Inventory: The Search for Parameters

By Mark A. Segal

In Brief

Recent Decisions Clarify Distinctions

The determination of when to account for merchandise using the accrual method under Treasury Regulations section 1.471-1 is a difficult one. The key distinction turns on whether the taxpayer primarily provides services or sells inventory. Taxpayers face a uphill battle in defending their use of the cash method and challenging the IRS’s discretion. Recent court decisions, however, have pointed to a clearer definition of inventory and permitted wider use of the cash method.

Two essential questions to resolve include whether the materials are inseparable from and subordinate to the services rendered and whether the services provided constitute the true basis of the taxpayer’s business. The details of the business and contractual relationships must be considered; factors such as the relative cost of the materials versus services provided and the length of the time the inventory is held are not enough to make the determination.

A ccording to Treasury Regulations section 1.471-1, the maintenance of beginning and ending inventories is necessary where “the production, purchase, or sale of merchandise is an income-producing factor.” Merchandise should be included in inventory to the extent it is finished or partly completed. Raw materials and supplies should only be included in inventory to the extent that the goods have been acquired for sale or will physically be part of the merchandise intended for sale.

Application of these definitions has been problematic. A fine line appears to be drawn between a taxpayer engaged in the provision of services and a taxpayer engaged in the sale of inventory. This distinction has important consequences: the taxpayer is generally required to use the accrual method if holding inventory for sale, whereas if the taxpayer’s business instead consists of the rendering of services, the cash method will typically apply. A number of recent court decisions help clarify the parameters of “inventory.”

Osteopathic Medical Oncology

The Tax Court addressed the issue of inventory in Osteopathic Medical Oncology and Hematology, P.C. v. Comm’r [113 TC 376 (1999), acq. in result 2000-23 IRB]. At issue was whether a professional medical corporation could use the cash method with respect to the drugs and pharmaceuticals (particularly chemotherapy drugs) held for use in providing medical services.

The court ruled that the corporation could use the cash method, based upon the following reasoning:

• The pharmaceuticals provided were vital to the rendering of the medical services.
• The situation involved a unique industry, and providing the goods was integral and inseparable from the rendering of the service.
• The taxpayer kept no more than a two-week supply of chemotherapy drugs and had used virtually all such drugs by the end of the year.
• The goods involved could only be acquired from a pharmacist or in the rendering of medical care.
• Although the cost of the medication was significant, it was not controlling, because the provision of the medicine was integral to the rendering of the service.

Turin

Jim Turin and Sons, Inc. v. Comm’r [AFTR2d Par. 2000-5103 (9th Cir.)] concerned whether a paving contractor could use the cash method. The taxpayer, a corporation, purchased asphalt at cost from the manufacturer, a sister corporation. The asphalt was shipped by the sister corporation hours prior to the paving job. Due to the inherent qualities of emulsifying asphalt, failure to use it within a few hours would result in it hardening and becoming worthless.

The IRS argued that the asphalt was merchandise and therefore required the use of the accrual method and the recognition of income when the job was completed rather than when payment was received. The Tax Court ruled that the IRS had abused its discretion in requiring use of the accrual method.

The case was appealed to the Ninth Circuit Court of Appeals. According to the Ninth Circuit, the IRS has the discretion to require that a particular method, unless clearly unlawful, be used and such discretion cannot be set aside unless plainly arbitrary. The Ninth Circuit further stated that what constitutes inventory is a question of law subject to review de novo. The court proceeded to find the asphalt to not be inventory. In its ruling, the court looked at the language and the rationale of IRC section 471. According to Treasury Regulations section 1.471-1, a taxpayer must use the accrual method of accounting when “the production, purchase, or sale of merchandise is an income-producing factor.” The rationale is that the taxpayer might otherwise use the cash method to deduct the cost of the purchases in a period prior to that in which the related income is recognized.

