain
piping), to perform its contracts.
The concrete, sand, rock, and hardware items were delivered
to the construction site, not to petitioner's equipment yard or
office. The invoices show that during the year at issue, the
cost of sand was $6.50 per ton and drain rock $11.65 per ton.
Occasionally, when the construction site became congested,
petitioner would put some of the hardware items in the back of a
truck, store the truck in its equipment yard overnight, and
return it to the construction site the following day. Petitioner
had a metal storage container similar to the type of containers
- 4 -
used on cargo ships at its equipment yard that it used to store
equipment and some hardware items.
The Construction Cycle
A. The Bid
During the year at issue, petitioner performed its
construction activity in the following manner. Petitioner
obtained a set of building plans from a developer and then
visited the construction site to evaluate the soil, weather, and
traffic conditions, and to ascertain the location of the
materials suppliers. Petitioner calculated its bid price by
summing its estimates of the cost of the labor and materials
required to perform the work plus a margin for profit based upon
the cost of the labor, the quantity of materials, and the
complexity of the job.
The following is a typical bid worksheet prepared by
petitioner:
Typical Bid Worksheet
Ready-mix concrete $547.80
Sand 225.00
Other materials 69.44
Other materials 7.70
Other materials 4.80
Total 854.74
Tax (8.5%) 72.65
Total materials cost 927.39
Plus labor 477.20
Equals 1,404.59
Plus 15% profit 210.69
Total 1,615.28
- 5 -
B. The Contract
If petitioner's bid was accepted by the developer, a written
contract was executed to construct, place, and finish the
required foundations and flatwork. The parties stipulated that a
typical contract between petitioner and its clients provided the
following:
In consideration of the mutual agreements
contained herein, Contractor and Subcontractor
[petitioner] agree as follows:
1. Work. The work to be performed hereunder
shall include, and Subcontractor shall perform, all
duties and services necessary or inherent to the type
and trade classification of FOUNDATION & FLATWORK, the
scope of which is more fully defined in Exhibit A -
Scope of the Work, hereto (the "Work"). The Work shall
include all work of such type and trade classification
for the Project, and is to be performed in strict
compliance with this Subcontract and the Contract
Documents (as defined in Paragraph 9 hereof) and all
addenda, amendments and changes thereto, whether or not
stipulated in the Contract Documents, and shall include
all work ordinarily and usually performed, and the
supply of all facilities ordinarily and usually
provided as part of the Work covered by this
Subcontract or ordinarily and usually performed by a
subcontractor doing work of such trade classification.
Subcontractor, to the entire satisfaction and approval
of Contractor (or its authorized representatives and/or
assigns) and all governing agencies agrees to furnish
sufficient labor, materials, tools, equipment and
services and to properly perform the Work in a sound
workmanlike and substantial manner. Subcontractor is
employed by Contractor as an independent contractor to
perform the work.
* * * * * * *
15. Materials and Workmanship; Inspection and Testing
(a) All materials used in the Work shall be
furnished in ample quantities to facilitate the proper
and expeditious execution of the Work and shall be new
- 6 -
and of the most suitable grade of their respective
kinds and purpose. At the request of the Contractor,
Subcontractor shall furnish to Contractor for approval,
full information and/or samples concerning the
materials or articles which Subcontractor intends to
incorporate in the Work. The materials actually used
in the Work shall conform to the information or samples
approved. Machinery, equipment, materials and articles
installed or used without such approval shall be used
by Subcontractor at the risk of subsequent rejection by
Contractor.
(b) Except as otherwise provided herein, all
material and workmanship, if not otherwise designated
by the Contract Documents, shall be subject to
inspection, examination and test by Contractor at any
and all times during manufacture and/or construction
and at any and all places when such manufacturing or
construction are carried on. Contractor shall have the
right to reject improper or defective material or
workmanship or require correction without charge to
Contractor. Subcontractor shall promptly segregate and
remove rejected material from the Project Site.
Nothing contained in this Paragraph 15 shall in any way
restrict the rights of Contractor under any warranty by
Subcontractor of material or workmanship.
16. Warranty; Customer Service
(a) Subcontractor warrants and represents to
Owner and to Contractor that the workmanship of the
Work, all materials and equipment furnished for the
Work, and all other aspects regarding the Work to be
performed under this Subcontract shall be in
conformance with this Subcontract and the Contract
Documents, be of finest quality, and be free from
faults and defects of design, material and Workmanship
for a period of two (2) years from (i) the date of the
initial occupancy of the particular residential unit
for which an applicable portion of Subcontractor's Work
was performed or (ii) for such longer period as may be
required by FHA, VA and/or other applicable
governmental authorities. Subcontractor agrees to
satisfy its warranty obligations upon receipt of
written notice from Contractor requiring same without
cost to Contractor. The remedies provided in this
Paragraph 16(a) shall not be restrictive but shall be
cumulative and in addition to all other remedies of
- 7 -
Contractor hereunder and under California law,
including all laws related to latent defects or fraud.
If Contractor reasonably deems it more expedient to
correct any of the Work covered by warranty itself
because of any delay by Subcontractor, a "backcharge"
may be made pursuant to Paragraph 23 below. This
provision shall be binding upon the successors and
assigns of Subcontractor and shall benefit the
successors and assigns of the Contractor; including
purchasers of residences within the Project.
* * * * * * *
Exhibit A, Specific Scope of Work, of the contract provided
the following:
1. General
a. Subcontractor is responsible for all
materials until final installation and
acceptance by CONTRACTOR. Any loss due to
theft or breakage prior to acceptance by
CONTRACTOR shall be replaced by SUBCONTRACTOR
at no additional charge to CONTRACTOR.
b. SUBCONTRACTOR agrees herein that any labor,
materials, and/or workmanship that does not
comply to the CONTRACTOR'S standards shall be
removed and replaced to conform to the
CONTRACTOR'S standards.
c. SUBCONTRACTOR further agrees that the quality
of his workmanship and his materials shall be
in strict accordance with the plans and these
specifications.
* * * * * * *
e. SUBCONTRACTOR shall warranty all concrete foundation
work for two years from acceptance of work by
CONTRACTOR.
- 8 -
C. Performance of the Contract
Petitioner began performance of the contract by constructing
the concrete forms on the ground out of lumber in accordance with
the developer's blueprints. After the placement of the forms was
accepted by the developer, fill sand and drain rock were spread
within the forms according to the plan specifications.
Petitioner cut wire mesh and rebar to size and placed them within
the forms and engaged a carpenter subcontractor for the correct
placement of the other hardware items. Once the form work was
inspected and accepted by the developer, petitioner ordered
delivery of the ready-mix concrete.
Ready-mix concrete is composed of water, cement, and
aggregate, which are mixed together to a mudlike consistency.
The concrete must be poured within 3 or 4 hours after the water
is introduced to the cement; the concrete cannot be poured after
this length of time as it changes from a liquid into a solid.
Petitioner ordered concrete from a supplier that delivered
it to the construction site. Petitioner did not manufacture,
deliver, or store the concrete. In a typical transaction,
petitioner placed the order with the concrete supplier's
dispatcher by telephone, specifying the quantity of concrete and
the time and place of delivery. The concrete supplier's invoice
provided that petitioner was liable for payment for the concrete.
After the order was placed, the concrete supplier sent a
- 9 -
California Preliminary Lien Notice to the developer and a copy to
petitioner. The preliminary lien notice notified the developer
that construction material would be or had been furnished to the
construction site, and, if the bill was not paid in full, a
mechanic’s lien could be placed against the developer’s real
property.
The mixed concrete was delivered by the manufacturer's truck
to the construction site where, if the concrete was accepted, it
was poured directly into the form. Petitioner would distribute
the concrete evenly throughout the form, install the anchor
bolts, and then use various tools to do finishing work.
"Finishing work" includes ensuring that the foundations and
flatwork are plumb and smooth and that the driveways and walkways
have the proper slope to ensure drainage where appropriate. Some
jobs called for decorative finishing work, such as adding a
design or pattern to the finished surface. At the end of the
day, petitioner did not have any concrete left on hand, and the
amount wasted was de minimis.
In order to track the quantity of concrete and the time of
delivery, the concrete supplier's drivers carried "batching
tickets" which showed the amount of concrete and the arrival
time, pour time, and departure time of the truck. Petitioner
signed the "batching ticket" to acknowledge the delivery.
Acceptance of the concrete was controlled by the developer, not
- 10 -
petitioner. The type and quality of the concrete was specified
by the builder's plans. When the concrete arrived at the
developer's building site, either petitioner or a quality control
technician in the employ of the developer could reject the batch.
However, if petitioner was willing to accept the batch, but the
quality control technician determined that the batch should be
rejected, the batch would be rejected. The quality control
technician took a sample of the concrete batch during the pour
for a "slump test". The developer had 45 days after taking the
sample to reject the concrete if it failed the test.
D. Billing and Payment
After the sand and drain rock had been spread, the hardware
items installed, and the concrete poured and finished, petitioner
received an invoice for the cost of the materials and a lien
release, which also stated the cost of the materials, from each
of the materials suppliers. At the end of the month, petitioner
submitted the suppliers’ lien releases and a single invoice for
the cost of the completed work to the developer for payment. The
invoice did not itemize the costs of the labor and material or
the amount of the profit.
The developer paid for the construction work in a two-part
process. First, the developer issued a joint check made payable
to petitioner and each supplier for the cost of the materials as
stated on each suppliers’ lien release and invoice. Petitioner
- 11 -
endorsed each joint check and forwarded it to the appropriate
supplier; petitioner did not deposit or otherwise cash this
check.
Second, the developer issued a check made payable only to
petitioner for the balance owed on its invoice.
E. Method of Accounting
Petitioner filed its Federal income tax returns using a
fiscal year ending on August 31. Petitioner used the cash method
of accounting to report its taxable income for the first year of
its incorporation, the one in issue. The parties stipulated that
petitioner’s gross receipts have not exceeded $5 million per year
since its incorporation.
Petitioner reported as income payments that it actually
received from developers during the taxable year and reported a
deduction for the cost of materials for which payments actually
were made. Petitioner did not report as income payments that it
did not receive nor did petitioner deduct the cost of materials
for which payment had not been made during the taxable year.
Petitioner reported $64,806 of taxable income, and the parties
stipulated that under the accrual method of accounting
petitioner’s taxable income would be $267,428.
For the taxable year at issue, petitioner reported gross
receipts of $1,564,045, which derived solely from the
construction, placement, and finishing of foundations and
- 12 -
flatwork. Petitioner reported as cost of goods sold the total
cost of all material used in its construction activity during the
taxable year at issue, $993,777. This sum comprised the
following amounts:
Item Amount Percentage
Concrete $642,923 64.7
All other material1 334,563 33.7
Lumber2 16,291 1.6
Total 993,777 100.0
1
"All other material" is all the other material that went
into construction of the foundations and flatwork, except the
concrete; it includes fill sand, drain rock, and the various
hardware items. According to the typical bid worksheet, the cost
of the hardware items is 5.07 percent of the contract price (the
total cost of the materials, other than concrete and fill sand,
$81.94 ($69.44 plus $7.70 plus $4.80) divided by the contract
price,$1,615.28), and 9.59 percent of the total cost of the
materials ($81.94 divided by $854.74).
2
Respondent stipulated that the lumber is a supply.
Petitioner's accounts receivable and accounts payable at the
end of the taxable year at issue were $294,436 and $60,143,
respectively.
OPINION
We must decide whether the provision of material by
petitioner in performing its service contracts is the sale of
"merchandise" for purposes of section 1.471-1, Income Tax Regs.
We decide this issue in the context of whether it was an
abuse of respondent's discretion to exercise his authority under
section 446 to require petitioner to change from the cash method
- 13 -
to the accrual method.2 The Commissioner is granted broad
discretion in determining whether a taxpayer’s use of a method of
accounting clearly reflects income. See sec. 446(b); United
States v. Catto, 384 U.S. 102, 114 & n.22 (1967); Commissioner v.
Hansen, 360 U.S. 446, 468 & n.12 (1959); Lucas v. American Code
Co., 280 U.S. 445, 449 (1930). A prerequisite to the
Commissioner’s exercise of authority to require a taxpayer to
change its present method of accounting is a determination 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).
