Masonry Magazine August 2000 Page. 30
RACMP maintained that it is in the business of providing service and that its clients purchase its expertise in constructing, placing and finishing foundations, driveways and walkways, not merchandise.
Not too surprisingly, the Tax Court agreed with RACMP. It said whether RACMP is required to report its income on the accrual method instead of the cash method depends on whether it is in the business of selling merchandise to customers in addition to providing a service or whether the material provided by it is a supply that is incidental to the provisions of the contracted service.
Unfortunately, as the Tax Court pointed out, neither the tax law nor the regulations define "merchandise" or "inventory" or clearly distinguish between "materials and supplies" that are not actually consumed and remain on hand and those that are "inventory."
In the course of trying this case, the Tax Court was reminded of an earlier situation where it had rendered a decision on "materials." In that case, where the inherent nature of the taxpayer's business (a surgical practice) was that of a service provider, the taxpayer used materials that were an indispensable and inseparable part of the rendering of its services. In other words, in that case, the materials were not "merchandise." Here, the Tax Court decided the masonry contractor, RACMP, was "inherently a service provider." Under our tax rules, material may be either merchandise or supplies depending upon whether it is held for sale or consumed in performing a service. The difference, said the Tax Court, is determined by context. In this context, it found that the concrete, sand, drain rock and hardware items used by RACMP were supplies, not merchandise. The construction material, when combined with other tangible personal property, lost its separate identity to become an integral and inseparable part of the real property in the construction activity.
Since the court concluded that RACMP was neither a manufacturer of merchandise, a merchandising concern, nor engaged in a merchandising activity, it held that it is not engaged in a business activity that requires it to maintain an inventory.
Given the fact that this operation did not exceed the $5 million income threshold, since it was not required to maintain an inventory, it was not required to use the accrual method of accounting.
Noting that the cash method of accounting has been widely used through the contracting industry and generally accepted by the IRS and the Tax Court, and in the absence of any assertion by the IRS that RACMP attempted to unreasonably prepay expenses or purchase supplies in advance, the Tax Court also found that the IRS abused its discretion in determining that RACMP's use of the cash method did not clearly reflect income.
BUT, ARE YOU REALLY SURE?
Unfortunately, the Tax Court's decision was not unanimous. Five judges joined in a strenuous dissent that challenged most of the majority's conclusions. The dissent maintained that RACMP was not primarily providing a service, even though its activities were labor-intensive. Rather, it said that RACMP's business, and construction businesses in general, have some element of labor and services and some element of merchandise or product. The dissent emphasized the fact that the materials used here were relatively substantial in amount and were used to create a finished product.
Fortunately, all of the parties involved had stipulated from the outset that the taxpayer's gross receipts had never exceeded $5 million per year since its incorporation. Regular 'C' corporations that have had three-year average annual gross receipts of more than $5 million for any prior year (or average annual gross receipts over $5 million for the period of its existence, if less) may generally not use the cash method of accounting. That would be the case even if the corporation were not required to keep inventories. However, qualified personal service corporations aren't subject to the restriction on use of the cash method.
According to the dissenting group of Tax Court judges, the effect of the majority's holding is to exempt contractors in the construction industry from having to use inventories and the accrual method of accounting if the materials that they purchased are used in constructing part of an addition to real estate.
Every masonry contractor that comes within the $5 million gross receipts exception and that now uses accrual accounting should consider whether they would benefit from switching to the cash method. Naturally, the IRS's approval would have to be requested in order to make this accounting method change, which the IRS would, in all likelihood, deny. Start-up construction companies, however, might want to select the cash method from the outset, which would not require the IRS's consent.
Keep in mind however, that given the strength and size of the dissent within the U.S. Tax Court in this case, the Internal Revenue Service is likely to appeal and to continue to challenge taxpayers who rely on it. But, there it is in black-and-white, should your use of the cash method be challenged by the IRS.
Mark E. Battersby is a tax and financial advisor, freelance writer and columnust
30 MASONRY-JULY/AUGUST, 2000
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