This concern was not present in Turin. Based on the facts, it was determined that a paving company, which lays asphalt immediately upon purchase, cannot delay income or accelerate deductions through the cash method, because it is impossible to inventory remaining emulsifying asphalt into a future period. The opinion is consistent with that reached in Galedridge (73 TCM 2838), wherein the Tax Court found that, because of its peculiar properties, emulsifying asphalt could not be held in inventory. In reaching its decision, the court noted that the cash method clearly reflected income under the circumstances. In doing so, the Ninth Circuit also rejected the IRS’s arguments that the appearance of accounts receivable on the taxpayer’s books should be the grounds for applying the accrual method and that precedent existed for inventorying the asphalt, by analogy to newspapers, which it argued were similarly perishable. The court noted that certain perishable items used in the newspaper business were nonetheless subject to inventory, such as ink and paper [see Knight-Ridder Newspapers, Inc. v. United States, 743 F.2d 781 (11th Cir. 1984) and Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d 352 (1st Cir. 1970), aff’g 28 TCM 450 (1969)].

RACMP

In RACMP Enterprises, Inc. v. Comm’r [114 TC 211 (2000)], the Tax Court held that a construction contractor could use the cash method. The contractor provided services entailing the finishing of concrete driveways, foundations, and walkways for real estate developers. The court found in favor of the taxpayer’s ability to use the cash method based upon the taxpayer’s generation of revenue through providing services wherein the materials used constituted an indispensable and inseparable part of the rendering of such services. Under the terms of the contracts between the taxpayer and the contractors, the materials provided by the contractors, when combined with the provided labor and other tangible property, lost their separate identity and became part of the building or real property—not merchandise for the purposes of IRC section 471. This fact was a significant factor in the decision.

The court in RACMP noted that the IRC and Treasury Regulations each lacked a precise definition of “merchandise.” Canvassing authority on the term, the court noted that merchandise is “property held for sale, and not simply property that is sold.” Looking at the legislative history, the court noted that the IRC section was targeted at manufacturers and merchandisers. As in Osteopathic Medical, the court ruled that where the materials used are indispensable in the rendering of services, such materials should not be considered merchandise under IRC section 471. According to the court, although the costs of the materials and supplies may be substantial, the true value of hiring a contractor lies in labor and contractual skill.

With respect to classification of fill sand, drain rock, and hardware items (e.g., emulsifying concrete), the court cited Honeywell, Inc. v. Comm’r (T.C. Memo 1992-453), which indicated that the purpose for which property is acquired and held determines whether it is considered merchandise. For example, an item purchased not for resale but for utilization in the rendering of services that is inseparable, indispensable, and integral to the service will not be considered merchandise.

Read in its totality, RACMP provides the following:

• The construction material, when it was combined with other tangible property, lost its separate identity and became an integral part of the realty.
• Because the taxpayer did not contract to sell materials, and the clients had no interest in acquiring materials from the taxpayer, the taxpayer could not be considered a merchant with regard to the acquisition of raw materials or supplies.
• The taxpayer had engaged in services constituting an improvement to real property. The court had previously held that such improvements did not constitute merchandise, and that therefore the materials used did not constitute merchandise held for sale.

The dissent in RACMP noted that the accrual method could be applicable to some aspects of the taxpayer’s business and not to others.

Other Decisions

In Mid-Del Therapeutic Center, Inc. v. Comm’r (T.C. Memo 2000-130), the court ruled in favor of a chemotherapy clinic using the cash method. The clinic provided outpatient chemotherapy to patients of a particular physician. Medicare decided that it would not pay for inpatient chemotherapy treatments on an outpatient basis. The court noted that the IRS had broad discretion to determine if a particular method of accounting clearly reflects income and is presumed correct unless clearly unlawful. In reviewing a challenge to the IRS’s determination, the court looked to whether there was an adequate basis in law for the Commissioner’s conclusion. The issue of whether a method of accounting is proper is a question of fact.

The IRS claimed that the drugs at issue constituted merchandise, whose sale and purchase were income-producing factors in the taxpayer’s business, and that the accrual method should be used. The court rejected the IRS’s argument. Citing Osteopathic Medical Oncology and Hematology, P.C. v. Comm’r, the court noted that where the provision of drugs and medical supplies is inseparable and subordinate to medical services, the drugs and supplies are not to be considered merchandise.