Whether an abuse of discretion has occurred depends upon
2
Sec. 446 provides in pertinent part:
SEC. 446. GENERAL RULE FOR METHODS OF ACCOUNTING
(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.
- 14 -
whether 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); 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. Commissioner, supra at 371; Hospital
Corp. of Am. v. Commissioner, T.C. Memo. 1996-105. Consequently,
section 446 imposes a heavy burden on the taxpayer disputing the
Commissioner’s determination on accounting matters. See Thor
Power Tool Co. v. Commissioner, 439 U.S. 522, 532-533 (1979). To
prevail, a taxpayer must establish that the Commissioner’s
determination was "clearly unlawful" or "plainly arbitrary". Id.
Despite the broad language of section 471,3 the Secretary's
discretion to require inventory accounting is not unlimited. See
Hewlett-Packard Co. v. United States, 71 F.3d 398, 403 (Fed. Cir.
1995); Hallmark Cards, Inc. v. Commissioner, supra; see also
3
Sec. 471(a) provides:
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.
- 15 -
Transwestern Pipeline Co. v. United States, 225 Ct. Cl. 399, 639
F.2d 679, 681 (1980) (distinguishing Thor Power Tool Co. v.
Commissioner, supra, because in that case "it was an uncontested
fact that the property in issue consisted of an inventory of
goods held for sale").
Respondent determined that the material petitioner used in
its construction activity was merchandise that was income
producing, and, therefore, petitioner must use the accrual method
of accounting to clearly reflect its income. Petitioner asserts
that it is in the business of providing service and that its
clients purchase its expertise in constructing, placing, and
finishing foundations, driveways, and walkways, not merchandise.
Therefore, petitioner contends that its use of the cash method of
accounting is proper. We agree with petitioner.
Issue 1. Whether the Material Provided by Petitioner in
Accordance With Its Contract To Construct and Place
Concrete Foundations, Driveways, and Walkways Is
Merchandise
Whether petitioner is required to report its income on the
accrual method of accounting instead of the cash method depends
on whether petitioner is in the business of selling merchandise
to customers in addition to providing service or whether the
material provided by petitioner is a supply that is incidental to
the provision of the contracted service. See Wilkinson-Beane,
Inc. v. Commissioner, 420 F.2d 352, 353-354 (1st Cir. 1970),
affg. T.C. Memo. 1969-79; Osteopathic Med. Oncology & Hematology,
- 16 -
P.C. v. Commissioner, 113 T.C. 376 (1999).
By regulation, the Secretary has determined that
inventories at the beginning and end of each taxable
year are necessary in every case in which the
production, purchase, or sale of merchandise is an
income-producing factor. The inventory should include
all finished or partly finished goods and, in the case
of raw materials and supplies, only those which have
been acquired for sale or which will physically become
a part of merchandise intended for sale, * * *. [Sec.
1.471-1, Income Tax Regs.; emphasis added.4]
Therefore, a determination of whether the taxpayer produces,
purchases, or sells "merchandise" is preliminary to any
determination of whether the taxpayer must account for inventory.
See Homes by Ayres v. Commissioner, 795 F.2d 832, 835 (9th Cir.
1986), affg. T.C. Memo. 1984-475.
Neither the Internal Revenue Code (the Code) nor the
regulations define "merchandise" or "inventory" or clearly
distinguish between "materials and supplies" that are not
actually consumed and remain on hand, and inventory. Wilkinson-
Beane, Inc. v. Commissioner, supra at 354 (noting "the lack of
any clearly pertinent definition of 'merchandise' in the relevant
tax sources"); Osteopathic Med. Oncology & Hematology, P.C. v.
Commissioner, supra at 382. Furthermore, the differences that
distinguish supplies from merchandise are determined by context
4
Completing the statutory and regulatory scheme, sec. 1.446-
1(c)(2)(i), Income Tax Regs., provides that a taxpayer that has
inventory must also use the accrual method of accounting with
regard to purchases and sales.
- 17 -
and therefore not always readily discernable. See Wilkinson-
Beane, Inc. v. Commissioner, supra at 354 ("Clearly, the meaning
of the term must be gathered from the context and the subject.").
Courts have held that "merchandise", as used in section
1.471-1, Income Tax Regs., is an item acquired and held for sale.
See, e.g., Wilkinson-Beane, Inc. v. Commissioner, supra at 354-
355 (a canvassing of authorities in the accounting field yields
several definitions, such as "goods purchased in condition for
sale", "goods awaiting sale", "articles of commerce held for
sale", and "all classes of commodities held for sale"; the
"common denominator * * * seems to be that the items in question
are merchandise if held for sale."); Honeywell Inc. v.
Commissioner, T.C. Memo. 1992-453 (rotable spare parts are
merchandise if they were acquired and "held for sale"), affd.
without published opinion 27 F.3d 571 (8th Cir. 1994); see also
Grant Oil Tool Co. v. United States, 180 Ct. Cl. 620, 381 F.2d
389, 397 (1967) (inventory is, simply stated, property that is
held for sale); Forrester v. Americus Oil Co., 19 S.E.2d 328, 330
(Ga. Ct. App. 1942) (inventory includes property held for sale
to customers in the ordinary course of trade or business). It is
important to note that all the definitions refer to property that
is held for sale, not simply property that is sold.
Congress did not intend by the predecessor of section 471
that all businesses, including some businesses that hold property
- 18 -
primarily for sale, use inventories. See W.C & A.N. Miller Dev.
Co. v. Commissioner, 81 T.C. 619, 630 (1983); Atlantic Coast
Realty Co. v. Commissioner, 11 B.T.A. 416, 419-420 (1928). As
indicated by the legislative history, Congress intended the
section to apply to manufacturing and merchandising concerns.5
In Osteopathic Med. Oncology & Hematology, P.C. v.
Commissioner, supra, we held that where the inherent nature of
the taxpayer's business is that of a service provider, and the
taxpayer uses materials that are an indispensable and inseparable
5
The original authority for the use of inventories is
contained in Revenue Act of 1918, ch. 18, sec. 203, 40 Stat.
1057, 1060. Sec. 203 of that Act is almost identical to section
471. In proposing this legislation, the Committee on Ways and
Means explained:
In many cases the only way that the net income can
be determined is through the proper use of inventories.
This is largely true in the case of manufacturing and
merchandise concerns. The bill authorizes the
Commissioner to require inventories whenever in his
opinion the same is necessary in order to clearly
reflect the income of the taxpayer. [H. Rept. 767,
65th Cong., 2d Sess. 88 (1918), 1939-1 C.B. (Part 2)
86, 89.]
See Seidman, Seidman's Legislative History of Federal Income Tax
Laws 1938-1861, at 900 (1953).
Pursuant to the authority vested in him by statute, the
Commissioner, with the approval of the Secretary, promulgated
Art. 1581 of Regulations 45 under the Revenue Act of 1918, which
essentially is the same as sec. 1.471-1, Income Tax Regs. See
Regs. 62, art. 1581; Sec. 29.22(c)-1, Regs. 111 (1944); see also
Burroughs Adding Mach. Co. v. Commissioner, 9 B.T.A. 938, 940
(1927) (Art. 1581 of Regulations 62 contains the same language as
Art. 1581 of Regulations 45); Galedrige Constr., Inc. v.
Commissioner, T.C. Memo. 1997-240 (sec. 1.471-1, Income Tax
Regs., contains the same language as Regs. 111, sec. 29.22(c)-1).
- 19 -
part of the rendering of its services, the materials are not
"merchandise" under section 1.471-1, Income Tax Regs.
Petitioner is inherently a service provider. Petitioner's
clients, real property developers, engage petitioner to complete
foundations, driveways, and walkways. It is the general rule in
this country for most areas of the law (including the Uniform
Commercial Code (UCC), the Uniform Sales Act (USA), State sales
tax laws, the statute of frauds, and the Robinson-Patman
Antidiscrimination Act) that a contractor is the consumer of
materials and a supplier of services, not the seller of personal
property; the courts have invariably found construction contracts
that provide for the furnishing of labor and materials to
constitute agreements for work, labor, and services rather than
the sale of goods.
For example, under the UCC, a highway construction contract
requiring a construction company to furnish gravel and other road
building materials in the quantities specified and to turn over
to the Commonwealth of Massachusetts a completed highway was a
contract for work and labor and not a contract for the sale and
purchase of personal property. See Saugus v. B. Perini & Sons,
Inc., 26 N.E.2d 1, 3-4 (Mass. 1940). The main objective of a
contract to construct a horse barn, which required the provision
of materials, was the construction of the barn, not the sale of
goods. See Hunter's Run Stables, Inc. v. Triple H Constr. Co.,
- 20 -
938 F. Supp. 166, 168 (W.D.N.Y. 1996). In the construction of
such improvements, the labor predominates with the materials
being merely an incident thereto. See Cork Plumbing Co. v.
Martin Bloom Associates., Inc., 573 S.W.2d 947, 958 (Mo. Ct. App.
1978).
Under the USA, a contract to "furnish the necessary labor
and material" for a radiant heating system was a contract for
labor and material, not a contract for sale of material. See
Aced v. Hobbs-Sesack Plumbing Co., 55 Cal. 2d 573, 580-581 (1961).
Furthermore, an agreement to build a structure according to
another's plans and specifications is not an agreement of sale of
any of the materials which may enter into its composition. See
United States v. San Francisco Elec. Contractors Association, 57
F. Supp. 57, 67 (N.D. Cal. 1944).
For purposes of State sales tax, the general rule views a
building contractor as a supplier of services and a consumer of
the building material. See Levine v. State Bd. of Equalization,
299 P.2d 738 (Cal. Ct. App. 1956).6
6
See, e.g., Department of Revenue v. Montgomery Woodworks,
Inc., 389 So. 2d 510 (Ala. Civ. App. 1980); Raynor Door, Inc. v.
Charnes, 765 P.2d 650 (Colo. App. 1988); H.B. Sanson, Inc. v. Tax
Commissioner, 447 A.2d 12 (Conn. 1982); King's Bay Yacht &
Country Club, Inc. v. Green, 173 So. 2d 509 (Fla. Dist. Ct. App.
1965); Sturtz v. Iowa Dept. of Revenue, 373 N.W.2d 131 (Iowa
1985); Pete Koenig Co. v. Department of Revenue, 655 S.W.2d 496
(Ky. Ct. App. 1983); Miedema Metal Bldg. Sys., Inc. v. Department
of Treasury, 338 N.W.2d 924 (Mich. Ct. App. 1983); Blevins
Asphalt Constr. Co. v. Director of Revenue, 938 S.W.2d 899 (Mo.
1997); George Rose & Sons Sodding & Grading Co. v. Nebraska Dept.
- 21 -
In considering whether a contract is within the statute of
frauds, a contract to "cut, furnish, and deliver" the stonework
for a building is essentially one of labor, the "material upon
which the work and labor were to be done was simply the
incident". Flynn v. Dougherty, 27 P. 1080 (Cal. 1891).
For purposes of the Robinson-Patman Antidiscrimination Act,
ch. 592, 49 Stat. 1526 (1936), 15 U.S.C. sec. 13(a) (1994), which
prohibits discriminatory pricing in the sale of goods, a
construction contract for the provision of labor and materials
including 2 million bricks was not a contract for the sale of
personal property. See General Shale Prods. Corp. v. Struck
Constr. Co., 132 F.2d 425, 428 (6th Cir. 1942).
It is clear from the case law that in the case at hand, the
essence of petitioner's typical contract with its clients was for
the provision of services, not for the sale of personal property.
The fact that the cost of the materials is substantial is
insufficient to transmute the sale of a service to the sale of
merchandise and a service. See Osteopathic Med. Oncology &
Hematology, P.C. v. Commissioner, 113 T.C. 386; see also North
Am. Leisure Corp. v. A & B Duplicators, Ltd., 468 F.2d 695, 697
of Revenue, 532 N.W.2d 18 (Neb. 1995); Chicago Bridge & Iron Co.
v. State Tax Commn., 839 P.2d 303 (Utah 1992); Yeargin, Inc. v.
