Tax Court O.K.’s Accounting for Profits

Words: Cass SternThe U.S. Tax Court recently ruled that the Internal Revenue Service exceeded its authority in requiring a contractor to use the accrual method of accounting. As a result, if this case is upheld on appeal, many building contractors and subcontractors will be allowed to defer the recognition of accounts receivable until they actually receive the funds.

For the record, the cash basis is the method of accounting used by most individuals and many masonry contractors. Income is generally reported in the year that it is actually or constructively received. Deductions and credits are generally taken for the year in which the related expenditures were actually paid.

Under the accrual method, on the other hand, income is accounted for when the right to receive it comes into being. It is not the actual receipt but the "right" to receive that counts.

Thus, under the accrual method, many masonry contractors have taxable income when they bill for a job rather than when they receive payment. Expenses are deductible on the accrual basis in the year incurred - i.e., when all the events have occurred that fix the amount of the item and determine the liability of the taxpayer to pay it. Every masonry contractor operating as a corporation or partnership is required by our tax laws to use the accrual method of accounting - unless they can meet the $5 million or less gross receipts test for all prior years. Those contractors that are required to use inventories must use the accrual method of accounting - with no exceptions. Now, a sharply divided U.S. Tax Court has ruled that a concrete contractor did not have to use the accrual method because the materials that it used in providing its services are not "merchandise" held for sale and, so, don't have to be inventoried. Instead, according to the Tax Court, the materials are an indispensable and inseparable part of the provision of its services and lose their separate identity to become part of a building or other real property. RACMP Enterprises is a construction contractor that builds concrete foundations, driveways and walkways for real estate developers. When bidding on a job, RACMP calculates its bid price by figuring the cost of labor and materials required to perform the work plus a margin for profit based on the cost of the labor, the quantity of materials and the complexity of the job.

The contact requires RACMP to furnish sufficient labor, materials, tools, equipment and services and to properly perform the work in a sound workmanlike and substantial manner. RACMP constructs concrete foundation forms on-site using lumber and other supplies in accordance with the developer's blueprints. It then uses fill sand and drain rock with the forms in place and wire mesh and rebar and other hardware in the forms. When this work is approved, RACMP orders ready-mix concrete from a supplier who delivers it to the construction site. RACMP does not manufacture, deliver or store this concrete.

The supplier pours the concrete directly into the form. RACMP then installs anchor bolts and performs other finishing work. RACMP is not left with any concrete on hand at the end of the day. It submits a single invoice for the completed work to the developer for payment, along with each supplier's invoice and lien release form. The developer issues a check payable to RACMP and each supplier for the cost of materials as stated on the suppliers' invoices and lien releases. RACMP endorses each joint check and forwards it to the appropriate supplier without depositing or otherwise cashing them. The developer pays for the construction work in a two part process. The developer also issues a check payable only to RACMP for the balance of its invoice.

Accounting Methods

RACMP uses the cash method of accounting, recognizing income as it is received and expensing the cost of concrete and other materials when paid. The IRS determined that the concrete, sand and other materials that RACMP used in its business should have been classed as "merchandise," requiring RACMP to use inventories and, therefore, to use accrual accounting. 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. Startup 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.

Tax Court O.K.’s Accounting for Profits

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