Paving Contractor Was Not Required to Use Accrual Method

The T Corporation provides paving services. When bidding on a contract, T prices the asphalt at cost. Another company ships the asphalt just before a paving job. The physical properties of emulsified asphalt demand that T use it within several hours of shipment; otherwise, it hardens and becomes useless. Once T completes a job, it generally receives payment within 1030 days of billing.

T used the cash method of accounting, deducting the cost of the asphalt for a paving job immediately on paying for it. T recognized income for a job when it received payment.

The IRS determined that the asphalt was "merchandise" under Regs. Sec. 1.471-1, such that T had inventories and thus was required to use the accrual method. The Tax Court concluded that the Service had abused its discretion, and the Court of Appeals (opinion Tashima, J.) affirms.

Under Regs. Sec. 1.471-1, a taxpayer must use inventories and the accrual method of accounting when the "production, purchase or sale of merchandise is an income-producing factor," to "reflect taxable income correctly." The rationale behind Sec. 471 and Regs. Sec. 1.471-1 is straightforward: If a taxpayer holds sizable inventories for resale, under a cash method, it could defer income by purchasing all of its goods at the end of one year, taking deductions for the purchase at that time, and then selling the goods in subsequent years, without recognizing income until receiving proceeds from sales.

This rationale does not apply to paving companies, as they must lay asphalt immediately on purchase. Thus, we agree with the Tax Court that asphalt is not merchandise and T should not have been required to use the accrual method because Regs. Sec. 1.471-1 does not apply.

The IRS's argument that T failed to adopt an accounting method that clearly reflected income is wholly unrelated to the inventory issues of Regs. Sec. 1.471-1. Rather, the disparity in taxable income that the Service calculated for the paving jobs stems from the mismatch of deductions and income attributable to the fact that T had outstanding accounts receivable at the end of each tax year that were not immediately recognized under the cash method. These accounts receivable did not stem from T'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 IRS to require the use of the accrual method. We thus agree with the Tax Court that the Service abused its discretion in requiring T to adopt the accrual method.

The Tax Court properly relied on its earlier decision in Galedrige Constr., Inc., TC Memo 1997-240, when it held that "the peculiar physical properties of emulsified asphalt make it impossible" for a taxpayer to hold it in inventory. On this basis, the Tax Court held that the IRS could not require the paving company to use an accrual method with respect to the asphalt. Recently, in RACMP Enters., Inc., 114 TC 211 (2000), the Tax Court reaffirmed Galedrige in deciding that a contractor that poured cement was not subject to the requirements of Regs. Sec. 1.471-1, because mixed cement, like asphalt, changes its physical state so rapidly as to become useless quickly.

Galedrige and RACMP Enterprises represent the sound principle that Regs. Sec. 1.471-1 does not apply when the item in question is not warehouse inventory, especially when traditional service providers are involved. The IRS's attempt to force asphalt into the cubbyhole of "merchandise" disregards the purpose of Regs. Sec. 1.471-1. The Service argues that the transfer of title from the asphalt manufacturer 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 IRS further contends that possessing title for an instant is sufficient to require a taxpayer to inventory its goods, as long as the goods are acquired and held for sale.

None of the cases on which the Service relies is on point; all involved goods that were either already in inventory or could be stored in inventory. T is physically unable to manipulate the matching or nonmatching of deductions and income. Because asphalt is not merchandise, cases holding that momentary title to merchandise is sufficient do not apply.

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 Regs. Sec. 1.471-1. The IRS therefore abused its discretion in requiring T to use the accrual method of accounting.

Jim Turin & Sons, Inc., 9th Cir., 7/21/00, aff'g TC Memo 1998-223

REFLECTIONS: Accord, Vandra Bros. Construction Co., Inc., TC Memo 2000-233.