Tax Court Reaches Different Conclusions on Use of Cash Method

In Von Euw & L.J. Nunes, TC Memo 2000-14, and RACMP Enterprises, 114 TC No. 16, the Tax Court considered whether taxpayers sold merchandise and thus were required to report income on the accrual method. These cases are significant in that they provide further clarification on what constitutes merchandise.

In Von Euw & L.J. Nunes, a cash-method taxpayer was in the business of hauling sand and gravel for various contractors and developers. For certain customers, the taxpayer purchased and delivered the materials, while other customers purchased the materials directly and the taxpayer delivered them. The IRS argued that the taxpayer was a seller of merchandise and had to account for inventories, thus requiring use of the accrual method. The taxpayer argued that it was primarily a service provider, purchasing materials for customers as an accommodation. In addition, it argued that it made the same profit whether it purchased and delivered the materials or merely delivered them to customers.

The court found that the taxpayer was a seller of merchandise and required to use the accrual method. In so doing, the court noted that the taxpayer's profit was higher when it purchased and delivered the materials rather than when it merely delivered them. Because the materials were not an indispensable and inseparable part of the delivery of materials, the taxpayer was a seller of merchandise. The court distinguished this case from RACMP, noting that the materials were indispensable to the services the taxpayer provided in that case, while, in Von Euw & L.J. Nunes, customers were purchasing materials from the taxpayer. Finally, the court concluded that the sand and gravel was an income-producing factor in the taxpayer's business, as it met the test in Wilkinson-Beane, TC Memo 1969-79.

In RACMP, a cash-method taxpayer was in the business of constructing sidewalks and driveways for developers. It would submit bids that included the costs of materials. The taxpayer used concrete, sand and drain rock to perform its services. It would purchase these materials and leave them at the construction site at the end of the day. When the site became congested, the taxpayer would bring the materials back to its place of business. The Service argued that the taxpayer was a seller of merchandise and therefore had to account for inventories, requiring use of the accrual method. The taxpayer argued that it was providing services and not merchandise and, thus, could use the cash method.

The court concluded that the taxpayer was not a seller of merchandise; the IRS, therefore, abused its discretion in requiring the taxpayer to change to the accrual method. The court looked at tax and nontax authority in reaching the conclusion that the contract as a whole was a service contract. Further, the court noted that the materials that the taxpayer used were an indispensable and inseparable part of providing services. Specifically, the court found that liquid concrete used by the taxpayer was analogous to the asphalt in Galedrige Constr., Inc., TC Memo 1997-240, in which the court found that materials with severely limited periods of utility are not held for sale and therefore are not merchandise. As to the fill sand and drain rock, the court found that these materials lose their separate identity when used in conjunction with services. The court also noted that clients contracted with the taxpayer for services, not the materials. Therefore, the taxpayer was not a seller of merchandise and could continue to use the cash method.

From Jane. I. Trachtenberg, J.D., LL.M., and Patricia C. Anderson, J.D., LL.M., CPA, Washington, DC