Court Opinion

ID: 4474010
Source: CourtListenerOpinion
Date Created: 2020-01-16 21:10:42.412959+00
Date Added: 2024-06-11T08:48:53.315589
License: Public Domain

Halpern, J., dissenting: I. Introduction Petitioner is a concrete contractor, licensed by the State of California to construct, place, and finish concrete foundations and flatwork. In performing its work, petitioner uses ready-mix concrete, sand, rock, various hardware items, and lumber (the materials), all of which (except, possibly, the lumber) belong to someone else at the end of the job. For the taxable year in question, petitioner treated as an expense, and deducted on its Federal income tax return, all payments actually made by it during the year for the materials. It included in gross income only payments actually received by it during the year. The majority addresses the question of whether petitioner must take inventories. In pertinent part, section 1.471-1, Income Tax Regs., provides: “In order to reflect taxable income correctly, inventories at the beginning and end of each taxable year are necessary in every case in which the production, purchase, or sale of merchandise is an income-producing factor.” The majority decides that petitioner need not take inventories. It does so on the following basis: We have found that petitioner’s contracts with its real property developer clients are service contracts, that the material provided by petitioner is indispensable to and inseparable from the provision of that service, that the materials lost their separate identity to become part of the real property in the construction activity, and that, in substance, no sale of merchandise occurred between petitioner and its clients. The bottom line is that petitioner did not hold merchandise for sale, and there simply was no sale of merchandise between petitioner and its clients. See Osteopathic Med. Oncology & Hematology, P.C. v. Commissioner, supra [113 T.C. 376 (1999)3; Honeywell, Inc. v. Commissioner, supra [T.C. Memo. 1992-453]. [Majority op. p. 231.] The majority recognizes that petitioner provides a mix of goods and services. Rules of law to decide whether taxpayers providing a mix of goods and services are producing, purchasing, or selling (without distinction, selling) merchandise that is an income-producing factor have proved elusive. See Schneider, Federal Income Taxation of Inventories, sec. 1.02, particularly at 1-13 through 1-26 (2000). The majority has attempted to craft such a rule of law. The majority looks to Osteopathic Med. Oncology & Hematology, P.C. v. Commissioner, 113 T.C. 376 (1999), which applies a rule of law of questionable, but narrow, application; viz, that medical practice is inherently a service business. The majority extracts from that case the dubious proposition that we can define the inherent nature; i.e., define the essential constituent, of a service business.1 The majority would test for that constituent as the principal determinative of whether a business is selling merchandise. The majority has disregarded precedent and, in my opinion, left the law less settled than before. II. Discussion A. Introduction I distill the following rule of law from the majority’s analysis: A taxpayer is not selling merchandise to customers when the material in question is integral to the provision of a service. See majority op. p. 220.2 The principal difficulty that I have with the test (the integral-to-service test) implicit in the majority’s rule is that it does not accommodate many of the factors that have proved useful in deciding whether the provider of a mix of goods and services is selling merchandise that is an income-producing factor. B. Traditional Factors For example, under the integral-to-service test, what role, if any, is left for the traditional inventory-determinative factors of ownership, risk, and relative cost? Under the integral-to-service test, is the fact that ownership of the materials vests in the taxpayer irrelevant? If not, how does that fact influence the determination of whether the materials are integral to the service? See Surtronics, Inc. v. Commissioner, T.C. Memo. 1985-277 (electroplater purchasing gold and silver to apply to customer’s components was required to use inventories); Epic Metals Corp. v. Commissioner, T.C. Memo. 1984-322 (taxpayer’s failure to prove that title to goods did not pass to it decisive to decision rejecting its argument that, in arranging the sale of goods between two other parties, it was only a broker selling its services and was not a seller itself), affd. without published opinion 770 F.2d 1069 (3d Cir. 1985). What about risk of loss? Assume that the taxpayer bears the risk of loss with respect to materials destroyed during production or if performance under the contract is rejected. Is that fact, likewise, irrelevant? If not, how does it influence the required determination? In Fame Tool & Manufacturing Co. v. Commissioner, 334 F. Supp. 23 (S.D. Ohio 1971), the taxpayer manufactured tools and dies to order. It maintained no finished inventory and had a substantial amount of work in progress, and