Question

The Commissioner of Internal Revenue ("Commissioner") appeals the Tax Court's decision that he abused his discretion in requiring Jim Turin & Sons, Inc. ("taxpayer"), to use the accrual method of accounting to compute its federal taxes for the tax years at issue. In particular, the Commissioner contests the Tax Court's finding that emulsified asphalt is not "merchandise," as that term is used in 26 C.F.R.S 1.471-1. The Tax Court had jurisdiction pursuant to 26 U.S.C.SS 6213, 6214, and 7442. We have jurisdiction pursuant to 26 U.S.C. S 7482, and we affirm.

Taxpayer is a corporation that provides paving services. Taxpayer purchases its asphalt from a sister manufacturing corporation. When bidding on a contract, taxpayer prices the asphalt at its cost. The sister company ships the asphalt just hours before a paving job. Because of the physical properties of emulsified asphalt, taxpayer must use it within several hours of shipment, otherwise it hardens and becomes useless. Once a job is completed, taxpayer is generally paid within 10 to 30 days of billing.

For the tax years at issue, taxpayer used a cash method of accounting for federal tax purposes, taking deductions for the cost of the asphalt for a job immediately upon its payment to the sister corporation and recognizing income for a job when it received payment. The Commissioner determined that asphalt was "merchandise," under Treas. Reg.S 1.471-1, such that taxpayer had inventories and thus was required to use the accrual method of accounting. The accrual method would require the taxpayer to recognize income upon the completion of a job, as opposed to when it received payment for a job.

The Tax Court concluded that the Commissioner abused his discretion in so requiring. See Jim Turin & Sons, Inc. v. Commissioner, 75 T.C.M. (CCH) 2534, 1998 WL 331431 (1998). It first found that asphalt was not merchandise, relying upon Galedrige Constr., Inc. v. Commissioner, 73 T.C.M. (CCH) 2838, 1997 WL 269574 (1997). Id. at 2535. The Tax Court also found that because the taxpayer had no inventories, S 1.471-1 did not apply. Id. Finally, it found that the cash method of accounting clearly reflected taxpayer's income, so that even if S 1.471-1 applied, taxpayer was not required to change its accounting method. Id. at 2535-36. The Commissioner timely appealed.

The Supreme Court has held that the Commissioner's decision to require the use of a particular method of inventory accounting is a discretionary one and that "his interpretation of the statute's . . . standard `should not be interfered with unless clearly unlawful.' " Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 532 (1979) (quoting Lucas v. American Code Co., 280 U.S. 445, 449 (1930)). " [T]he Commissioner's disallowance of an inventory accounting method is not to be set aside unless shown to be `plainly arbitrary.' " Id. at 532-33 (quoting Lucas v. Structural Steel Co., 281 U.S. 264, 271 (1930)). Thus, we independently review for abuse of discretion,2 and our task is to determine whether the Commissioner's decision to require taxpayer to use the accrual method of accounting is clearly unlawful or plainly arbitrary. See Homes by Ayres v. Commissioner, 795 F.2d 832, 834 (9th Cir. 1986)3 .

Under Treas. Reg. S 1.471-1, a taxpayer must use inventories and the accrual method of accounting4 when the "production, purchase or sale of merchandise is an incomeproducing factor" in order to "reflect taxable income correctly." The rationale behind S 1.471-1,5 and the underlying statute, I.R.C. S 471,6 is straightforward. If a taxpayer held sizable inventories for resale, under a cash method, the taxpayer could defer income by purchasing all of its goods at the end of one year and taking deductions for the purchase at that time, then selling the goods in subsequent years without recognizing income until its receipts of proceeds from the sales. For example, in Knight-Ridder Newspapers, Inc. v. United States, 743 F.2d 781 (11th Cir. 1984), the court stated that:

According to accounting wisdom, the income realized from the sale of merchandise is most clearly measured by matching the cost of that merchandise with the revenue derived from its sale. In order to achieve such a matching of revenue and cost, it is necessary to keep an inventory account reflecting the costs of merchandise, raw materials, and manufac turing expenses. These costs are not deducted imme diately when paid but are deferred until the year when the resulting merchandise is sold.

To make the matching complete, the taxpayer must report income on the accrual method. That method helps to ensure that income from the sale (like the inventory costs) is reflected in the year of the sale. For example, if the sale is made on credit, the accrual method nevertheless treats the income as accrued and reflects it when the sale occurs. . . .