Tax Commn., 977 P.2d 527 (Utah Ct. App. 1999); Wisconsin Dept. of
Revenue v. Johnson & Johnson, 387 N.W.2d 91 (Wis. Ct. App. 1986);
State Bd. of Equalization v. Cheyenne Newspapers, Inc., 611 P.2d
805 (Wyo. 1980).
- 22 -
(2d Cir. 1972) (when service predominates, the incidental sale of
items of personal property does not alter the basic
transaction.); Aced v. Hobbs-Sesack Plumbing Co., supra at 580;
Filmservice Labs., Inc. v. Harvey Bernhard Enters., 256 Cal.
Rptr. 735, 738 (1989); Alonzo v. Chifici, 526 So. 2d 237, 241
(La. Ct. App. 1988) (in applying a "value test" to determine
whether the labor expended in constructing the item, or the
materials incorporated therein, constitute the principal value of
the contract, it is clear that building or construction contracts
involve primarily the furnishing of labor and contractual
skills).
Material may be either merchandise or supplies depending
upon whether it is held for sale or consumed in performing a
service. The differences that distinguish a supply material from
a merchandise material are determined by context. Thus, the same
material in different contexts may be either an inventory item or
a supplies item. For instance, although the paper and ink used
to prepare blueprints are inventory in the hands of the paper and
ink manufacturers, they are supplies in the hands of an
architect. See, e.g., sec. 1.263A-2(a)(2)(ii)(B)(2), Income Tax
Regs. (the cost of materials used by an architect to prepare
blueprints provided to clients may be deducted as an expense
because the blueprints are de minimis and incident to the
provision of service). This is so even though the architect
- 23 -
purchases the paper and ink from a manufacturer, the architect's
sale of services and materials to his or her clients includes the
paper and ink, and the clients purchase the blueprints from the
architect. The essence of the architect's business is providing
the service of designing buildings, not the sale of blueprints.
Cf. Knight-Ridder Newspapers, Inc. v. United States, 743 F.2d 781
(11th Cir. 1984) (paper and ink held by newspaper publisher for
use in producing newspapers for sale to customers is inventory).
We hold that the inherent nature of petitioner's business is
that of a service provider. Accordingly, we must determine
whether the materials petitioner uses are an indispensable and
inseparable part of rendering its services.
A. The Liquid Concrete
Petitioner relies upon our decision in Galedrige Constr.,
Inc. v. Commissioner, T.C. Memo. 1997-240, for its argument that
the materials are not merchandise. We agree that the rationale
of Galedrige applies to the liquid concrete in this case.
In construing the word "merchandise" in Galedrige, we
applied the rule that "'the natural and ordinary meaning of the
words used will be applied * * * unless the Congress has
definitely indicated an intention that they should be otherwise
construed'". Wilkinson-Beane, Inc. v. Commissioner, supra at 354
(quoting Huntington Sec. Corp. v. Busey, 112 F.2d 368, 370 (6th
Cir. 1940)). In Galedrige Constr., Inc., for the first time,
- 24 -
this Court considered the issue of whether a person in the
business of only laying emulsified asphalt sold merchandise or
maintained an inventory of emulsified asphalt.7
In Galedrige Constr., Inc. it was clear that the taxpayer,
an asphalt paving contractor, provided a service to its clients;
if its clients had wanted only to purchase emulsified asphalt,
they could have done so by dealing directly with the emulsified
asphalt supplier. Similarly, in the case at hand, it is clear
that petitioner provides service to its clients; if its clients
wanted only piles of fill sand, drain rock, liquid concrete, and
miscellaneous hardware items, they could obtain them directly
from the various suppliers. It is evident that petitioner's
clients could order the various materials directly from the
7
In Akers v. Commissioner, T.C. Memo. 1984-208, affd. in
part and revd. in part sub nom. Asphalt Prods. Co. v.
Commissioner, 796 F.2d 843 (6th Cir. 1986), this Court considered
the issue of whether a taxpayer in the business of manufacturing
and selling asphalt and asphalt products, who maintained
inventories including oil byproducts and other raw materials, in
addition to performing some paving work, must account for
inventories and use the accrual method of accounting.
In contrast, the taxpayer in Galedrige Constr. Inc. v.
Commissioner, T.C. Memo. 1997-240, was not in the business of
manufacturing asphalt and maintained no inventory of asphalt, oil
byproducts, or other raw materials. Moreover, unlike the
taxpayer in Akers who had large tanks in which it was able to
preserve the emulsified condition, and therefore the marketable
quality, of its finished product, the taxpayer in Galedrige
Constr., Inc. was unable to prevent or delay the asphalt from
becoming rock hard and worthless within a very few hours.
- 25 -
suppliers by the fact that the clients paid for the various
materials separately and specifically with a joint payee check.
From the moment the taxpayer in Galedrige Constr., Inc.
received the "emulsified asphalt from the supplier * * * [it] was
joined in a race that had an unalterable predetermined outcome;
within 2 to 5 hours the emulsified asphalt would be rock hard and
worthless." Id. The race was not to sell or to deliver the
asphalt to the taxpayer's client; rather, it was to lay the
asphalt before time expired and the asphalt changed its physical
state into a form that was worthless to the taxpayer; only the
liquid state of the emulsified asphalt provided any utility to
the taxpayer, and that state expired very quickly.
Consequently, in Galedrige Constr., Inc. v. Commissioner,
supra, the only form of the material that provided any value to
the taxpayer was "used up" or consumed in providing service to
the taxpayer's client. Consumption of a material in the
performance of a service or in a manufacturing process is
indicative that the material is a supply, not merchandise held
for sale. See Osteopathic Med. Oncology & Hematology, P.C. v.
Commissioner, 113 T.C. 385; see also Rev. Rul. 75-407, 1975-2
C.B. 196 (public utility that used the accrual method of
accounting should continue to deduct as a supply expense under
section 1.162-3, Income Tax Regs., the cost of fuel oil consumed
and used to generate electricity distributed to customers during
- 26 -
the taxable year); Rev. Rul. 90-65, 1990-2 C.B. 41 (the cost of
unrecovered platinum from prills used in refining petroleum is a
material or supply expense allowed under section 1.162-3, Income
Tax Regs.). Accordingly, in Galedrige Constr., Inc. v.
Commissioner, supra, we held that in the hands of the
taxpayer/paving contractor, the emulsified asphalt was a supply,
not merchandise.
Similarly, in this case the only form of the concrete that
provides utility to petitioner is the liquid or wet form. Also,
similar to the emulsified asphalt in Galedrige Constr., Inc. v.
Commissioner, supra, the physical state of the concrete changes
very quickly from one that provides utility to petitioner, to one
that has no value at all.
The ready-mix concrete in this case is practically
indistinguishable from the emulsified asphalt material in
Galedrige Constr., Inc. Considering the facts of this case (and
Galedrige) and the ephemeral quality of the material at issue,
only a strained and unconventional interpretation of the word
"merchandise" would include liquid concrete (or emulsified
asphalt) within its definition.8
These materials with their severely limited periods of
utility that were ordered specifically for, delivered to, and
8
We here are dealing with the physical laws of the Universe,
against which the laws of mere mortals cannot stand.
- 27 -
paid for by the taxpayer's client, cannot in any natural or
ordinary sense be considered "held for sale" by the taxpayer.
Accordingly, considered in this context, we find that the ready-
mix concrete is a supply, not merchandise.
B. The Other Materials
Other materials under consideration in this case--the fill
sand, drain rock, and hardware items--do not share the ephemeral
physical properties of liquid concrete or the emulsified asphalt
in Galedrige Constr., Inc. Rather, they are durable like the
replacement parts in Honeywell, Inc. v. Commissioner, T.C. Memo.
1992-453. In Honeywell, Inc. we stated that the purpose for
which the property was acquired and held is determinative of
whether the property is merchandise within the meaning of section
1.471-1, Income Tax Regs. In Honeywell, Inc., we concluded that,
because replacement parts were used by the taxpayer to perform
its service contracts, the replacement parts were not acquired
and held for sale and those parts were not merchandise within the
meaning of the applicable regulation. See id. Moreover, it is
apparent that the replacement parts were indispensable and
inseparable from the service provided by the taxpayer.
We now conclude that the fill sand, drain rock, and hardware
items, like the liquid concrete, were indispensable and
inseparable from the service provided by petitioner.
First, the construction material in this case, when combined
- 28 -
with other tangible personal property, lost its separate identity
to become an integral and inseparable part of the real property
in the construction activity.9 Cf. Wilkinson-Beane, Inc. v.
Commissioner, 420 F.2d 352, 355 (1st Cir. 1970) (caskets sold as
part of undertaking establishment’s funeral service retain their
separate identity); Thompson Elec., Inc. v. Commissioner, T.C.
Memo. 1995-292 (lighting fixtures, which by definition do not
lose their separate identity, used with other materials in
taxpayer’s electrical contracting business). Thus, the materials
in this case are similar to the chemotherapy drugs in Osteopathic
Med. Oncology & Hematology, P.C. v. Commissioner, supra, which,
though not ephemeral in the sense that their usefulness would
disappear if not immediately used, when injected also lost their
identity separate from that of the patient. Materials that lose
their separate identity in these circumstances are not
merchandise within the meaning of section 1.471-1, Income Tax
Regs.; rather, they are supplies consumed in the provision of
service that are properly deducted under section 162.
Second, petitioner did not contract to sell materials to its
developer clients, and the clients had no interest in purchasing
materials from petitioner. Petitioner's contract with its real
9
We note that the materials suppliers sent the California
Preliminary Lien Notices to the developer; the notices provided
that if the bill for the materials was not paid in full, a
mechanic’s lien could be placed against the developer’s real
property.
- 29 -
property developer clients was for the construction of
foundations, driveways, and walkways. Thus, we cannot find that
petitioner is a merchant10 that has acquired "raw materials and
supplies" for sale, see sec. 1.471-1, Income Tax Regs., or that
holds and sells "goods purchased in condition for sale",
Wilkinson-Beane, Inc. v. Commissioner, supra at 354-355.
Third, foundations, driveways, and walkways are improvements
to real property. We have held previously that improvements to
real property are not merchandise. See Homes by Ayres v.
Commissioner, 795 F.2d 832, 835 (9th Cir. 1986) (tract houses are
not merchandise), affg. T.C. Memo. 1984-475 (rejecting taxpayer's
argument that a homebuilder "manufactures" houses); see also W.C
& A.N. Miller Dev. Co. v. Commissioner, 81 T.C. 630 (developed
real property constructed and held for sale is not inventory).
Therefore, the foundations, driveways, and walkways are not
merchandise, and the materials used in their construction do not
"become a part of merchandise intended for sale". See sec.
10
For purposes of accounting, "merchandise" is defined as
"Purchased articles of commerce held for sale; the inventory of a
merchant." Kohler, Kohler's Dictionary for Accountants 329 (6th
ed. 1983). Furthermore, "merchant" is defined as "One who buys
and sells articles of commerce without change in their form."
Id.
"In its commonly accepted usage, the term 'merchandise' is
defined to encompass wares and goods, not realty." W.C. & A.N.
Miller Dev. Co. v. Commissioner, 81 T.C. 619, 630 (1983).
Furthermore, "real property and the labor, materials and supplies
which enter into improving real property, are generally not
considered for accounting purposes to be inventoriable." Id.
- 30 -
1.471-1, Income Tax Regs.
Consequently, petitioner is not a manufacturer of
merchandise or a merchandising concern, nor engaged otherwise in
a "merchandising" activity. Because petitioner does not produce
or sell merchandise, petitioner is not engaged in a business
activity that requires the maintenance of an inventory. See
Homes by Ayres v. Commissioner, supra.
Mr. Martinez, a corporate officer and shareholder of
petitioner, testified that the only material left over at the
completion of a job is a small pile of sand or gravel. Although
Mr. Martinez' testimony may be regarded as self-serving, in this
case it is consistent with the objective evidence.
The operation of petitioner's construction activity required
it to use most of the materials at the time they were delivered
to the construction site. The stipulations and other evidence
show that materials required to perform the work were ordered
from the suppliers and delivered to the job site, where they were
incorporated almost immediately into the real property
improvements. Each material supplier sent the real property
developer a preliminary lien notice for the materials delivered
to the site. Petitioner submitted its invoice and lien releases
to the real property developer for the materials used to complete
its work at each residential lot. The developer paid for the
cost of the materials that had been used in completing the
- 31 -
improvements by checks made out to each supplier and petitioner
as joint payees, which petitioner forwarded to each material
supplier. The joint checks were not deposited in petitioner's
bank account.