the average time to complete an order was 1 or 2 weeks. Since the end product manufactured by the taxpayer had to satisfy the customer’s specifications, if the tool or die failed to meet those specifications, it was rejected and had to be scrapped. The percentage of rejects varied widely. The taxpayer argued that, since it was a “pure” tool and die maker, as distinguished from a precision manufacturer, it provided a service and, therefore, there was no “merchandise” or any “production” within the meaning of section 1.471-1, Income Tax Regs. The District Court rejected that argument, relying on Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d 352 (1st Cir. 1970), affg. T.C. Memo. 1969-79, for the rule that the taxpayer was required to take inventories even if he was partly or mainly performing a service. The District Court pointed out that the taxpayer’s argument that it was a service provider would have been stronger if it had subcontracted out the actual production of the tools and dies: “[I]nasmuch as the customer is obviously only interested in getting a tool or die to his specifications, regardless of who made it”. Fame Tool & Manufacturing Co. v. Commissioner, supra at 28. Finally, in applying the integral-to-service test, what weight do we give to a comparison of the relative costs of the materials and labor constituting the taxpayer’s work product (assuming that the taxpayer had title to the materials)? Compare Drazen v. Commissioner, 34 T.C. 1070, 1078-1079 (1960) (taxpayers arguing for inventories — (to put them on the accrual method, so they could accrue deferred payments against current costs) — did not have sufficient manufacturing operations to require inventories) with Thompson Elec., Inc. v. Commissioner, T.C. Memo. 1995-292 (substantiality of material costs compared to receipts taken into account in determining whether material is a substantial income-producing factor). Shasta Indus., Inc. v. Commissioner, T.C. Memo. 1986-377, is a traditional factor case that, apparently, would come out differently under the integral-to-service test. The taxpayer, a swimming pool contractor, constructed custom-designed, in-ground swimming pools. We found the physical construction process utilized by the taxpayer to be as follows: The layout site was excavated including dynamiting or other special techniques if necessary. The plumber installed the filter, pump, motor, and the skimmer. Steel reinforcing bars were used to form a metal basket to fit the excavation and form the shape of the pool. Wiring was then added to the pool site. The necessary electrical work was done before the concrete was poured, covering the steel, plumbing and electrical work. Tile was placed around the pool surface and the deck around the pool was constructed. Final details of construction were the cleanup of the pool area, setting of the turbos, and plastering of the pool. Equipment needed to service the pool was then delivered to the pool site and the operation of the pool was explained to the customer. \Id.; emphasis added.] We also found: “Although most supplies came from the warehouse, some materials such as concrete and tile were purchased for specific contracts and normally delivered directly to the pool site.” Id. (emphasis added). The question before us was whether the taxpayer could use the LIFO method for its inventory of partially completed swimming pools. The taxpayer overcame the argument that the completed contract method precluded the use of LIFO, as well as the argument that the swimming pools were not inventory because they constituted improvements to land. We held that inventories are necessary in order to reflect taxable income correctly in every case in which the sale of merchandise is an income-producing factor, citing Wikstrom & Sons, Inc. v. Commissioner, 20 T.C. 359 (1953), for the proposition that inventories are required when merchandise is produced in accordance with customer specifications. Also, we found that the taxpayer was maintaining inventories in the form of materials and work in process, and not in the form of real estate to which it held title or in the form of improvements to its own real estate. On that basis, we distinguished Miller Dev. Co. v. Commissioner, 81 T.C. 619 (1983) (real estate and improvements to real estate are not normally considered “merchandise” for purposes of determining whether the use of inventories is permitted to the taxpayer). Shasta Indus., Inc. v. Commissioner, supra, is a Memorandum Opinion. Therefore, we applied settled law to the facts before us. Those facts and the facts before us today are quite similar, yet, today, we reach a different result. I assume, therefore, that settled law has changed. C. The Integral-to-Service Test The majority finds that petitioner’s business is inherently a service business. See majority op. pp. 222, 225. As stated, the majority does not identify the essential constituent that marks the inherent nature of a service business. In Osteopathic Med. Oncology & Hematology, P.C. v. Commissioner, supra, we found the chemotherapy drugs in question were