Docket No. 2689-79. | Tax Ct. | Jun 25, 1984
S, a corporation, primarily sold products manufactured by M, a manufacturing corporation. S was the wholly owned subsidiary of M. S reported its income for Federal tax purposes on the cash method of accounting; M reported its income on the accrual method. The Commissioner determined that S was required by
MEMORANDUM OPINION
SIMPSON,
All of the facts have been stipulated, and those facts are so found.
The petitioner, Epic Metals Corporation (EMC) and subsidiaries, had their principal places of business in Rankin, Pa., at the time they filed their petition. On November 29, 1973, EMC formed Epic Sales Corporation (ESC). ESC is a Pennsylvania corporation and a 100-percent subsidiary of EMC. For the years in issue, EMC filed consolidated returns for itself and its wholly owned subsidiaries, including ESC, with the Internal Revenue Service, Philadelphia, Pa.EMC and ESC maintain separate accounting records. EMC uses the accrual method of accounting for both bookkeeping and income tax reporting purposes. ESC uses the accrual method of accounting for bookkeeping purposes but uses the cash method of accounting for income tax purposes.
EMC is engaged in the manufacture and sale of metal products, primarily metal decking, modular buildings, and roofing systems, which are fabricated to custom specifications for each order from raw metal coils. EMC does not stock socalled standard or stock metal decking as finished goods, and it does not sell custom fabricated metal decking directly to the ultimate user unless it installs the metal decking at the jobsite. EMC employees, who are not part of the ESC sales department, solicit orders for EMC for custom fabricated metal decking that requires installation at the customer's jobsite.
ESC derives its income from the sale of custom fabricated metal decking, which it sells without installation. It procures orders for metal decking through its own sales department, commission agents, dealers, and jobbers. It does not solicit orders which require jobsite installation; when it encounters such an order, it refers the order to EMC. ESC places almost all of its orders for metal decking with EMC. However, ESC places orders for metal decking with fabricators other than EMC whenever EMC, for any reason, either chooses not to or is unable to fill an order. EMC fills approximately 95 percent of ESC's orders.
ESC never has physical possession of the metal decking, whether the order is placed with EMC or another fabricator. Whether an ESC order is filled by EMC or by another fabricator, the order is always shipped F.O.B. fabricator's place of business. ESC's customer always has the right to select the mode of transportation and the specific carrier to transport the finished product to the jobsite.
ESC's sales department consists of approximately 8 full-time sales persons located in Rankin and approximately 7 full-time sales persons located in Florida, Illinois, Michigan, Minnesota, North Carolina, and Ohio. ESC's vice president of sales is not an officer, director, shareholder, or employee of EMC. ESC pays rent at a fair price to EMC for the space it occupies in EMC's building. In addition, EMC charges ESC a yearly management service fee, and it charges ESC for a percentage of certain expenses, including those for advertising, utilities, drafting, designing, and credit clearance. ESC and EMC have never had a master contract or any written contract describing the business transactions between them.
During the years in issue, the typical transaction between ESC and EMC occurred as follows: ESC solicited an order from its customer or received an invitation to bid from a customer. ESC received and acknowledged the order from its customer. ESC received a sales tax exemption designating it as the vendor. ESC's sales department personnel sent a credit request from to the EMC credit department for approval. EMC charged ESC for the credit check. If the credit check disclosed that credit should not be extended, the order was rejected by ESC. If the order was accepted, ESC's sales department personnel completed an ESC order summary form. This form listed information concerning the order including quantity, pricing information, sales tax information, required shipping date, and sales terms. ESC's personnel forwarded a copy of the ESC order summary to EMC's production scheduling department. EMC's production scheduling department used ESC's order summary to enter the order into EMC's computer. EMC then had its own personnel produce all the EMC documentation and paper work necessary to perform the custom fabrication of the metal decking. EMC contacted the ESC customer to confirm or adjust the time of shipment. Once EMC had completed the custom fabrication of the ESC order, EMC, as directed by ESC, loaded the metal decking onto the mode of transportation requested by the ESC customer (customer truck, contract truck, common carrier, or railroad car) for shipment to the ESC customer jobsite. The ESC-ordered custom fabricated metal decking was shipped directly to its customer's jobsite using ESC's shipping papers and bills of lading. EMC notified ESC when the metal decking had been shipped.
After an order was custom fabricated but before it had been shipped from EMC's plant (while it was awaiting loading for shipment), the risk of loss or damage to the metal decking was with EMC. The risk of any loss or damage to the metal decking during transit was with the ESC customer under the shipping contract. ESC advanced freight charges for the shipment to its customer, and the freight charges were billed to the ESC customer either as part of the purchase price or separately depending on the terms of the particular order. In either case, the ESC customer bore the freight charges and had the right to select the method of shipment and the specific carrier. EMC sent its invoice for the metal decking to ESC, and ESC paid the invoice by making payments to EMC. ESC then sent an invoice to its customer for the metal decking, and the customer paid the ESC invoice by making payment to ESC. ESC bore the credit risk should its customer default on the contract.