By contrast, the primal cash method is unable to achieve such a mystical joinder of inventory deduc tions and credit sale income. To be sure, the cash method could theoretically operate in tandem with inventories. The beast could conceivably close its eyes to deductions until the year of the sale. It could never learn, however, to prophesy future cash pay ments. If there were a credit sale, the beast could not grasp income and deductions simultaneously in its rugged paw. The goal of matching costs and reve nues would fail.

Id. at 789 (footnotes and internal citations omitted); see also Herberger v. Commissioner, 195 F.2d 293, 295 (9th Cir. 1952) (finding that taxpayer who purchased and stored cucumbers for pickling was requiredto use accrual method to reflect accurately purchases and sales).

A paving company that lays asphalt immediately upon purchase cannot delay income or accelerate deductions by inventorying its asphalt, because there is no inventory that can be purchased late in one tax year and held over to the next. Thus, given the rationale of S 1.471-1, we agree with the Tax Court that asphalt is not merchandise, and that taxpayer should not have been required to use the accrual method because S 1.471-1 does not apply.

The Commissioner's argument that taxpayer failed to adopt an accounting method that clearly reflected income is wholly unrelated to the inventory issues of S 1.471-1. Rather, the disparity in taxable income calculated by the Commissioner relating to the paving jobs stems from the mismatch of deductions and income due to the fact that taxpayer had outstanding accounts receivable at the end of each tax year that were not immediately recognized under the cash method of accounting. These accounts receivable did not stem from taxpayer's misuse of inventories, but were merely run-of-the-mill debts for collection. The failure of a taxpayer to include accounts receivable in taxable income is not a sufficient basis for the Commissioner to require the use of the accrual method. See Ansley-Sheppard-Burgess Co. v. Commissioner, 104 T.C. 367, 371-75 (1995). We thus agree with the Tax Court that the Commissioner abused his discretion in requiring taxpayer to adopt the accrual method.

The Tax Court properly relied upon its earlier decision in Galedrige, where it held that "the peculiar physical properties of emulsified asphalt make it impossible" for the taxpayer to hold it in inventory. 73 T.C.M. (CCH) at 2842. On this basis, the Tax Court held that the paving company was not required to use an accrual method with respect to the asphalt. See id. at 2843-46. Recently, in RACMP Enters., Inc. v. Commissioner, No. 23954-97, 2000 WL 330333 (T.C. Mar. 30, 2000) (en banc), the Tax Court reaffirmed Galedrige in deciding that a contractor who poured cement was not subject to the requirements of S 1.471-1, because mixed cement, like asphalt, changes its physical state rapidly so as quickly to become useless. See id., 2000 WL 330333.

Galedrige and RACMP Enterprises represent the sound principle that S 1.471-1 does not apply where the item in question cannot be warehoused in inventory, especially where traditional service providers are involved. See RACMP Enters., 2000 WL 330333 ("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."); cf. Osteopathic Med. Oncology and Hematology, P.C. v. Commissioner, 113 T.C. 376, 384-92 (1999) (holding that drugs and pharmaceuticals used during the treatment of patients were not merchandise under S 1.471-1 because their use was part of an overall service); Homes By Ayres, 795 F.2d at 836 n.5 ("common usage of the term merchandise excludes . . . improvements to real estate").

The Commissioner's attempt to force asphalt into the cubby-hole of "merchandise" disregards the purpose of S 1.471-1. The Commissioner argues that the transfer of title from the manufacturer of asphalt to the taxpayer is determinative, as opposed to whether the asphalt has the "physical properties necessary for it to be held for sales `at the end of the day.' " The Commissioner further contends that possessing title for an instant is sufficient to require a taxpayer to inventory its goods, so long as the goods are acquired and held for sale. The Commissioner cites a number of Tax Court cases in support of his contentions; however, all of them are distinguishable.

In Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d 352 (1st Cir. 1970), the taxpayer sold caskets as part of a package of providing funeral services. See id. at354. The application of S 1.471-1 in that case, however, is distinguishable because caskets, unlike asphalt, may clearly be stored in inventory. See also Addison Distrib., Inc. v. Commissioner, 76 T.C.M. (CCH) 251, 254, 1998 WL 453667 (1998) (holding that company which repackaged and shipped silicon wafers and circuit boards, which can be warehoused and which the parties stipulated were merchandise, was subject to S 1.471-1); Surtronics, Inc. v. Commissioner, 50 T.C.M. (CCH) 99, 104, 1985 WL 14904 (1985) (finding that the use of metals, which can be stored in inventory, necessitated the use of S 1.471-1 with respect to the taxpayer's electroplating business).