unavailable to the ultimate consumers, the patients', without the intervention of a physician, and they had to be injected into the patient by a physician or nurse. The analogy to the case at hand is weak. Here, the materials could be purchased by anyone, and the only distinguishing characteristics of petitioner were its license and its skill to do the work involved. Do we thus conclude that the essential constituent of a service business is the requirement of some level of skill or the necessity of some Government license to carry it out? Do we not make a distinction without a difference when we suggest that we can divide the class of businesses that deliver a mix of goods and services on the basis of those that are inherently service businesses and those that are not? In Rev. Rul. 74-279, 1974-1 C.B. 110, the Commissioner dealt with a taxpayer engaged in business as an optometrist. The taxpayer not only examined eyes and prescribed corrective lenses (which requires a license) but also sold frames and eyeglasses. The ruling holds that, although the taxpayer provides various services, there is also a substantial amount of merchandise sold, and, therefore, inventories are required. Not surprising. But how does the optometrist fare under the integral-to-service test? I assume that the business of optometry (at least when limited to examining eyes, diagnosing defects, and prescribing corrective lenses) is inherently a service business under that test. Cf. Osteopathic Med. Oncology & Hematology, P.C. v. Commissioner, supra. But the business of filling the prescription for the corrective lenses also involves the optometrist’s performing a service. The service requires skill and, in some jurisdictions, it requires a license. See, e.g., Cal. Bus. & Prof. Code sec. 2550 (West 1990 & Supp. 1999). Therefore, filling the prescription is inherently a service business under the integral-to-service test. I assume that the lenses and frames are integral to that service. If so, under the integral-to-service test, the lenses and frames are not merchandise within the meaning of section 1.471-1, Income Tax Regs. The integral-to-service test is different; it changes the emphasis of the inquiry that, traditionally, has served; it brings into play new factors, which will encourage the reexamination of settled questions. For instance, consider the hotel and restaurant business. The courts have consistently held that the sale of large amounts of food, beverages, and tobacco is a sufficient basis upon which to predicate the use of inventories. See, e.g., Dwyer v. Commissioner, a Memorandum Opinion of this Court dated June 29, 1951 (inventories necessary for hotel and restaurant business since purchase and sale of wines, liquors, and beers is an income-producing factor), affd. on other issues 203 F.2d 522 (2d Cir. 1953); Schuyler v. Commissioner, a Memorandum Opinion of this Court dated May 11, 1951 (similar; purchase and sale of food, beer, wine, liquor, and tobacco products), affd. on other issues 196 F.2d 85 (2d Cir. 1952). Do we now give license to challenge that orthodoxy? Restaurants do not sell tobacco products anymore, and liquor may give them pause, but can fancy French restaurants (or large food service operations) now argue that they need not inventory their comestibles since they are inherently a service business, with peas, carrots, truffles, and boeuf being integral to that service? What about the proliferation of dot.com businesses, whose added value is generally some service, such as the ability to shop at home for merchandise, such as books or music, that used to require a trip to the store? I fear that our new rule may be misunderstood.3  III. Conclusion Leslie J. Schneider, in his treatise Federal Income Taxation of Inventories, writes: “Notwithstanding the fact that the inventory issue is raised in a variety of contexts, the issue is resolved by a consideration of the same basic question — is the production, purchase or sale of merchandise an income-producing factor?” Schneider, supra at 1-12. I would take into account the traditional factors to determine whether petitioner’s method of accounting clearly reflects its income. For many of the reasons stated by Judge Gerber, I would conclude that it does not. Cohen, Ruwe, Gerber, and Thornton, JJ., agree with this dissenting opinion.   Inherent means: “Existing as an essential constituent or characteristic; intrinsic.” The American Heritage Dictionary 928 (3d ed. 1992).    The principal meaning of the word “integral” is “Essential or'necessary for completeness; constituent”. American Heritage Dictionary 937 (3d ed. 1992). The word “integral” expresses nicely the concept of “indispensable and inseparable” that the majority lifts from Osteopathic Med. Oncology & Hematology, P.C. v. Commissioner, 113 T.C. 376 (1999).    Indeed, I am not that sure how well the majority understands it. The majority’s discussion of the integral relationship of the materials to petitioner’s service relies on an old-style factor analysis. Judge Gerber, in his dissent, does a good job of criticizing that analysis.