C O R P O R A T E B U S I N E S S T A X A T I O N M O N T H L Y Tax Accounting BY JAMES E. SALLES he regulations require taxpayers that sell mer- goods in conjunction with the provision of services. In T the seminal case of Wilkinson-Beane , the court required chandise to accrue their purchases and sales. Thirty years ago, the court in Wilkinson-Beane, an undertaker to inventory its caskets, even though the Inc. v. Commissioner , 420 F .2d 352 (1st Cir. 1970), caskets could not be purchased separately. The court required a funeral home to accrue all its purchases and noted that the cost of the caskets was 15 percent of the sales because, although its main business was provid- taxpayer’s gross receipts, and held that they were an “income-producing factor” within the meaning of the ing funeral services, the caskets it sometimes provided regulations. The court then held that the taxpayer had as part of the package were merchandise. The years since have produced periodic litigation but little real to adopt accrual accounting unless it could demon- guidance from either the courts or the IRS on the limits, strate “substantial identity of results” using its method. if any, on the application of the Wilkinson-Beane holding Wilkinson-Beane, 420 F .2d at 356. and the regulations. Later Court Cases Suddenly, the question of when a taxpayer that pro- In evaluating whether the taxpayer could demon- vides goods in connection with services is selling mer- strate a substantial identity of results using its method, chandise has been the subject of three T ax Court deci- the Wilkinson-Beane court naturally considered not only sions in four months. The issue has also hit the IRS’s fluctuations in inventory but also accounts receivable and Congress’s radar screen—although largely and payable. Later courts have followed the same because of unrelated developments—and is now the approach and have consistently been willing to enforce subject of both a regulatory project in the current IRS the regulations’ requirement to use the accrual method business plan and pending bills before the House and of accounting even though taxpayers’ actual inventory Senate. balances were insignificant. Thus, for example, in BACKGROUND Asphalt Products Co. v. Commissioner , 796 F .2d 843 (6th Cir. 1986), rev’d per curiam on another issue , 482 The Regulations and Wilkinson-Beane U.S. 1117 (1987), a taxpayer that sold emulsified asphalt for road making was required to accrue pur- The regulations provide that inventories must be kept chases and sales, even though its year-end inventories “[i]n all cases in which the production, purchase, or sale were nugatory because roads could not be asphalted of merchandise of any kind is an income-producing during the winter. The court likewise required the tax- factor.” T reas. Reg. §§ 1.446-1(a)(4)(i), 1.471-1(a)(1). payer in Epic Metals Corp. v. Commissioner , 48 T .C.M. Ordinarily, “[i]n any case in which it is necessary to use (CCH) 357 (1984), to accrue purchases and sales even an inventory the accrual method of accounting must be though its business was specialized metal decking, used with regard to purchases and sales.” T reas. Reg. which it ordered for its customers from custom fabrica- § 1.446-1(c)(2)(i). tors and to which it held title only momentarily. A perennially troublesome area has been in what cir- cumstances the requirement to keep inventories and IRS Considered De Minimis Rule the associated requirement for accrual accounting In Revenue Ruling 74-279, 1974-1 C.B. 110, the IRS apply to taxpayers that provide, or utilize, tangible ruled that an optometrist had to keep inventories and accrue purchases and sales because “although the taxpayer provides various services there is also a sub- James E. Salles is a member of Caplin & Drysdale, Chartered, in Washington, DC. stantial amount of merchandise sold.” General Counsel J U N E 2 0 0 0 1
C O R P O R A T E B U S I N E S S T A X A T I O N M O N T H L Y Memorandum 37699 (Sept. 29, 1978) considered the Osteopathic court’s holding that the drugs were not obvious follow-up question: What if the optometrist kept merchandise meant that the regulations’ requirement to no inventory but custom-ordered the lenses and frames use accrual accounting in conjunction with inventories did not apply either. 2 from the manufacturer? The memorandum concluded that the taxpayer was required to keep inventories, and RACMP Enterprises therefore to accrue purchases and sales, and approved In RACMP Enterprises, Inc. v. Commissioner , 114 T .C. a proposed revenue ruling amplifying Revenue Ruling No. 16 (2000), decided in March and also a reviewed 74-279. A later general counsel memorandum, howev- opinion, the taxpayer was a construction subcontractor er, noted that “the Service may allow the use of the cash that specialized in foundations and flatwork—concrete method despite the fact that taxpayer may furnish some driveways and walkways. In its activities it naturally tangible product in the course of rendering profession- used concrete, sand and rock, and assorted steel hard- al services,” and approved withholding the proposed ware. Again, the IRS contended that these materials revenue ruling “pending development of guidelines in were inventories and therefore the taxpayer had to this area.” The IRS National Office was apparently con- adopt accrual accounting. The T ax Court framed the templating either amending the regulations themselves issue as “whether petitioner is in the business of selling or issuing a revenue procedure; however, neither the merchandise to customers in addition to providing serv- ruling nor the guidance has ever appeared. ices or whether the material provided by petitioner is a supply that is incidental to the provision of the contract- RECENT TAX COURT CASES ed service.” REVIVE INTEREST The T ax Court held that the contractor was “inherent- Instead, after some delay, and evidently encouraged ly a service provider,” noting that in various nontax con- by a favorable judicial climate, 1 the IRS went on the liti- texts “the courts have invariably found construction gation warpath. The T ax Court has had occasion to contracts that provide for the furnishing of labor and consider the Wilkinson-Beane holding in no less than materials to constitute agreements for work, labor and three recent cases, handing two victories to taxpayers services rather than the sale of goods.” The court con- and the third to the IRS. cluded that the concrete, sand and rock, and hardware used were “indispensable and inseparable from the Osteopathic Medical service provided” and were consequently not merchan- In Osteopathic Medical Oncology and Hematology, dise. The taxpayer could continue to use the cash .C. v. Commissioner , 113 T .C. 376 (1999), a reviewed P method. opinion decided in November 1999, the T ax Court held Von Euw Trucking that a cancer clinic’s chemotherapy drugs were not merchandise within the meaning of the regulations. The Judge Vazquez, who joined in the majority opinion in clinic could not, and did not, sell the drugs as such to RACMP , reached the opposite result in a memorandum patients. The court held that the drugs were provided case decided the following day. Von Euw & L.J. Nunes as “an integral, indispensable, and inseparable part of T rucking, Inc. v. Commissioner , T .C. Memo. 2000-114, the rendering of medical services,” and were not mer- involved a trucking firm that supplied sand and gravel chandise, but supplies consumed in the process of pro- to building sites. Some customers already owned the viding services. sand and gravel they contracted with the taxpayer to Inventory accounting is confined to merchandise held transport, but others expected the taxpayer to acquire for sale to customers and raw materials that will “physi- the material as well as transport it to the site. cally become a part of” merchandise. T reas. Reg. The T ax Court held that the taxpayer was at least part- § 1.471-1(a)(1). Supplies, whether used in producing ly in the business of selling sand and gravel. The record goods or providing services, are not inventoried, showed that the taxpayer reaped a greater profit when it although taxpayers may be required to keep records of both acquired and transported the sand and gravel than supplies on hand and consumption if necessary to when it merely provided transportation services. On clearly reflect income. T reas. Reg. § 1.162-3. Thus, the these facts, the court held that the sand and gravel were 2 2 J U N E 2 0 0 0
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