The Commissioner cites Knight-Ridder, 743 F.2d at 790, to emphasize that even a perishable commodity, such as newspapers, are subject to S 1.471-1. The Commissioner fails to note, however, that the Knight-Ridder court substantially relied upon the disparity in deductions and income created from the advance purchase and subsequent storage of paper and ink used to produce the daily newspaper. See 743 F.2d at 789-91. While the finished product -a daily newspaper -may be perishable, because the underlying ingredients -paper and ink -can be stored in a manner to advance deductions and delay income, the application of S 1.471-1 was proper, and distinguishes Knight-Ridder from this case. See also Asphalt Prods. Co., Inc. v. Commissioner, 796 F.2d 843 (6th Cir. 1986) (holding that manufacturer of asphalt was required to use inventory and accrual method because it stored the raw materials used to make asphalt), rev'd in part on other grounds, 482 U.S. 117 (1987); Tebarco Mechanical Corp. v. Commissioner, 74 T.C.M. (CCH) 29, 33, 1997 WL 366817 (1997) (finding that mechanical subcontractor who maintained a warehouse with construction materials was subject to the requirements of S 1.471-1); Thompson Elec., Inc. v. Commissioner, 69 T.C.M. (CCH) 3045, 3049, 1995 WL 382120 (1995) (holding that electrical contractor who stored materials to be installed was required to use inventory and accrual method under S 1.471-1).

In Middlebrooks v. Commissioner, 34 T.C.M. (CCH) 1187, 1191, 1975 WL 2893 (1975), also cited by the Commissioner, the taxpayer published a magazine and was required to use the inventory method, because the taxpayer took title to the magazines, notwithstanding the fact that the taxpayer usually did not physically possess the magazines. Middlebrooks is similar to Wilkinson-Beane because magazines (although somewhat perishable) may be held in inventory for a sizable time period, thus allowing a taxpayer who deals in magazines to accelerate deductions and delay income. See Middlebrooks, 34 T.C.M. at 1191. Because the ability to take deductions turns on title, as opposed to physical possession, Middlebrooks properly held that possession is not a prerequisite to the application of S 1.471-1. See id. As with Wilkinson-Beane, however, Middlebrooks is not persuasive authority on these facts, because here, the nature of asphalt does not allow it to be warehoused.

It also is not determinative here that the Tax Court has held that taxpayers who sell merchandise, but who either retain only "momentary title" or keep no inventory, are subject to S 1.471-1. Epic Metals Corp. v. Commissioner, 48 T.C.M. (CCH) 357, 361, 1984 WL 14974 (1984), aff'd, 770 F.2d 1069 (3rd Cir. 1985). Section 1.471-1 applies to any merchandise that could be stored as inventory. See, e.g., Von Euw & L.J. Nunes Trucking, Inc. v. Commissioner, T.C.M. (RIA) 2000-14, 2000 WL 337562 (2000) (holding that transporter of sand and gravel was required to use accrual method, even though taxpayer kept no sand or gravel on hand); Epic Metals, 48 T.C.M. (CCH) at 361 (holding that taxpayer was required to use inventory and accrual method where commodity at issue was metal decking which could be warehoused, even though title passed to the taxpayer for only an instant);J.P. Sheahan Assocs., Inc. v. Commissioner, 63 T.C.M. (CCH) 2842, 1992 WL 80927 (1992) (finding that the taxpayer was required to take inventories and use the accrual method for otherwise storable construction materials, even though it had no year-end inventory).

None of the cases on which the Commissioner relies is on point because all involved goods that were or could be stored in inventory.7 They have no application to the case at bench because, to repeat, taxpayer is physically unable to manipulate the matching or non-matching of deductions and income. Because we hold that asphalt is not merchandise, cases holding that momentary title to merchandise is sufficient are inapposite.

Because asphalt cannot be stored, it is not susceptible to being inventoried. We thus agree with the Tax Court that asphalt is not "merchandise" within the scope of Treas. Reg. S 1.471-1.8 The Commissioner therefore abused his discretion in requiring taxpayer to use the accrual method of accounting.