Therefore, the materials were used up before petitioner sent
its invoice and the lien releases for the completed work to the
developer, before the developer paid for the materials, and
before petitioner recorded the materials expense.
Respondent makes much of the fact that, unlike the concrete,
small amounts of some of the materials may have been left over
after the job. Respondent argues that these materials could have
been loaded onto petitioner's truck and moved to another job site
or stored in its equipment yard. It is clear from the facts that
no concrete was left over, and any leftover sand or gravel was
abandoned onsite upon the completion of each job, as the expense
of moving it would have exceeded its cost; moreover, only an
insignificant amount of any of the other material could have been
left over. Cf. J.P. Sheahan Associates, Inc. v. Commissioner,
T.C. Memo. 1992-239 (roofing materials and supplies remaining at
the close of a job are returned to the supplier for credit).
The parties stipulated that petitioner kept some of the
hardware items in the storage container at its place of business.
Since the total cost of all the hardware items was approximately
5 percent of the total cost of a typical contract, and all the
- 32 -
materials were delivered to the developer's site, any amount
kept on hand at the equipment yard had to be insignificant.
Petitioner's possession of a de minimis amount of material
would not be sufficient to require it to use the accrual method
of accounting for inventories. See Osteopathic Med. Oncology &
Hematology, P.C. v. Commissioner, supra at 113 T.C. 387
(taxpayer that had 2 weeks' supply of chemotherapy drugs on hand
not required to use inventory method of accounting); Honeywell,
Inc. v. Commissioner, supra (taxpayer not required to use
inventory method of accounting for computer replacement parts
that were stored on taxpayer's premises and represented 11 and 12
percent of income, even though taxpayer transferred title to the
replacement parts to the customer); see also Tech. Adv. Mem. 98-
48-001 (July 16, 1998) (taxpayer that purchases and sells
merchandise not required to maintain inventories because the
purchase and sale of the merchandise was de minimis and not an
income-producing factor within the meaning of section 1.471,
Income Tax Regs.; therefore, taxpayer may continue to account for
these merchandise items on the cash basis); G.C.M. 38,288 (Feb.
21, 1980) (the IRS may allow the use of the cash method of
accounting despite the fact that the taxpayer may furnish some
tangible product in the course of rendering a service, a
reconsideration of Rev. Rul. 74-279, 1974-1 C.B. 110).
We decline to attach significance to the fact that in calculating
- 33 -
its bid, petitioner used the total cost of labor and materials as
a basis to calculate the value of its service.
In calculating its potential profit, petitioner had to
consider the complexity of the work, and, therefore, its
potential for loss in case of errors. For instance, contracts
for construction projects that use a greater amount of concrete
and other materials, or involve curved rather than straight
lines, are more difficult to perform. The quantity of the
material used was another factor in this estimation. The
consideration of such costs, however, does not dictate the
classification of the material as inventory. See Osteopathic
Med. Oncology & Hematology, P.C. v. Commissioner, supra;
Honeywell, Inc. v. Commissioner, supra. That petitioner used the
total cost of labor and materials as a base to calculate the
project profit does not mean that petitioner sold merchandise to
its clients.
We have found that petitioner's contracts with its real
property developer clients are service contracts, that the
material provided by petitioner is indispensable to and
inseparable from the provision of that service, that the
materials lost their separate identity to become part of the real
property in the construction activity, and that, in substance, no
sale of merchandise occurred between petitioner and its clients.
The bottom line is that petitioner did not hold merchandise for
- 34 -
sale, and there simply was no sale of merchandise between
petitioner and its clients. See Osteopathic Med. Oncology &
Hematology, P.C. v. Commissioner, supra; Honeywell, Inc. v.
Commissioner, supra.
C. Income-Producing Factor
Respondent may require petitioner to use an inventory method
of accounting only if we find each of the following as facts:
(1) Petitioner produced, purchased, or sold merchandise, and (2)
petitioner’s production, purchase, or sale of that merchandise
was an income-producing factor. See Osteopathic Med. Oncology &
Hematology, P.C. v. Commissioner, supra; Honeywell, Inc. v.
Commissioner, supra. Section 1.471-1, Income Tax Regs., does not
provide that any material that is an income-producing factor is
ipso facto merchandise. We have found that petitioner does not
produce, purchase, or sell merchandise; therefore, whether the
material is an income-producing factor is irrelevant. See
Osteopathic Med. Oncology & Hematology, P.C. v. Commissioner,
supra.
Accordingly, we find that petitioner is not required to use
an inventory method of accounting.
Issue 2. Whether Respondent Abused His Discretion in Determining
That Petitioner's Use of the Cash Method of Accounting
Did Not Clearly Reflect Its Income
"'The cash method of accounting has been widely used
throughout the contracting industry and accepted by respondent
- 35 -
since time immemorial.'" Ansley-Sheppard-Burgess Co. v.
Commissioner, 104 T.C. 367, 375 (1995) (quoting Magnon v.
Commissioner, 73 T.C. 980, 1004 (1980)); see also Magnon v.
Commissioner, supra at 1004-1006 (use of cash method of
accounting by electrical contractor held to clearly reflect
income); National Builders, Inc. v. Commissioner, 12 T.C. 852,
858-859 (1949) (Court reviewed) (Court found that cash method of
accounting clearly reflected taxpayer's income and rejected
Commissioner's determination that construction contractor use
hybrid method of accounting instead of cash method); C.A. Hunt
Engg. Co. v. Commissioner, T.C. Memo. 1956-248 (use of the cash
method of receipts and disbursements held to reflect income
clearly). Thus, it is clear that the construction industry
practice of using the cash method of accounting has long been
accepted by this Court.
Respondent argues that petitioner must use an inventory
method of accounting to clearly reflect its income because it
sells merchandise. We have found that the materials used by
petitioner are not merchandise. Respondent did not assert that
petitioner attempted to unreasonably prepay expenses or purchase
supplies in advance, and the evidence shows the contrary.11 See
11
Petitioner received the invoices from the suppliers within
30 days of the delivery of the materials to the developer's
construction site. Petitioner also received within 30 days of
the provision of its services a check from the developer, made to
petitioner and the supplier as joint payees, for payment of the
- 36 -
Ansley-Sheppard-Burgess Co. v. Commissioner, supra at 374; Van
Raden v. Commissioner, 71 T.C. 1083, 1104 (1979), affd. 650 F.2d
1046 (9th Cir. 1981).
It is irrelevant that the amount of taxable income that
petitioner reported using the cash method of accounting is not
the same amount that it would have reported if it used the
accrual method. We previously have held that where a taxpayer is
a "small" corporation permitted to use the cash method under
section 448(b)(3),12 is not required to maintain an inventory,
invoices, which petitioner forwarded to the supplier. Under the
cash method of accounting, petitioner deducted the cost of the
expense of the already consumed materials when paid, and recorded
as income the payment when received. Thus, petitioner's method
of accounting matched the receipt of the payment for the material
with the deduction for the expense. Cf. Knight-Ridder
Newspapers, Inc. v. United States, 743 F.2d 781, 792 (11th Cir.
1984) (inventories of paper and ink deducted at time of purchase,
rather than at time of use); Wilkinson-Beane, Inc. v.
Commissioner, 420 F.2d 352, 353-354 (1st Cir. 1970), affg. T.C.
Memo. 1969-79 (cost of caskets held for long periods of time,
some for more than one year, deducted during year in which
taxpayer paid for them); J.P. Sheahan Associates, Inc. v.
Commissioner, T.C. Memo. 1992-239 (cost of material deducted in
year of purchase, not at time of use). Therefore, we cannot find
that petitioner accounted for the cost of the materials
incorrectly.
12
Sec. 448 provides in pertinent part:
SEC. 448. LIMITATIONS ON USE OF CASH METHOD OF ACCOUNTING.
(a) General Rule.--Except as otherwise provided in this
section, in the case of a--
(1) C corporation,
(2) partnership which has a C corporation as a partner,
or
(3) tax shelter,
taxable income shall not be computed under the cash receipts
- 37 -
consistently used the cash method of accounting since its
incorporation, and has made no attempt to unreasonably prepay
expenses or purchase supplies in advance, the taxpayer is not
required to show a substantial identity of results between the
taxpayer’s method of accounting and the method selected by the
Commissioner. See Ansley-Sheppard-Burgess Co. v. Commissioner,
and disbursements method of accounting.
(b) Exceptions.--
* * * * * * * *
(3) Entities With Gross Receipts of Not More Than
$5,000,000.–-Paragraphs (1) and (2) of subsection (a) shall
not apply to any corporation or partnership for any taxable
year if, for all prior taxable years beginning after
December 31, 1985, such entity (or any predecessor) met the
$5,000,000 gross receipts test of subsection (c).
(c) $5,000,000 Gross Receipts Test.--For purposes of this
section--
(1) In General.–-A corporation or partnership meets the
$5,000,000 gross receipts test of this subsection for any
prior taxable year if the average annual gross receipts of
such entity for the 3-taxable-year period ending with such
prior taxable year does not exceed $5,000,000.
* * * * * * *
(3) Special Rules.–-For purposes of this subsection--
(A) Not In Existence For The Entire 3-Year Period.--If
the entity was not in existence for the entire 3-year period
referred to in paragraph (1), such paragraph shall be
applied on the basis of the period during which such entity
(or trade or business) was in existence.
- 38 -
supra at 377.13
It is clear from petitioner's billing procedure and the
operation of its construction activity that the materials were
used up before they were paid for by the developer and before
petitioner reported their expense. Therefore, petitioner had no
opportunity to report as an expense any materials that may have
been delivered to a job site before the close of its taxable year
but not yet used.
As was the case in Osteopathic Med. Oncology & Hematology,
P.C. v. Commissioner, supra, the notice of deficiency is worded
broadly as to the specific basis for respondent's determination
that the cash method does not clearly reflect petitioner's
13
According to the typical bid worksheet, the only factors
in petitioner's income are materials, labor, and profit. On the
worksheet the total materials cost is $927.39, and the labor cost
is $477. Therefore, typically the cost of labor as a percentage
of the total materials cost is 51.46 percent.
The total cost of all items purchased in the taxable year at
issue was $993,777. Thus, the associated labor cost may be
estimated as approximately $511,360. The sum of these amounts is
$1,505,137. Petitioner received $1,564,045 in gross receipts for
the year at issue and reported $64,806 as taxable income. The
difference between the gross receipts and the sum of the
materials and the approximate cost of labor is $58,908; this
amount is very close to the amount petitioner reported as income.
The profit percentage varied depending on the job, but it
was usually between 10 and 20 percent. The difference between
the amount of income as calculated above and the amount reported
by petitioner is probably attributable to the different profit
percentages charged by petitioner for jobs of different levels of
complexity. Thus, the "typical" profit of 15 percent is a rough
average of the various profit percentages actually charged.
Therefore, petitioner's method of accounting clearly
reflected the amounts that it actually received and the actual
costs incurred to perform the work.
- 39 -
income. However, in his answer and on brief respondent argues
only that this is so because petitioner sells merchandise that
must be inventoried. We have held that petitioner does not sell
merchandise. Consequently, we need not and do not engage in
further analysis of the clear reflection of income standard of
section 446. See id.
In light of the above, we hold that respondent’s
determination that petitioner’s method of accounting did not
produce a clear reflection of income was an abuse of discretion.
We have considered all arguments in this case for a contrary
holding and, to the extent not discussed above, find those
arguments to be without merit or irrelevant. To reflect the
foregoing,
Decision will be entered for
petitioner.
Reviewed by the Court.
CHABOT, WELLS, WHALEN, COLVIN, BEGHE, LARO, FOLEY, VASQUEZ,
and GALE, JJ., agree with this majority opinion.
MARVEL, J., dissents.