In his notice of deficiency, the Commissioner determined that the accrual method of accounting used by ESC to keep its books and records should also be used in preparation of the consolidated return since such method clearly reflects income, and that the cash receipts and disbursements method used by ESC in the preparation of the consolidated return does not clearly reflect income. The Commissioner also determined that the use of the accrual method is necessary to clearly reflect the consolidated taxable income of EMC and its subsidiaries. Use of the accrual method of accounting, instead of the cash method, resulted in an increase in the petitioner's taxable income for the taxable year ended March 31, 1974, of $1,386,605, and an increase in taxable income for the year ended March 31, 1976, of $238,737.
The first issue for decision is whether ESC is required by
Whenever in the opinion of the Secretary the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer on such basis as the Secretary may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income.
The regulations promulgated under
ESC argues that its cash method of accounting clearly reflects income pursuant to
The Commissioner, on the other hand, contends that ESC is a seller of custom fabricated metal decking, that ESC has title to the metal decking which it sells, and that the sales of such decking are an income-producing factor for ESC. Accordingly, the Commissioner argues that ESC is required by
Where inventories are required, the regulations mandate the use of the accrual method of accounting for purchases and sales.
The parties have stipulated, and we have found as a fact, that ESC never had physical possession of the metal decking. However, the regulations under
ESC argues strenuously that it is a jobber, and not a seller, of custom fabricated metal decking, and that, as such, it never acquires title to the metal decking. In support of such contention, ESC points out that it does not manufacture goods; that it places orders for metal decking with manufacturers only after it has a firm order for the decking from its customer; that it never invests capital or labor in order to acquire or maintain an inventory of metal decking; that it never has control over or constructive possession of the custom fabricated metal decking; that after the metal decking is fabricated, it is shipped directly to ESC's customer from the manufacturer's plant, F.O.B. manufacturer's plant, and completely bypasses ESC in all respects; that ESC has no control over the manufacture or the method of transportation for the metal decking; that ESC does not bear the risk of loss during shipment, nor does it bear the risk of defects or errors during or arising out of the fabrication of the metal decking; and that the only risk ESC bears is the risk of nonpayment by its customer. ESC also argues that its practices are consistent with industry costom in that other jobbers or middlemen in the custom fabricated metal decking industry also never take title to the metal decking which they provide to their customers.
The parties have stipulated that Pennsylvania adopted the Uniform Commercial Code (UCC), effective July 1, 1954, and that Article 2 thereof is applicable to the transactions at issue. ESC, citing
The Commissioner argues that ESC's arrangement whereby it never has physical possession of the metal decking is insufficient for it to avoid the requirement that it maintain inventories for tax purposes. He contends that even momentary title is sufficient to require the use of inventories. In support of his contention, the Commissioner cites
The Commissioner also contends that under applicable provisions of the UCC, title passes from EMC to ESC at the time and place of shipment, and that thereafter, title passes from ESC to its customer virtually immediately. He cites
Although ESC now claims that it never had title to the custom fabricated metal decking sold by it, the record before us does not disclose that such claim was ever made before this litigation, and such claim is wholly inconsistent with the treatment of the transactions by ESC and EMC and by ESC and its customers. ESC, EMC, and the ultimate purchasers of the custom fabricated metal decking all consistently treated the transactions as if title passed from EMC to ESC and then to the ultimate purchaser. ESC treated the transactions between itself and EMC for Federal tax purposes as sales of the metal decking by EMC to ESC and the transaction between itself and the ultimate purchaser as a sale by ESC to such purchaser. On the consolidated returns, EMC treated the transaction as a sale and reported the income therefrom. On such returns, ESC treated itself as having purchased metal decking from EMC and claimed a deduction for cost of goods sold. Such treatment is wholly inconsistent with ESC's claim that it was merely a jobber. In addition, ESC was designated the vendor for State sales tax purposes, and in its contracts with its customers, ESC was designated as the seller.
In another context, the previously stated: "When negotiating with customers over the terms of sales, petitioners could have insisted on a clear contractual statement of where title was to pass or could have arranged the terms to indicate clearly where the parties intended title to pass."
Moreover, the facts of this case illustrate well the reason for requiring the use of inventories and the accrual method of accounting in such a situation. For its taxable year ending on March 31, 1974, EMC treated the costs of custom fabricated metal decking sold to ESC in such year as a cost of goods sold, and since it used the accrual method of accounting, it treated any such sale as an account receivable for such year. However, since ESC used the cash method for tax purposes, it treated all such purchases for which it made payments for such year as cost of goods sold and claimed a deduction for them, but if it did not actually receive payment for such sales until the succeeding year, such payments were not reported until the succeeding year. As a result, it deferred reporting over $1,386,605 of income. If those sales had been made directly by EMC to the ultimate purchaser, such income could not have been deferred, and if ESC is required to use the accrual method, it cannot be deferred. The creation of ESC to handle certain of the sales of the custom fabricated metal decking and its use of the cash method of accounting for tax purposes would result in the deferral of substantial income, and such circumstances provide a sound basis for the Commissioner's position that the deferral of such income would be a failure to clearly reflect income within the meaning of
ESC relies heavily on
In our view, the Second Circuit's opinion in
Since we have concluded that ESC is required to maintain inventories, it follows that it is required to use the accrual method of accounting.