Required

Analyze the cash method and the accrual method described in the case above. How did Jim Turin & Sons, Inc. assert its position? What were the key points in the decision that determined revenue recognition?

Answer 1

A) Analyzing Cash Method - Generally, cash basis businesses recognize income when it's received and deduct expenses when they are paid. Income is reported when a customer pays the entire amount for sale of goods or for services rendered. However, income received near the end of the tax year requires the use of constructive receipt doctrine. Constructive receipt is determined when the taxpayer has control over the income. An ideal example of constructive receipt would be of the day when funds are credited to a bank account. Expenses are reported when the funds are released on the end of the debtor. One major disadvantage of using cash method is that a successful flow of income could actually be from events that occurred sometime previously (Cash vs Accrual Accounting for Small Businessess 2016). Mr Turin, the case's plaintiff utilizes the cash method of accounting for tax purposes. Operations are set up so the plaintiff's company recognizes revenues when customer payments are received and expenses are recognized once debt to crediors is paid in full. Most revenues are considered recognized within a month of when the paying services are rendered. Expenses are deducted when a paying job is complete as well as payment is received for purchase of materials. The cash method allows Mr. Turin to monitor the cashflows of his company through knowing what customers are paying and what bills are being paid. In similarity to other construction based companies, there is a flexibility present with using the cash method that allows the business owner to see how much taxable income will there be at the year end. Revenue transactions that occur near year end are required by constructive receipt to be recorded when the funds are in possession of Turin's company. Therefore, payments received by customers in possession must be included in tax year received.

B) Analyzing Accrual Method - The accrual method of accounting for tax purposes allows taxpayer to recognize revenue and expenses as and when they are supposed to be paid. Sales of goods or services rendered are reported on the day they occur opposed to when the receivables are paid by customers. Expenses are treated similarly as they are recorded on the date incurred opposed to when they are credited from cash account. The accrual method is beneficial to taxpayers because it gives a clear projection of the cash inflow and outflow. This helps in accessing whether company will have net profit or loss. The commissioner in this case believes that Turin needs to use the accrual method of accounting for tax purposes. According to S1.471-1, inventory valuation is required to properly calculate taxable income. It is to be believed that the asphalt purchased should be counted as sellable merchandise. The inventory includes finished goods, work in progress goods as well as a portion of raw materials and supplies. Therefore any business that is possession of merchandise needs to use the matching principle to recognize income and expenses. When a piece of merchandise is sold, two transactions are recorded; one to record the revenue and one to record the expense. The revenue transaction includes a debit to accounts receivable and credit to Sales. To counter the revenue, the expense transaction is a debit to Cost of Goods sold and a credit to Merchandise inventory. If Mr. Turin's purchase of Asphalt are considered pieces of merchandise then the recording of revenue and expense is going to occur on the day the merchandise is sold.

C) How did Jim Turin & Sons Inc assert its position - Turin declared that purchases of asphalt are received around the time of job performance. It is very likely that estimates are created prior to ordering materials to ensure that accurate amounts are purchased and used. Once the asphalt has been used for a job the paving company no longer owns the material. The Commissioner used S1471--1 to define asphalt as inventory and it was cosidered as raw material to be used in an income producing venture. None of the materials are stored in warehouse but the cost of asphalt should still be accounted for. The appellate tax court disagreed with the Commissioner with the reasoning behind using accrual method. The ordered asphalt is only momentarily owned by Turin's company before being used and should not be considered as merchandise. Emulsified asphalt is a combination of three ingredients - water, asphalt cement and an emusified agent that turns into a liquid when released. Once a bag of asphalt has been opened, the mixture within the bag starts to liquefy.The emulsified agent cannot return to solid form so none of the asphalt can be used for another job. Therefore all of the raw material gets used during the job and Turin is not responsible for claiming inventory.