- 40 -
GERBER, J., dissenting: I respectfully disagree with the
majority’s conclusions that petitioner was not selling
merchandise and that respondent abused his discretion by
determining that petitioner’s use of the cash method did not
clearly reflect income. I disagree for the following reasons:
(1) Petitioner did not meet its heavier-than-normal burden of
showing an abuse of respondent’s discretion; (2) the majority’s
conclusion that the materials involved are merely an inseparable
part of petitioner’s performance of a service is not supported by
the record; (3) the majority’s holding and approach may result in
unintended preferential Federal tax treatment for a particular
industry and/or taxpayers dealing in so-called “ephemeral”
products or materials; (4) the holding in Galedrige Constr., Inc.
v. Commissioner, T.C. Memo. 1997-240, is in error, and,
accordingly, the majority’s reliance upon it is unfounded; and
(5) this case is factually distinguishable from Osteopathic Med.
Oncology & Hematology, P.C. v. Commissioner, 113 T.C. 376 (1999).
The majority sets forth the correct standards for
determining whether respondent has abused his discretion. Those
standards are summarized here to emphasize that petitioner has
failed to meet the standard expressed by the majority: The
Commissioner has broad authority to decide whether a taxpayer’s
accounting method clearly reflects income. We need only decide
whether there is adequate basis in law for the Commissioner’s
conclusion, and section 446 imposes a heavy burden on the
- 41 -
taxpayer to show otherwise. “[A] taxpayer “must establish that
the Commissioner’s determination was ‘clearly unlawful’ or
‘plainly arbitrary’.” Majority op. p. 14 (quoting Thor Power
Tool Co. v. Commissioner, 439 U.S. 522, 532-533 (1979)) (emphasis
added).
Respondent determined that “[petitioner’s] current method of
accounting (cash), is an improper method and * * * changed * * *
[petitioner] to an accrual method. This change has resulted in
an increase in * * * [petitioner’s] gross receipts.” Respondent
also determined, in the alternative, that “under the cash method
of accounting, * * * [petitioner’s] income is increased for
failure to properly substantiate * * * [petitioner’s] accounts
receivable.” The majority, however, limits the issue to the
question of whether the material used by petitioner in performing
its service contracts is the sale of “merchandise” for purposes
of section 1.471-1, Income Tax Regs. Majority op. p. 12. The
majority incorrectly expresses respondent’s notice determination
in the following manner: “Respondent determined that the
material petitioner used in its construction activity was
merchandise that was income producing, and, therefore, petitioner
must use the accrual method of accounting to clearly reflect its
income.” Majority op. p. 15. The majority has treated
respondent’s response to petitioner’s argument as respondent’s
determination. Respondent’s arguments on brief were in response
to petitioner’s position that it should not be placed on the
- 42 -
accrual method because it was in a service business and because
it had no inventories. The majority’s limited focus represents
only a portion of the standard to be considered in order to
decide this issue. Petitioner’s burden (heavier than normal) is
to show that respondent’s determination is in error; i.e., that
respondent abused his discretion by determining that petitioner’s
method does not clearly reflect income. Petitioner cannot carry
that burden by the simple expedient of contending that the
materials it uses to produce finished sidewalks, driveways, and
foundations should be labeled as supplies consumed. It must also
show that its method of accounting clearly reflected income and
that respondent’s determination was clearly unlawful or plainly
arbitrary. Based on the facts of this case, petitioner has
failed to carry its burden.
Ultimate Factual Conclusions by the Majority1
The majority attempts to persuade us that the materials used
by petitioner, which represented two-thirds of the total cost,
were incidental to and absorbed in the performance of services
(labor), which represented one-third of the cost. The majority
1
As the trial Judge (finder of fact) in a factually
oriented case, I am placed in the difficult and unpleasant
position of providing, in the context of a dissenting opinion, my
factual perspective. Two critical factual inquiries are
presented by the issues: (1) Whether petitioner has shown that
respondent abused his discretion, and (2) whether petitioner
produced or sold merchandise and/or had ending inventory. I
disagree with the majority’s ultimate findings of fact, and, to
some degree, the standard employed. Each of these matters is
separately addressed in this dissent.
- 43 -
focuses upon the wet concrete and unincorported materials.
However, the record, when considered in its entirety, supports
the conclusion that petitioner contracted to produce a finished
product (sidewalks, driveways, and foundations). Equally
important, petitioner has not shown the amounts of materials
and/or work in progress that remained on hand at the end of the
taxable period. Nor has petitioner shown that its accounting
method clearly reflected income. The majority accepts
petitioner’s conjectural, uncorroborated, and admittedly “self-
serving” statement that there were little materials left when a
job was completed. Even if that statement is correct,
petitioner’s taxable period did not necessarily or likely end at
the exact time petitioner’s job(s) ended. Therefore, petitioner
has failed to show the amount of materials on hand at the close
of the taxable year. The majority uses conjecture and draws
inferences from the record to reach the conclusion that there was
no inventory on hand and/or that it would not have had a material
effect on petitioner’s income. Such an approach falls far short
of the showing that an inventoriable amount of materials was or
was not on hand at the close of its taxable year.
The majority paints an image in which petitioner could be
viewed as merely providing a service and consuming concrete and
supplies incidental to providing that service. Although the
record does confirm that petitioner is in a service-oriented
business, the overwhelming weight of the evidence shows that
- 44 -
petitioner produced a product (sidewalks, driveways, and
foundations). The majority myopically focuses on the wet
concrete and not on the end product that petitioner produced.
Significantly, that product was completed with materials
purchased by petitioner and accepted by the customer in completed
form before petitioner was entitled to payment. Until such time
as the customer/developer accepted the finished product,
petitioner was at risk and responsible for the construction,
placement, and quality of the product. Finally, it is
significant that petitioner’s profit percentage (about 15
percent) was marked up on both materials (including concrete) and
labor.
The majority also attempts to minimize the possible effect
on petitioner’s income of the purchase and storage of sand,
gravel, re-bar, anchor bolts and rods, expansion anchors,
holddowns, straps, and piping for sewer and drainage (other
materials) used in producing the final product (sidewalks,
driveways, and foundations). It is my understanding of the facts
that only concrete suppliers were involved in asserting their
liens and were paid by a separate check from the developer
through petitioner in order to ensure that any suppliers’ liens
were satisfied. Even if a separate check was issued by the
developer to petitioner and the supplier jointly, petitioner had
the contractual relationship with all suppliers and claimed the
concrete and all other materials as cost of goods sold. In
- 45 -
either event, there is no specific evidence that the suppliers of
sand, gravel, re-bar, anchor bolts and rods, expansion anchors,
holddowns, straps, and piping for sewer and drainage were paid by
a separate check from the developer. To the contrary, sand and
gravel were ordered periodically and delivered to the job site
and used over a period of time. The record also confirms that
re-bar, anchor bolts and rods, expansion anchors, holddowns,
straps, and piping for sewer and drainage were periodically
ordered in bulk and taken as needed from a standing supply that
was maintained in a large metal storage container at petitioner’s
place of business and transported to job sites on a regular
basis. Petitioner did not show the amount of sand and gravel at
job locations as of the end of the taxable period. Nor did
petitioner show the amount of other materials stored in the metal
container or at the job site as of the end of the taxable period.
In addition, petitioner had work in progress (finished concrete
structures) for which components were deducted, but the final
payment may not have been received. Again, petitioner made no
showing of the amount or status of paid-for materials contained
in work in progress at the close of its taxable year.
The majority also attempts to show that the amount of sand
and gravel and other materials on hand at the end of the taxable
year was de minimis by surmising that the percentage cost of
those items reflected in the final product was smaller than the
percentage of labor or concrete. But that in no way shows the
- 46 -
amount that petitioner may have had on hand at the end of the
taxable period. The invoices for the sand and gravel and other
materials show periodic purchases in the tens of thousands of
dollars. Accordingly, sufficiently large quantities of these
items may have been on hand at any particular time, including the
end of the taxable year. Petitioner was constructing
foundations, sidewalks, and driveways in large subdivisions, so
it is likely that at any particular time petitioner maintained a
relatively large quantity of sand and gravel at the job site.
Petitioner has provided no specific evidence as to the amount of
these items on hand or that they were, in fact, without a
significant effect on the amount of income that would have been
reported under the accrual method. The majority accepts, without
any corroboration, testimony that the amount of sand and gravel
on hand was small. Petitioner, however, kept no records of the
inventory of sand, gravel, and other materials on hand and was
not able to show the amount of materials on hand. Considering
the heavy burden imposed here, a taxpayer should not be able to
show that respondent’s determination was arbitrary by the simple
expedient of stating that any difference in accounting method is
“small”. Petitioner paid the suppliers for these items, and
accordingly they were contained in petitioner’s “cost of goods
sold” shown on the return. It should also be noted that
petitioner included the cost of the concrete in its cost of goods
sold and that hardened concrete existed in the form of work in
- 47 -
progress. In that regard, petitioner did not show that amounts
claimed in cost of goods sold did not represent poured/hardened
concrete for which the profit/income had not yet been
received/reported.
It must also be emphasized that petitioner decided which
concrete supplier to use and had contractual relationships with
particular suppliers. It was petitioner who placed orders and
accepted delivery of the concrete at the job site. Although the
developer’s agent was occasionally on the job site for inspection
of the concrete, petitioner bore the risk of loss from a
substandard or misplaced concrete order. Petitioner had the
right under its contract with the concrete supplier to refuse
delivery of substandard concrete, and, under normal conditions,
it was petitioner who was present at and controlled the pouring
of concrete into the forms. Finally, petitioner took possession
of the concrete at the time it was being poured and likely held
title to the concrete under California law.
The majority labels petitioner’s contractual relationship
with the developer as one for services, but that same contract
contains the specifications for the final product that petitioner
was obligated to produce. Other portions of the contract set
forth the materials that petitioner must provide and include in
the finished product. It is important to note that we are not
presented with a situation where the developer purchases
materials and the contractor simply provides labor and incidental
- 48 -
supplies; i.e., a contractor who is hired solely to supervise the
pour and/or finish the concrete. The contract and other facts in
the record reflect an agreement for the delivery of a finished
product. The total cost of the product, two-thirds of which was
composed of materials, was marked up with a 15-percent profit.
Finally, the developer could reject the finished product, and
petitioner would have had to bear the cost of removing the
solidified concrete, which includes the re-bar, bolts, and other
materials (“hardware items”).
Based on the record, I reach the ultimate conclusion that
petitioner was engaged in producing and selling sidewalks,
driveways, and foundations. Petitioner did not merely provide a
service and consume the concrete, sand, re-bar, bolts, plates,
pipes, etc., in providing the service. To so find would stretch
the majority’s analogy to architects and blueprint ink “to
infinity and beyond.” Finally, the value of the materials used
far outweighed the value of the services by a 2 to 1 ratio (66
percent materials vs. 34 percent labor). At the close of
petitioner’s taxable year, it had on hand materials that had been
paid for and were accordingly included in cost of goods sold in
the form of: “Hardware” (re-bar, anchor bolts and rods,
expansion anchors, holddowns, straps, and piping for sewer and
drainage); sand and gravel in place at existing job sites; and
work in progress (including finished sidewalks, driveways, and
foundations composed of purchased materials, which had not been
- 49 -
accepted by the developer/customer and, accordingly, for which
income was not reported). All of those items may have had a
significant effect on petitioner’s reportable taxable income.
Again, petitioner has not shown the amount of materials on hand
or work in progress as of the end of the taxable year under
consideration.2
Petitioner, at the end of its very first year in existence,
had accounts receivable of $294,436 on accrual method gross
receipts of $1,798,338; i.e., 16.4 percent of its receipts were
unreported at the end of its taxable year. Moreover, the
accounts receivable of $294,436 was 18.8 percent of the reported
gross receipts, under the cash method, of $1,564,045. If the
taxable income reported by petitioner included the receivables
under the accrual method of income, petitioner would have
reported taxable income of $267,428. Petitioner claimed cost of
goods sold in the amount of $993,777, which resulted in taxable
income on the cash method of $64,806. Any reduction in cost of
goods sold, of course, would increase income. In spite of these
2
The existence of $294,436 in accounts receivable at the
end of petitioner’s very first taxable year may indicate that
petitioner had a substantial amount of completed work and work in
progress for which it had not been paid, but for which it had
deducted the cost of materials. Under the cash method, the
accounts receivable and work in progress for which payment has
not been received are not included in gross receipts. A mismatch
thus occurs by the overstatement of deductions for materials
under the cash method. In this case, the mismatch is potentially
large considering that the accounts receivable represent a large
percentage of the gross receipts for the tax year under
consideration.