In holding that ESC must maintain inventories and is required to use the accrual method of accounting, we have considered the petitioner's argument that its method of accounting had been consistently used and its argument that such method was used in its industry. However, such arguments are irrelevant. 3 In view of our holding, it is unnecessary to consider the Commissioner's alternative position concerning the applicability of the consolidated return regulations.
Footnotes
1. All statutory references are to the Internal Revenue Code of 1954 as in effect during the years in issue, unless otherwise indicated.↩
2. ESC misapprehends its burden of proof when it states:
Further, it is Respondent's burden to prove that ESC holds title to the custom fabricated metal decking. It is well-settled Pennsylvania law that proof of title is borne by the one who claims title, and in the case of personalty, the person in possession is presumed to be the owner. The burden is on the person out of possession to prove otherwise. Therefore, the burden is on Respondent to show that title is in the one who does not have possession of the custom fabricated metal decking, i.e., ESC. [Citations omitted.]
In the present case, the Commissioner is not "the person out of possession." The burden of proof as to who has title in the present case is on the petitioner.
Rule 142(a), Tax Court Rules of Practice and Procedure ;Welch v. Helvering, 290 U.S. 111" court="SCOTUS" date_filed="1933-11-06" href="https://app.midpage.ai/document/welch-v-helvering-102139?utm_source=webapp" opinion_id="102139">290 U.S. 111Duesenberg, Inc. of Delaware v. Commissioner, 31 B.T.A. 922" court="B.T.A." date_filed="1934-12-19" href="https://app.midpage.ai/document/duesenberg-inc-v-commissioner-4495519?utm_source=webapp" opinion_id="4495519">31 B.T.A. 92284 F.2d 921" court="7th Cir." date_filed="1936-06-29" href="https://app.midpage.ai/document/duesenberg-inc-v-commissioner-of-internal-revenue-1489354?utm_source=webapp" opinion_id="1489354">84 F.2d 921 ">84 F.2d 921" court="7th Cir." date_filed="1936-06-29" href="https://app.midpage.ai/document/duesenberg-inc-v-commissioner-of-internal-revenue-1489354?utm_source=webapp" opinion_id="1489354">84 F.2d 921↩ (7th Cir. 1936).3. The present case is clearly distinguishable from the case where a taxpayer has consistently used a particular method of accounting over a long period of time. Cf.
Van Pickerill & Sons, Inc. v. United States, 445 F.2d 918" court="7th Cir." date_filed="1971-07-16" href="https://app.midpage.ai/document/van-pickerill--sons-incorporated-v-united-states-297955?utm_source=webapp" opinion_id="297955">445 F.2d 918Magnon v. Commissioner, 73 T.C. 980" court="Tax Ct." date_filed="1980-02-28" href="https://app.midpage.ai/document/magnon-v-commissioner-4484177?utm_source=webapp" opinion_id="4484177">73 T.C. 980Fort Howard Paper Co. v. Commissioner, 49 T.C. 275" court="Tax Ct." date_filed="1967-12-27" href="https://app.midpage.ai/document/ft-howard-paper-co-v-commissioner-4480659?utm_source=webapp" opinion_id="4480659">49 T.C. 275Frank G. Wikstrom & Sons, Inc. v. Commissioner, 20 T.C. 359" court="Tax Ct." date_filed="1953-05-15" href="https://app.midpage.ai/document/frank-g-wikstrom--sons-inc-v-commissioner-4476431?utm_source=webapp" opinion_id="4476431">20 T.C. 359Nor are we persuaded by the evidence introduced concerning industry practice and trade custom that ESC's cash method of accounting is the method of accounting utilized by similarly situated taxpayers in its trade or business, and that therefore, such method clearly reflects income. Industry practice and trade custom are factors to be considered in determining whether a method of accounting clearly reflects income. See
Public Service Co. of N.H. v. Commissioner, 78 T.C. 445" court="Tax Ct." date_filed="1982-03-22" href="https://app.midpage.ai/document/public-service-co-v-commissioner-4484631?utm_source=webapp" opinion_id="4484631">78 T.C. 445Fox Chevrolet, Inc. v. Commissioner, 76 T.C. 708" court="Tax Ct." date_filed="1981-05-11" href="https://app.midpage.ai/document/fox-chevrolet-inc-maryland-v-commissioner-4484423?utm_source=webapp" opinion_id="4484423">76 T.C. 70873 T.C. 980" court="Tax Ct." date_filed="1980-02-28" href="https://app.midpage.ai/document/magnon-v-commissioner-4484177?utm_source=webapp" opinion_id="4484177">73 T.C. 980"> . However, industry practice is not determinative of whether an accounting method clearly reflects income.Magnon v. Commissioner, supra at 1004-1006Public Service Co. of N.H. v. Commissioner, supra↩ at 455-456