Exceptions can be made for business taxpayers with inventory to still use the cash method. If Turin's company makes less than a million dollars in gross receipts over the course of a year, he is not required to account for the inventory or use the accural method. Section 446 states that the business taxpayer must account for taxable income using the same accounting method used for daily business operations. Since Turin uses the cash method for recognizing revenue and expenses he might be able to apply for the exception if the gross receipts for the year is under $1,000,000. Another exception is if Turin makes between one million to ten millions for a period of three years, he is exempt from using accural method. There is a different set of guidelines that need to be followed but the inventory owned by the company can be deducted as non-incidental materials. In the case of extra asphalt from a project, Turin can still use the cash method for figuring out his taxable income if there is inventory present. However the exceptions are not necessary for this case since Turin is permitted by the appellate tax court to continue using cash method. The issue that led the Commissioner to question the accounting method used by Turin results from a valuation discrepancy of revenues and expenses. He believed that Turin needed to utilize the accrual method as parts of inventory are not represented in the calculation to make the matching principle valid. The appellate tax court rendered the Commissioner’s argument of wrongdoing inadequate as the discrepancy had nothing to do with classifying inventory. The asphalt used in everyday business operations are only used for the job and is not owned by Turin for very long. The discrepancy in figures presented to the court actually comes from outstanding customer debts not included in year-end figures. Revenues received using the cash method can only be recognized when the money is received, so Turin could not recognize any revenues for receivables not paid for. Once the old receivables are receivable, Turin can recognize the revenues and include the figures in taxable income. The final decision on this case agreed with the plaintiff that the discrepancy in receivables are not grounds to require a change in accounting method.

D) Revenue Recognition Key Points -

Revenue recognition requires four criteria to be met before the aforementioned revenue can be recognized on the books. Firstly, revenue is recognized when there is evidence present that a revenue-creating event has occurred. Once the transaction has happened, the second criteria is that revenue has to be earned. The delivery of goods or services rendered constitute for revenues being earned. Once the revenue has been earned, it needs to have a value that can be easily determinable at the time of sale. Finally, the fourth criterion is that revenues earned and determined are expected to be paid for within a reasonable period of time from time of billing. Revenue recognition is mostly used in the accrual method of accounting, but does play a role in cash-based accounting as well.

Revenue Recognition-Cash Based Accounting
Revenue is recognized for cash-based accounting taxpayers when payments from customers are received. In some cases, cash-based accounting taxpayers do not list accounts receivable or inventory on their balance sheets. The plaintiff in the case study, Mr. Turin, uses the cash-based accounting method for reporting revenues. His company, for the most part, receives payments for paving services rendered within thirty days of completing work. For example, Turin does $1,000 of work for a client on March 17th. Turin later receives the $1,000 payment from the client on April 12th. Turin records the receipt of revenue on April 12th since that is when the cash reached his possession. The transaction is recorded as: Cash is debited for $1,000 and Service Revenue is credited for $1,000. Expense recognition is done in a similar method as expenses are not recorded until the payment is sent to the creditor and monies withdrawn from the account.

Revenue Recognition- Non-Matching Principle-Cash-Based Accounting
There are occasions when services are rendered that are not recognized as revenue. One of the more common occasions is when customers are behind in making payments for services. Outstanding customer accounts could be resulted from forgotten payments or falling behind. The discrepancy created from the deductions of expenses from recognized revenues is why the Commissioner questioned Turin’s accounting method of choice. It is possible that Turin will receive the outstanding payments owed within the next tax year. Even after the payment are received, there might still be a discrepancy until the outstanding customer accounts are cleared

Revenue Recognition-Inventory- Accrual-Based Accounting
Turin’s company is not required to report inventory since the asphalt is only in the company’s possession for a few moments. Due to that consideration, the company does not need to record any secondary transaction when services are rendered since nothing is being sold. When the revenue is recognized for payments made for services rendered, cost of goods sold and merchandise inventory are not involved. This makes tracking expenses easier as Turin is only responsible for what he pays for the asphalt as well as other expenses related to the business. Businesses with inventory need to include a section to the balance sheet regarding purchases and cost of goods sold for merchandise.

Revenue Recognition-Matching Principle-Accrual Based Accounting
The matching principle is quite often used in accrual-based accounting to help recognize revenue. Revenue taken in over the sale of merchandise needs to be matched up to expenses that incur during the sale. The date of the transaction is the day the event happened, not when the payment is received. Also, a big difference between accrual and cash methods is that accrual method taxpayers accept sales on account which is classified as credit sales. If Mr. Turin had inventory that he sold to a customer, there is two transactions to report the revenue and expense. For example, Turin sold a few bags of asphalt for $1200 on account on July 8th. The revenue received is recorded on July 8th since that it is the day the revenue incurred. The transaction is recorded as Accounts Receivable is debited for $1,200 and Sales Revenue is credited for $1,200. The second transaction is recorded as Cost of Goods Sold is debited for $1,200 and Merchandise Inventory is credited for $1,200.