- 50 -
disparities, the majority did not address the question of
substantial identity of results. See majority op. p. 37.
Petitioner’s failure to show that any of the above-discussed
factors or items would not have made a difference in petitioner’s
cost of goods sold or income, ultimately, should result in our
holding that petitioner failed to show that respondent abused his
discretion in determining that petitioner’s use of the cash
method did not clearly reflect income. In the vernacular used by
the majority, petitioner has not shown that respondent’s
determination was “plainly arbitrary”.3 Majority op. p. 14. We
next consider whether petitioner has shown that respondent’s
determination was “clearly unlawful”. Id.
Legal Discussion
The majority’s legal discussion is broken into two major
categories involving whether the sidewalks, driveways, and
foundations were merchandise and whether respondent abused his
discretion. Each is separately addressed.
(1) Whether the Materials Used or the Structures Constructed
by Petitioner Were Merchandise
Normally, in cases where respondent determines that a
taxpayer’s accounting method should be changed to the accrual
method, the controversy concerns whether the merchandise is a
material income-producing factor and whether the accrual or cash
3
Even if the facts equally supported both parties’
positions, petitioner necessarily fails to meet the heavy burden
imposed.
- 51 -
method of accounting more clearly reflects income. Respondent
has determined that petitioner should use the accrual method,
and, accordingly, petitioner must show that there has been an
abuse of discretion by addressing the above-referenced factors.
Petitioner, relying on Galedrige Constr., Inc. v. Commissioner,
T.C. Memo. 1997-240, attempts to lessen its burden by attempting
to show that the materials used and the objects constructed are
not merchandise and are instead supplies consumed in performing a
service.
Following petitioner’s lead, the majority holds that neither
the materials nor the constructed products constitute
merchandise. In support of the holding that the materials used
and the products completed by petitioner are not merchandise, the
majority relies on the following: (a) Petitioner is primarily a
service provider (a fact that is not supported by the record when
viewed as a whole); (b) there is no established definition for
the terms “inventory” or “merchandise”; (c) in order for items to
be “merchandise” they must be goods held for sale; (d) case law
holds that, per se, construction contracts are contracts for the
provision of services as opposed to the sale of goods; (e) liquid
concrete cannot be merchandise because it hardens in a short
period of time; i.e., is ephemeral in nature and must, therefore,
be consumed in the performance of a service; (f) the sand,
gravel, re-bar, anchor bolts and rods, expansion anchors,
holddowns, straps, and piping for sewer and drainage lose their
- 52 -
separate identity, become part of the hardened concrete, and are
thus “indispensable and inseparable from the service provided by
the taxpayer”, majority op. p. 27; (g) driveways and walkways are
improvements to real property and, ipso facto, cannot be
merchandise. Because of the majority’s conclusion that the
materials that went into the product (sidewalks, driveways, and
foundations) were not merchandise, the majority does not discuss
whether they were material income-producing factors.
A full and complete analysis of the record does not support
the majority’s ultimate finding of fact that the materials and
products were merely supplies consumed in petitioner’s
performance of a service for customers. Likewise, an analysis of
established precedent of this Court leads to the conclusion that
petitioner has not carried its burden of showing: That the
materials and/or finished product were not material income-
producing factors; that the cash method of accounting more
clearly reflects income; and, ultimately, that respondent abused
his discretion by determining that petitioner should change to
the accrual method.
(a) Petitioner’s Business Is Not Primarily Providing a
Service--To be sure, petitioner is engaged in a labor-intensive
activity. Generally, the construction industry is considered to
be service oriented. Most businesses, however, have some element
- 53 -
of labor or service and some element of merchandise or product.4
See, e.g., Thompson Elec., Inc. v. Commissioner, T.C. Memo. 1995-
292, where the taxpayer, an electrical contractor, used materials
such as wiring, conduits, electrical panels, and lighting
fixtures in its contracting business. The question that must be
considered is: “At what point do the materials become an income-
producing factor?” The taxpayer in Thompson Elec., Inc.,
maintained on its premises an inventory of unassigned materials
that were used for small contracts and, in addition, delivered
materials directly from the supplier to its large-contract
customers’ sites. In Thompson Elec., Inc., it was held that
those materials were merchandise that was an income-producing
factor even though: The taxpayer did not display the material to
customers or to the public, the material was not itemized on bids
or invoices nor separately charged to the customer, the taxpayer
did not sell material separately from its services, and the
taxpayer’s customers generally did not select the materials to be
used.
As in Thompson Elec., Inc., petitioner is a contractor but
is in the business of constructing concrete sidewalks, driveways,
and related structures. Petitioner makes bids and then contracts
4
The majority contends that the substantiality of the
materials or product is irrelevant to the question of whether or
not such items are merchandise. At least two cases, however,
have given weight to the proportion of such items to service.
See Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d 352, 355 (1st
Cir. 1970), affg. T.C. Memo. 1969-79; Thompson Elec., Inc. v.
Commissioner, T.C. Memo. 1995-292.
- 54 -
with developers to construct a finished structure or product.
Petitioner purchases concrete, sand, gravel, re-bar, anchor bolts
and rods, expansion anchors, holddowns, straps, and piping for
sewer and drainage and uses those materials to produce sidewalks,
driveways, and foundations. The developer, who does not have any
contractual relationship with the suppliers of concrete, sand,
gravel, and other materials, must accept the finished product
before petitioner is entitled to payment. The materials
represent approximately two-thirds of the cost of the finished
product and the labor approximately one-third. Petitioner is
financially responsible for any deficiencies in the contract
specifications up until the acceptance of the finished product by
the developer. At any particular time, petitioner has on hand
sand, gravel, re-bar, anchor bolts and rods, expansion anchors,
holddowns, straps, and piping for sewer and drainage stored at
various sites, including its place of business.
When all of these facts are taken into consideration, it
becomes evident that petitioner is not solely engaged in
providing labor and that the materials are not merely consumed in
providing a service. If, however, petitioner had contracted to
set forms, pour and finish concrete for a developer who purchased
the sand, gravel, concrete, re-bar, anchor bolts and rods,
expansion anchors, holddowns, straps, and piping for sewer and
drainage, the majority’s finding or holding would then ring
truer. Instead, the facts in this case are difficult to
- 55 -
distinguish from those set forth in Thompson Elec., Inc.
(b) The Majority’s Use of the Terms “Merchandise”,
“Inventory”, and “Goods Held for Sale”--Although the terms
“merchandise” and “inventory” are not specifically defined in the
tax law, it is fair to say that those terms are broadly used in
the pertinent statutes and regulations. Petitioner’s contractual
relationships involve large residential construction projects,
and, at any particular time, petitioner has work in progress
(including placed sand, gravel, re-bar, anchor bolts and rods,
expansion anchors, holddowns, straps, piping for sewer and
drainage, and finished sidewalks, driveways, and foundations that
the developer has not yet accepted). Petitioner also purchases
materials that remain on hand and in place at the end of its
taxable year. I disagree with the majority’s holding based on
petitioner’s uncorroborated statements and argument that there
was no inventory on hand or that it was not producing
merchandise.
The majority also makes a distinction that is at odds with
existing case law by holding that merchandise/inventory must be
“property that is held for sale, not simply property that is
sold.” Majority op. p. 17. Implicit in the majority’s statement
is that goods do not become merchandise or inventory if they are
not “held” for some period of time. The only difference one
might glean from the majority’s distinction is that the purchased
items must be “held” for some period of time for sale to
- 56 -
customers. That statement is contrary to existing case law. It
is well established that the length of time the goods are held
does not have a bearing on whether they are merchandise/
inventory.
Even if the taxpayer possessed title to the goods for an
instant, it is sufficient to require a taxpayer to inventory the
goods as the stock in trade. See Addison Distrib., Inc. v.
Commissioner, T.C. Memo. 1998-289; Middlebrooks v. Commissioner
T.C. Memo. 1975-275. In Addison Distrib., Inc., the taxpayer had
electronic materials for a very short period (for inspection
purposes), and then it forwarded the materials to the customer.
In Addison Distrib., Inc., it was held that the taxpayer should
be required to account for inventory and be on the accrual method
even though it appeared unlikely that there would be any
inventory on hand at the end of an accounting period. In another
case involving a taxpayer in the construction industry, it was
held that inventories were required, and the accrual method
should be used even though the materials were shipped directly to
job sites, and no substantial amounts of materials were
inventoried at the taxpayer’s warehouse. See Tebarco Mechanical
Corp. v. Commissioner, T.C. Memo. 1997-311 (involving a plumbing,
heating, and air-conditioning contractor who was generally
involved in commercial construction projects).
Considering the above-cited cases, it is hard to understand
the majority’s point or distinction in emphasizing that inventory
- 57 -
and/or merchandise must be held for sale in addition to being
merely sold. There is no question here that petitioner
contracted to purchase the concrete, sand, gravel, concrete, re-
bar, anchor bolts and rods, expansion anchors, holddowns, straps,
and piping for sewer and drainage. Some of those items were
inventoried at petitioner’s place of business, some were stored
at the customer’s job site (sand and gravel). The concrete,
however, was ordered by petitioner in a contract relationship
between petitioner and a supplier. Petitioner controlled the
ordering of the concrete, its time of delivery, pouring, and
placement. Finally, although the concrete hardened in place,
petitioner remained responsible for any risk of loss until the
developer/customer accepted the finished product.
By way of analogy, some contractors precast and sell large
concrete structures that are transported from the contractors’
place of business to the buyers’ job sites. Would the majority
hold that such a precast product is not merchandise? Should the
place of casting the concrete dictate a taxpayer’s choice of
accounting method? In either case, the contractor is purchasing
the materials, casting the concrete shape (incorporating the so-
called hardware), then marking up the material and labor, and
selling it to the end user. Should there be a difference between
contractors who provide electrical, plumbing, heating, air
conditioning services and/or materials and those who provide
other structural components (e.g., concrete)?
- 58 -
The majority cites several nontax cases for the proposition
that construction contracts are, per se, contracts for labor and
not contracts for the sale of goods. Considering Thompson Elec.,
Inc. v. Commissioner, T.C. Memo. 1995-292, Tebarco Mechanical
Corp. v. Commissioner, supra, and related cases, it has made no
difference for Federal income tax purposes that the taxpayers
were involved in construction or a service-oriented business.
The more important question (which the majority has not
addressed) is whether the items here were income-producing
factors. Indeed, the answer to the question of whether taxpayers
should maintain inventories and be placed on the accrual method
of accounting should not be different depending upon which
industry we are considering. It must be noted that two-thirds of
petitioner’s profit in this business are attributable to the
materials and only one-third to services or labor.
We consider these factual issues on an ad hoc basis. If, as
a matter of tax law, particular taxpayers fall within the ambit
of a regulation requiring the use of the inventory method and/or
the accrual method of accounting, they should not be exempted
because of State case or statutory law, especially if other
similarly situated Federal taxpayers must otherwise comply with
the same rules under the same circumstances.
To the extent that the majority relies on cases that hold
that an accretion to real property is not the sale of goods,
those holdings should be given no more credibility than contract
- 59 -
case law. After all, on numerous occasions this Court has been
confronted with the question of whether realty was held for sale
or investment. If real property is held primarily for sale in
the ordinary course of a trade or business, gain from its sale is
ordinary income as opposed to capital gain. See Eline Realty Co.
v. Commissioner, 35 T.C. 1 (1960); Phillips v. Commissioner, 24
T.C. 435 (1955). In other words, taxpayers have been found to be
in the business of selling houses. The costs of materials used
in the construction of houses are not deductible expenses, but
rather they are included in the basis of the home and give rise
to ordinary income or capital gain upon sale. The present
situation is analogous and should be accounted for in the same
manner; i.e., petitioner should not be allowed to deduct expenses
prior to reporting income. Thus, while it is true that real
property is not considered merchandise or inventoriable in the
same sense that personal property is, the method of accounting
for the sale of real property, by way of analogy, reflects that
the material and products remaining on hand or contained in work
in progress should be considered inventory and/or their costs
subtracted from petitioner’s cost of goods sold.