The following facts bore on the decision:

• The drugs are administered to patients during the course of treatment.
• The patient does not acquire title or exert control over the drugs.
• The patient does not direct how or when drugs are to be administered and cannot simply purchase the drugs for self-treatment.
• At the end of treatment, the patient has nothing which to acquire, sell, or otherwise exert ownership over.

Three recent cases provide further insight into the boundary distinguishing merchandise from materials and supplies which are incidental to a service: Pitman v. Comm’r (T.C. Memo 1999-389), Von Euw v. Comm’r (T.C.Memo 2000-114), and Smith and Smith v. Comm’r (T.C. Memo 2000-353). In two of these cases the court sided with the IRS; the third court ruled in favor of the taxpayer.

In Pitman v. Comm’r, the Tax Court held that a manufacturer of electrical coils possessed inventory and had to use the accrual method. The manufacture of the coils was based upon customer specifications and the materials were acquired locally. Approximately 90% of the jobs were completed within three days, and all jobs were completed within five days. Orders were shipped upon completion. The company used the cash method.

According to the court, the taxpayer has a heavy burden to overcome when challenging the IRS’s discretion. The court cited as precedent the case of Epic Metals Corp. & Subs. v. Commissioner [T.C. Memo 1984-322, aff’d without pub. opn. 770 F.2d 1065 (3d Cir. 1985)], in which the company ordered materials for each job and sold custom-fabricated metal decking. According to the court, the possession of inventory—even if but momentarily—justifies use of the accrual method. In addition, the court indicated that where the cost of material is substantial in comparison with the taxpayer’s receipts, the material would be viewed as an income-producing factor.

In Von Euw v. Commissioner (T.C. Memo 2000-11), the Tax Court also ruled in favor of the IRS. The taxpayer was in the business of acquiring and transporting sand and gravel to developers and contractors, which then used it to construct streets, houses, and buildings. Certain customers owned and acquired their own sand and gravel, which was merely transported to the work site by the taxpayer. The court cited Treasury Regulations section 1.446-1(c)(2)(i), which requires the accrual method to be used with respect to the purchase and sale of inventory. IRC section 471 and Treasury Regulations section 1.471-1 were cited as providing that a taxpayer possesses inventory when the “production, purchase, or sale of merchandise is an income producing factor in the taxpayer’s business and the taxpayer has acquired title to the merchandise.” The court rejected the taxpayer’s assertions that the sand and gravel was not held for sale and was not retained at the beginning nor end of the day.

In the November 2000 decision in Smith and Smith v. Comm’r (T.C. Memo 2000-353), the Tax Court ruled in favor of the taxpayer’s use of the cash method. Smith involved a business that installed flooring, and was purportedly known for its skill and craftsmanship in hand-cutting and incorporating custom designs into flooring. The taxpayer had a showroom in which it displayed samples of flooring materials and a warehouse in which it stored flooring that was not for sale to the public. The company used the cash method, but did retain an inventory account (of $15,000) for flooring installation material left on hand at the end of a job (e.g., glue, nails, cap metal, and cove stick). The taxpayer did not include the flooring itself or padding in inventory, because they were bought as specified for particular jobs.

According to the court, the defining issue was whether the taxpayer “is in the business of selling merchandise to customers in addition to providing flooring services or whether the flooring materials provided by Smith Floors is a supply that is incidental to Smith Floors installation services.” The context in which the item is used was crucial to determining whether it is merchandise. Citing RACMP and Osteopathic Medical Oncology and Hematology, P.C., the court deemed that the mere fact that the cost of materials was high in comparison to the labor was inadequate grounds to consider a contract for services to be a sale of merchandise. As in RACMP, the court found that the flooring materials were not merchandise. The Court focused on the following facts:

• Smith is inherently a service provider.
• Smith’s business is essentially the installation of flooring.
• Smith’s customers normally negotiate the price of materials directly with the manufacturer.
• Smith is neither a manufacturer nor a retailer of flooring materials.
• Smith takes delivery of flooring materials to inspect for quality and quantity, and charges customers a mark-up for inspection and delivery.
• Smith’s buying flooring materials for a particular job is incidental and secondary to its provision of flooring installation services.

The court held that the taxpayer could use the cash method and that the IRS’s position constituted an abuse of discretion.