CBTM March text 2002 #2 2/13/02 11:28 AM Page 27 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 T his month’s column presents the second half of dise a “material income-producing factor.” The IRS evi- a two-part discussion of Notice 2001-76, 1 dently contemplated publishing some sort of safe harbor, 6 which permits some smaller businesses to use but never did. Some inferential guidance appeared in the cash basis of accounting despite selling “mer- 1993 with the issue of the final uniform capitalization (“UNICAP”) regulations. 7 These regulations included an chandise.” exemption for “property provided incident to services” so JUDICIAL DEVELOPMENTS long as the property was both “ de minimis in amount” and As discussed in last month’s column, the Regulations “not inventory in the hands of the service provider.” 8 The require a taxpayer to keep inventories and accrue pur- regulations provide that if the “acquisition or direct mate- chases and sales if sales of “merchandise” are a “mate- rial cost of the property” does not exceed 5 percent of the rial income-producing factor” in its business. Wilkinson- taxpayer’s total charges, then the property will be Beane 2 and its immediate successors established that deemed “ de minimis in amount.” goods could be “merchandise” even if they were only Strictly speaking, the UNICAP regulations do not sold as part of a package with accompanying services. address the “material income-producing factor” inquiry. Thereafter, there slowly evolved a variety of approaches Indeed, they at least contemplate the possibility that to determining when the sale of merchandise was an property might be “ de minimis ” but nonetheless still be “material income-producing factor” in cases where “inventory in the hands of the service provider.” goods and services were provided together. However, in a 1997 technical advice memorandum, the Comparing Costs to Receipts National Office concluded that merchandise sales were not a “material income-producing factor” in the busi- The earliest and most straightforward approach was ness of a medical clinic despite purchases totalling based on a numerical comparison. In holding mer- roughly 8 percent of revenues (although this figure chandise to be a material income-producing factor, the included non-”merchandise” materials and supplies). 9 court in Wilkinson-Beane had noted that the cost of cas- In another ruling issued later the same year, the IRS kets was approximately 15 percent of the taxpayer’s allowed a landscaper to use the cash method despite gross revenues. In Surtronics, Inc. v. Commissioner , 3 the materials purchases of roughly 3 percent, 3 percent, Tax Court rejected the taxpayer’s argument that it and 6 percent of sales in the three years at issue. 10 should not have to accrue sales because material costs Taking the regulations together with the rulings, practi- accounted for only 5 percent of its billings.More recent- tioners and commentators began to regard the 5 per- ly, the Tax Court described “comparison of the cost of cent neighborhood as relatively safe. 11 the merchandise to the taxpayer’s gross receipts com- puted under the cash method of accounting” as the “Ephemeral” Goods: Galedrige “recognized standard” to be applied in determining Construction and Turin whether sales of merchandise were a material income- Comparing the cost of goods with revenues, howev- producing factor in the taxpayer’s business. 5 er, is only useful if the goods are merchandise in the first For a time, there was little guidance as to what ratio of place. The IRS, following long-standing regulations pre- costs to receipts might suffice to make sales of merchan- scribing what goods are included in inventory 12 took the position that all property that was transferred (or physi- cally incorporated into something that was transferred) Jim Salles is a member of Caplin & Drysdale in Washington, D.C. M A R C H 2 0 0 2 27
CBTM March text 2002 #2 2/13/02 11:28 AM Page 28 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 in the transaction was merchandise. Thus a dentist’s appears most clearly in two reviewed decisions, anesthetics, crowns, bridges, and dentures, or a med- Osteopathic Medical Oncology and Hematology, P .C. v. Commissioner , 21 and RACMP Enterprises, Inc. v. ical clinic’s medicine, serum and bandages were “mer- chandise,” whereas such items as syringes, gloves, Commissioner. 22 and disposable towels fell under the heading of “mate- The question in Osteopathic was whether a cancer clin- rials and supplies.” 13 ic’s chemotherapy drugs were merchandise or supplies. The courts, however, began to challenge the The stage had been set in an earlier case, Hospital Corp. of America v. Commissioner , 23 which considered whether assumption that any property whose ownership might pass to a customer was necessarily “merchandise.” In a hospital was selling services or providing goods when Galedrige Construction, Inc.. v. Commissioner , 14 and it furnished drugs and other items to its patients. The Jim Turin & Sons v. Commissioner , 15 the Tax Court held accrual requirement was not at issue in Hospital Corp . that paving contractors were not required to inventory Through 1986, HCA had used a hybrid method under their stocks of emulsified asphalt because it was not which it accrued purchases and sales, which the IRS had their “merchandise.” Unlike in Asphalt Products , the tax- unsuccessfully tried to change to full-fledged accrual accounting. 24 Thereafter, Code Section 448 unquestion- payers themselves laid the asphalt, and “sold” it only as part of a finished road surface. ably required HCA to adopt an accrual method for all Both the Tax Court and the Ninth Circuit emphasized items of income and deduction. The issue concerned the that the useful life of emulsified asphalt was measured in application of Code Section 448(d)(5). That provision hours — if not laid promptly when it was heated, it hard- allows some taxpayers to avoid accruing accounts ened and had to be discarded. 16 To the Ninth Circuit in receivable “which (on the basis of experience) will not be Turin , the asphalt’s “ephemeral” status was the critical collected,” essentially providing a more tightly-con- strained version of the old reserve for bad debts. 25 This factor, because it meant that “there is no inventory that can be purchased late in one tax year and held over to “nonaccrual experience method,” however, is confined to the next.” 17 Thus, whether or not the asphalt might be in receivables from the sale of services , raising the question some sense “merchandise,” it was not as a practical mat- whether the hospital was selling goods, services, or both . ter an inventoriable good. This reasoning enabled the Many of hospital consumables are clearly supplies. court to distinguish both the “drop shipment” authorities The controversy before the court was how to classify following Epic Metals and the earlier contractor cases items that found their way into, or on to, the patient in the such as J.P . Sheahan Co. on the grounds that they all course of medical treatment, such as casts, splints, involved goods which “were or could be stored in inven- sutures, skin staples, implants, and pacemakers as well tory.” 18 For example, the taxpayer in Epic Metals could as intravenous drugs. 26 The IRS contended that have stored the metal decking in a warehouse while it charges for such items represented proceeds from the awaited sale. sale of goods and were ineligible for the nonaccrual Beyond such materials as asphalt and liquid concrete, 19 experience method under Code Section 448(d)(5). the Ninth Circuit’s analysis could call into question the IRS However, the court concluded that the medical supplies position that electricity is “merchandise,” 20 not to mention were “inseparably connected” to the services that HCA raising interesting (but unlikely to be litigated) questions provided and therefore any income attributable to the about, for example, whether fast food chains are selling supplies was still “income earned from the performance goods or a service. (Few fast food chains have much in of services” that qualified for the nonaccrual experience the way of receivables to worry about.) However, the method. “ephemerality exception” has little application beyond The court in Hospital Corp. did not have to decide such specialized situations because most materials are whether the drugs were inventoriable “merchandise,” 27 not incapable of being stored in usable form. but its reasoning strongly suggested that they were not. Osteopathic Medical When the Tax Court faced the issue in Osteopathic Medical , it held the drugs were supplies, not merchan- While the Ninth Circuit appeared to concentrate exclusively on the asphalt’s “ephemeral” nature, the Tax dise, because they were “an integral, indispensable, Court was pursuing a broader distinction. Its reasoning and inseparable part of the rendering of medical serv- 28 28 M A R C H 2 0 0 2
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