Finally, the majority cites Levine v. State Bd. of
Equalization, 299 P.2d 738 (Cal. App. 2d 1956), a sales tax case,
to support its holding/finding that petitioner is a service
business and the materials that go into making concrete
structures are not merchandise. Although it is irrelevant to the
- 60 -
question of Federal taxation, petitioner passed on the charges
for sales tax on all materials that were used in making the
walkways and driveways. No sales tax was charged on the labor.
The costs of the product sold included about two-thirds materials
and one-third labor. More importantly, we cannot consider the
Federal laws as being subservient to or dependent upon State
sales tax statutes. That would likely cause differing results
depending on the sales tax law and rulings in each State.
Although we might look to State law to determine the ownership of
property, we must apply the Federal tax statutes uniformly in
accord with our mandate.
(c) Galedrige Constr., Inc. v. Commissioner, T.C. Memo.
1997-240, Should Not Be Applied in This Case and Is Incorrect as
a Matter of Law--Galedrige Constr., Inc., is relied on by
petitioner and is foundational to the majority’s conclusion that
liquid concrete is “the only form of the material that provided
any value to * * * [petitioner, and it is] ‘used up’ or consumed
in providing service to the * * * [petitioner’s] client.”
Majority op. p. 25. From that premise, the majority reaches the
ultimate conclusion that the material has been consumed in the
performance of a service and that it is a supply and not
merchandise held for sale.5 Assuming, arguendo, that Galedrige
5
For purposes of comparison, the parties in this case
stipulated that the lumber that was used to construct the forms
and was removed from the final product and sometimes reused was a
supply and not merchandise. We note that the lumber constituted
approximately 1 percent of the cost of the materials.
- 61 -
Constr., Inc., is correct as a matter of law, it should not be
applied in the setting of this case.
Here again, the focus of the majority is too limited. If
petitioner had been hired merely to provide the service of
overseeing the pouring of liquid concrete and/or finishing semi-
hardened concrete, the majority’s conclusion would have a more
rational and sounder basis. Those, however, are not the facts of
this case. As more fully explained, supra, petitioner entered
into a contract to construct sidewalks, driveways, and
foundations to certain specifications. At the end of
petitioner’s performance of labor (which represents about 34
percent of the total costs) the materials had not been “consumed”
or “used up”. Indeed, the materials had been constructed into
the very item (product) that petitioner contracted to construct.
At that point, legal principles may hold that the sidewalks or
driveways then belonged to the owner of the real property, but
they most certainly had not been consumed or used up in the
performance of a service.
The holding in Galedrige Constr., Inc., is not in accord
with established case precedent. That holding is that “the
ephemeral quality of the emulsified asphalt bars its inclusion in
the class of goods or commodities held for sale as
‘merchandise’”. The Galedrige Constr., Inc., holding is premised
on the fact that something that will lose value in a short time
or will be difficult to “inventory” cannot be merchandise or
- 62 -
inventory. No other reasoning is offered or appears obvious for
such a holding, and no prior case discussed this premise. That
holding appears to be in conflict with the Court of Appeals for
the Eleventh Circuit’s holding in Knight-Ridder Newspapers, Inc.
v. United States, 743 F.2d 781 (11th Cir. 1984). In that case,
the court held that, even though the taxpayer sold an extremely
perishable commodity and had no inventory of finished goods, the
taxpayer was required to account for inventories because
newspapers were merchandise, and there was a significant
fluctuation of newsprint and ink on hand. By way of comparison,
a morning newspaper will be stale later the same day.
How does the majority distinguish between concrete that
hardens and news that becomes stale? The hardened concrete, if
not formed, and the old newspaper both lose substantial value.
Petitioner, however, ordered no more concrete than it needed or
could use in a particular period of time, and the incidence of
wasted or unused and hardened concrete was not a financial factor
or risk in petitioner’s business. To the contrary, after the
concrete was poured, petitioner had created a valuable product
for which it would receive payment.
In addition, the lack of inventory on hand has already been
held not to be determinative of the question of whether
merchandise is an income-producing factor for the application of
the accrual method. See, e.g., J.P. Sheahan Associates, Inc. v.
Commissioner, T.C. Memo. 1992-239. Also, the fact that
- 63 -
merchandise may only briefly be in the possession of the seller
is of no consequence. See, e.g., Addison Distrib., Inc. v.
Commissioner, T.C. Memo. 1998-289.
The conclusion that a product with a limited commercial life
cannot be merchandise defies reason. In Asphalt Prods. Co. v.
Commissioner, 796 F.2d 843 (6th Cir. 1986), affg. on this issue,
revg. in part, and remanding Akers v. Commissioner, T.C. Memo.
1984-208, revd. on another issue 482 U.S. 117 (1987), it was held
that a seller of asphalt to contractors like the one in Galedrige
Constr., Inc., should be on the accrual method because it held
merchandise/inventory to be for sale. Is the asphalt or concrete
less ephemeral for the person who supplies it? If a supplier of
asphalt or concrete also contracted to pour and place it for
customers, would it have to use differing methods of accounting
for each activity? If taxpayers sell products that spoil easily,
should those taxpayers be exempt from the section 471 or section
446 requirements if they otherwise fall within the statute’s
reach? The answer to these questions should be “no”, and the
Galedrige holding is in error.
(d) Osteopathic Med. Oncology & Hematology, P.C. v.
Commissioner, 113 T.C. 376 (1999), Is Factually Distinguishable
From the Circumstances in This Case--Osteopathic Med. Oncology &
Henatology, P.C., was a Court-reviewed opinion in which 10 of 16
participating Judges joined in the majority’s findings and
holding, and 4 of 16 joined in the dissent specifically
- 64 -
disagreeing with the majority’s findings and holding. Of the
remaining two Judges, one dissented without comment and one
concurred in the result but did not join the majority. To be
sure, the majority’s opinion in Osteopathic Med. Oncology &
Hematology, P.C., is the view of this Court, but it is
substantially a factual finding that the drugs in that case were
a supply consumed in the performance of a service and that the
drugs were not merchandise.6 In any event, the case before us
now does not involve a medical practice, the administration of
drugs, or hybrid accounting methods. The facts we consider here
involve the use of relatively substantial amounts of materials to
construct finished products.
The question of whether an accounting method clearly
reflects income is a factual question that is decided on a case-
by-case basis. See Hamilton Indus., Inc. v. Commissioner, 97
T.C. 120, 128-129 (1991). Without detailing all of the findings
in Osteopathic Med. Oncology & Hematology, P.C., it should
suffice to understand that the chemotherapy drugs were consumed
in the patients’ bodies. The physicians were treating patients’
illnesses by administering drugs into the patients’ bodies.
Although there was disagreement about whether the drugs were
merchandise or a supply, Osteopathic Med. Oncology & Hematology,
6
See, however, Judge Halpern’s dissenting opinion
indicating that the majority’s conclusion may constitute a rule
of law as it relates to businesses involved in medical practices.
Osteopathic Med. Oncology & Hematology, P.C. v. Commissioner, 113
T.C. 376, 402 (1999) (Halpern, J., dissenting).
- 65 -
P.C., presents a situation where the conclusion that the drugs
are consumed in the performance of a service is easier to make.
Clearly, no product resulted from the administration of drugs
into patient’s bodies.
The purchase of materials and construction of them into
finished products in this case is not easily transformed into
being “an indispensable and inseparable part” of a service.
Majority op. p. 19. As already explained in this dissenting
opinion, petitioner purchased materials and sold them to
customers in the form of a finished product. The very reasons
for finding the drugs to be supplies consumed in performing a
service in Osteopathic Med. Oncology & Hematology, P.C., are the
antithesis of the circumstances presented in this case where
finished products result from petitioner’s labors.
(2) Whether Respondent Abused His Discretion
Finally, the majority in this case finds irrelevant the fact
that petitioner had accounts receivable of $294,436 for its very
first year, in which it reported $64,806 of taxable income under
the cash method. The majority relies on section 448 for its
conclusion that petitioner’s failure to meet the substantial-
identity-of-results test is irrelevant because that section
allows certain taxpayers to use the cash method and/or not
maintain inventories. The majority also finds significant the
holding in Ansley-Sheppard-Burgess Co. v. Commissioner, 104 T.C.
367, 377 (1995).
- 66 -
Section 448 permits certain smaller businesses to use the
cash method, but it does not preclude the Commissioner from
determining, as was done here, that a taxpayer’s method does not
clearly reflect income. Section 448 was argued by petitioner on
brief to the extent that petitioner contended that it was within
the $5-million maximum limitation of that section. Respondent
made no comments in his brief concerning section 448 but instead
relied on the argument that petitioner failed to show that its
method (cash) clearly reflected income; i.e. that respondent
abused his discretion.
Respondent’s discretion to determine that petitioner’s
method does not clearly reflect income is derived from section
446 and is not obviated by section 448. Although section 448 may
enable smaller businesses to use the cash method, it also
effectively abolishes the use of the cash method for all other
taxpayers.7 Where a taxpayer is qualified under section 448,8
the cash method may be used if the taxpayer can show that the
cash method more clearly reflects income. Section 448 cannot be
treated as a complete answer to our inquiry. To do so would
ignore the statute, regulations, and our case precedent that hold
7
Congress’ enactment of sec. 448, in part, reflects its
acceptance that the cash method results in mismatching, but it
did not make its use by small taxpayers into a safe haven from
the exercise of the Commissioner’s discretion under sec. 446.
8
There has been no showing here that petitioner is in all
respects qualified under sec. 448. In addition, the parties did
not stipulate that petitioner was qualified under sec. 448.
- 67 -
that taxpayers may be required to use the inventory and/or
accrual method even though they do not have goods on hand. To
use the lack of inventory on hand as a reason to hold that
respondent has abused his discretion is, likewise, not
appropriate.9 Although the opinion in Ansley-Sheppard-Burgess
Co. v. Commissioner, supra, focused on section 448, the parties
in that case stipulated that the taxpayer did not maintain an
inventory and met the requirement of section 448(b)(3). In this
case, no such agreement exists.
In this case, petitioner is not exempted from showing that
the cash method clearly reflected its income by any of the
expedients relied upon by the majority. Moreover, petitioner has
not shown that respondent’s determination was plainly arbitrary.
The use of Osteopathic Med. Oncology & Hematology, P.C. v.
Commissioner, supra, as a pervasive rule that income from
services, by definition, cannot involve the sale of goods or
merchandise would be unsound.10 The majority’s holding here
would have the effect of overruling numerous cases, including
several involving similarly situated taxpayers engaged in the
construction industry. The effect of the majority’s holding is
to exempt contractors in the construction industry from sections
9
That reasoning is further weakened by petitioner’s failure
to show that no materials were on hand at the close of its
taxable year.
10
For example, at the other end of the spectrum, a service
(as opposed to self-service) grocery store provides many services
for its customers in connection with the sale of its merchandise.
- 68 -
446 and 471 if the materials they purchase/sell are used in
constructing part of an addition to real estate. The majority’s
approach would confer preferential treatment on a limited class
of taxpayers without congressional mandate.
COHEN, RUWE, HALPERN, and THORNTON, JJ., agree with this
dissenting opinion.
- 69 -
HALPERN, J., dissenting:
I. Introduction
Petitioner is a concrete contractor, licensed by the State
of California to construct, place, and finish concrete
foundations and flatwork. In performing its work, petitioner
uses ready-mix concrete, sand, rock, various hardware items, and
lumber (the materials), all of which (except, possibly, the
lumber) belong to someone else at the end of the job. For the
taxable year in question, petitioner treated as an expense, and
deducted on its Federal income tax return, all payments actually
made by it during the year for the materials. It included in
gross income only payments actually received by it during the
year.
The majority addresses the question of whether petitioner
must take inventories. In pertinent part, section 1.471-1,
Income Tax Regs., provides: “In order to reflect taxable income
correctly, inventories at the beginning and end of each taxable
year are necessary in every case in which the production,
purchase, or sale of merchandise is an income-producing factor.”
The majority decides that petitioner need not take inventories.
It does so on the following basis:
We have found that petitioner’s contracts with its
real property developer clients are service contracts,
that the material provided by petitioner is
indispensable to and inseparable from the provision of
that service, that the materials lost their separate
identity to become part of the real property in the
construction activity, and that, in substance, no sale
of merchandise occurred between petitioner and its
- 70 -
clients. The bottom line is that petitioner did not
hold merchandise for sale and there simply was no sale
of merchandise between petitioner and its clients. See
Osteopathic Med. Oncology & Hematology, P.C. v.
Commissioner, supra [113 T.C. 376 (1999)]; Honeywell,
Inc. v. Commissioner, supra [T.C. Memo. 1992-453].
[Majority op. pp. 33-34]
The majority recognizes that petitioner provides a mix of
goods and services. Rules of law to decide whether taxpayers
providing a mix of goods and services are producing, purchasing,
or selling (without distinction, selling) merchandise that is an
income-producing factor have proved elusive. See Schneider,
Federal Income Taxation of Inventories, sec. 1.02, particularly
at 1-13 through 1-26 (2000). The majority has attempted to craft
such a rule of law. The majority looks to Osteopathic Med.
Oncology & Hematology, P.C. v. Commissioner, 113 T.C. 376 (1999),
which applies a rule of law of questionable, but narrow,
application; viz, that medical practice is inherently a service
business. The majority extracts from that case the dubious
proposition that we can define the inherent nature; i.e., define
the essential constituent, of a service business.1 The majority
would test for that constituent as the principal determinative of
whether a business is selling merchandise. The majority has
disregarded precedent and, in my opinion, left the law less
settled than before.
1
Inherent means: “Existing as an essential constituent or
characteristic; intrinsic.” The American Heritage Dictionary 928
(3d ed. 1992).
- 71 -
II. Discussion
A. Introduction
I distill the following rule of law from the majority’s
analysis: A taxpayer is not selling merchandise to customers
when the material in question is integral to the provision of a
service. See majority op. p. 15.2 The principal difficulty that
I have with the test (the integral-to-service test) implicit in
the majority’s rule is that it does not accommodate many of the
factors that have proved useful in deciding whether the provider
of a mix of goods and services is selling merchandise that is an
income-producing factor.
B. Traditional Factors
For example, under the integral-to-service test, what role,
if any, is left for the traditional inventory-determinative
factors of ownership, risk, and relative cost?
Under the integral-to-service test, is the fact that
ownership of the materials vests in the taxpayer irrelevant? If
not, how does that fact influence the determination of whether
the materials are integral to the service? See Surtronics, Inc.
v. Commissioner, T.C. Memo. 1985-277 (electroplator purchasing
gold and silver to apply to customer’s components was required to
2
The principal meaning of the word “integral” is “Essential
or necessary for completeness; constituent”. American Heritage
Dictionary 937 (3d ed. 1992). The word “integral” expresses
nicely the concept of “indispensable and inseparable” that the
majority lifts from Osteopathic Med. Oncology & Hematology, P.C.
v. Commissioner, 113 T.C. 376 (1999).
- 72 -
use inventories); Epic Metals Corp. v. Commissioner, T.C. Memo.
1984-322 (taxpayer’s failure to prove that title to goods did not
pass to it decisive to decision rejecting its argument that, in
arranging the sale of goods between two other parties, it was
only a broker selling its services and was not a seller itself),
affd. without published opinion 770 F.2d 1069 (3d Cir. 1985).
What about risk of loss? Assume that the taxpayer bears the
risk of loss with respect to materials destroyed during
production or if performance under the contract is rejected. Is
that fact, likewise, irrelevant? If not, how does it influence
the required determination? In Fame Tool & Manufacturing Co. v.
Commissioner, 334 F. Supp. 23 (S.D. Ohio 1971), the taxpayer
manufactured tools and dies to order. It maintained no finished
inventory, had a substantial amount of work in progress, and the
average time to complete an order was 1 or 2 weeks. Since the
end product manufactured by the taxpayer had to satisfy the
customer’s specifications, if the tool or die failed to meet
those specifications, it was rejected and had to be scrapped.
The percentage of rejects varied widely. The taxpayer argued
that, since it was a “pure” tool and die maker, as distinguished
from a precision manufacturer, it provided a service and,
therefore, there was no “merchandise” or any “production” within
the meaning of section 1.471-1, Income Tax Regs. The District
Court rejected that argument, relying on Wilkinson-Beane, Inc. v.
Commissioner, 420 F.2d 352 (1st Cir. 1970), affg. T.C. Memo.
- 73 -
1969-79, for the rule that the taxpayer was required to take
inventories even if he was partly or mainly performing a service.
The District Court pointed out that the taxpayer’s argument that
it was a service provider would have been stronger if it had
subcontracted out the actual production of the tools and dies:
“[I]nasmuch as the customer is obviously only interested in
getting a tool or die to his specifications, regardless of who
made it”. Fame Tool & Manufacturing Co. v. Commissioner, supra
at 28.
Finally, in applying the integral-to-service test, what
weight do we give to a comparison of the relative costs of the
materials and labor constituting the taxpayer’s work product
(assuming that the taxpayer had title to the materials)? Compare
Drazen v. Commissioner, 34 T.C. 1070, 1078-1079 (1960) (taxpayers
arguing for inventories--(to put them on the accrual method, so
they could accrue deferred payments against current costs)--did
not have sufficient manufacturing operations to require
inventories) with Thompson Elec., Inc. v. Commissioner, T.C.
Memo. 1995-292 (substantiality of material costs compared to
receipts taken into account in determining whether material is a
substantial income-producing factor).
Shasta Indus., Inc. v. Commissioner, T.C. Memo. 1986-377, is
a traditional factor case that, apparently, would come out
differently under the integral-to-service test. The taxpayer, a
swimming pool contractor, constructed custom-designed, in-ground
- 74 -
swimming pools. We found the physical construction process
utilized by the taxpayer to be as follows:
The layout site was excavated including dynamiting or
other special techniques if necessary. The plumber
installed the filter, pump, motor, and the skimmer.
Steel reinforcing bars were used to form a metal basket
to fit the excavation and form the shape of the pool.
Wiring was then added to the pool site. The necessary
electrical work was done before the concrete was
poured, covering the steel, plumbing and electrical
work. Tile was placed around the pool surface and the
deck around the pool was constructed. Final details of
construction were the cleanup of the pool area, setting
of the turbos, and plastering of the pool. Equipment
needed to service the pool was then delivered to the
pool site and the operation of the pool was explained
to the customer. [Id.; emphasis added.]
We also found: “Although most supplies came from the warehouse,
some materials such as concrete and tile were purchased for
specific contracts and normally delivered directly to the pool
site.” (Id.; emphasis added.)
The question before us was whether the taxpayer could use
the LIFO method for its inventory of partially completed swimming
pools. The taxpayer overcame the argument that the completed
contract method precluded the use of LIFO, as well as the
argument that the swimming pools were not inventory because they
constituted improvements to land. We held that inventories are
necessary in order to reflect taxable income correctly in every
case in which the sale of merchandise is an income-producing
factor, citing Wikstrom & Sons, Inc. v. Commissioner, 20 T.C.
359 (1953), for the proposition that inventories are required
when merchandise is produced in accordance with customer
- 75 -
specifications. Also, we found that the taxpayer was maintaining
inventories in the form of materials and work in process, and not
in the form of real estate to which it held title or in the form
of improvements to its own real estate. On that basis, we
distinguished Miller Dev. Co. v. Commissioner, 81 T.C. 619 (1983)
(real estate and improvements to real estate are not normally
considered “merchandise” for purposes of determining whether the
use of inventories is permitted to the taxpayer).
Shasta Indus., Inc. v. Commissioner, supra, is a Memorandum
Opinion. Therefore, we applied settled law to the facts before
us. Those facts and the facts before us today are quite similar,
yet, today, we reach a different result. I assume, therefore,
that settled law has changed.
C. The Integral-to-Service Test
The majority finds that petitioner’s business is inherently
a service business. See majority op. pp. 19, 23. As stated, the
majority does not identify the essential constituent that marks
the inherent nature of a service business. In Osteopathic Med.
Oncology & Hematology, P.C. v. Commissioner, supra, we found the
chemotherapy drugs in question were unavailable to the ultimate
consumers, the patients, without the intervention of a physician,
and they had to be injected into the patient by a physician or
nurse. The analogy to the case at hand is weak. Here, the
materials could be purchased by anyone, and the only
distinguishing characteristics of petitioner were its license and
- 76 -
its skill to do the work involved. Do we thus conclude that the
essential constituent of a service business is the requirement of
some level of skill or the necessity of some Government license
to carry it out? Do we not make a distinction without a
difference when we suggest that we can divide the class of
businesses that deliver a mix of goods and services on the basis
of those that are inherently service businesses and those that
are not?
In Rev. Rul. 74-279, 1974-1 C.B. 110, the Commissioner dealt
with a taxpayer engaged in business as an optometrist. The
taxpayer not only examined eyes and prescribed corrective lenses
(which requires a license) but also sold frames and eyeglasses.
The ruling holds that, although the taxpayer provides various
services, there is also a substantial amount of merchandise sold,
and, therefore, inventories are required. Not surprising. But
how does the optometrist fare under the integral-to-service test?
I assume that the business of optometry (at least when limited to
examining eyes, diagnosing defects, and prescribing corrective
lenses) is inherently a service business under that test. Cf.
Osteopathic Med. Oncology & Hematology, P.C. v. Commissioner,
supra. But the business of filling the prescription for the
corrective lenses also involves the optometrist’s performing a
service. The service requires skill and, in some jurisdictions,
it requires a license. See, e.g., Cal. Bus. & Prof. Code sec.
2550 (West 1990 & Supp. 1999). Therefore, filling the
- 77 -
prescription is inherently a service business under the integral-
to-service test. I assume that the lenses and frames are
integral to that service. If so, under the integral-to-service
test, the lenses and frames are not merchandise within the
meaning of section 1.471-1, Income Tax Regs.
The integral-to-service test is different; it changes the
emphasis of the inquiry that, traditionally, has served; it
brings into play new factors, which will encourage the
reexamination of settled questions. For instance, consider the
hotel and restaurant business. The courts have consistently held
that the sale of large amounts of food, beverages, and tobacco is
a sufficient basis upon which to predicate the use of
inventories. See, e.g., Dwyer v. Commissioner, a Memorandum
Opinion of this Court dated June 29, 1951 (inventories necessary
for hotel and restaurant business since purchase and sale of
wines, liquors, and beers is an income-producing factor), affd.
on other issues 203 F.2d 522 (2d Cir. 1953); Schuyler v.
Commissioner, a Memorandum Opinion of this Court dated May 11,
1951 (similar; purchase and sale of food, beer, wine, liquor, and
tobacco products), affd. on other issues 196 F.2d 85 (2d Cir.
1952). Do we now give license to challenge that orthodoxy?
Restaurants do not sell tobacco products anymore, and liquor may
give them pause, but can fancy French restaurants (or large food
service operations) now argue that they need not inventory their
comestibles since they are inherently a service business, with
- 78 -
peas, carrots, truffles, and boeuf being integral to that
service? What about the proliferation of dot.com businesses,
whose added value is generally some service, such as the ability
to shop at home for merchandise, such as books or music, that
used to require a trip to the store? I fear that our new rule
may be misunderstood.3
III. Conclusion
Leslie J. Schneider, in his treatise, Federal Income
Taxation of Inventories, writes: “Notwithstanding the fact that
the inventory issue is raised in a variety of contexts, the issue
is resolved by a consideration of the same basic question-–is the
production, purchase or sale of merchandise an income-producing
factor?" Schneider, supra at 1-12. I would take into account
the traditional factors to determine whether petitioner’s method
of accounting clearly reflects its income. For many of the
reasons stated by Judge Gerber, I would conclude that it does
not.
COHEN, RUWE, GERBER, and THORNTON, JJ., agree with this
dissenting opinion.
3
Indeed, I am not that sure how well the majority
understands it. The majority’s discussion of the integral
relationship of the materials to petitioner’s service relies on
an old-style factor analysis. Judge Gerber, in his dissent, does
a good job of criticizing that analysis.