UNITED STATES TAX COURT

T.C. Memo. 1998-289

UNITED STATES TAX COURT

ADDISON DISTRIBUTION, INC., Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

WIN H. EMERT, Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 4838-96, 9817-96.

Filed August 6, 1998.

David M. Kirsch, for petitioners.

Steven Walker, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

VASQUEZ, Judge:

In these consolidated cases, respondent

determined deficiencies in, and penalties on, petitioners'

Federal income taxes as follows:

Docket No.

4838-96

Tax Year

Ended

Deficiency

Penalty

Sec. 6662

02/28/93

02/28/94

$83,109

130,083

$16,622

26,017

- 2 9817-96

12/31/92

12/31/93

233,413

111,093

46,683

22,219

All section references are to the Internal Revenue Code in

effect for the years in issue, and all Rule references are to the

Tax Court Rules of Practice and Procedure.

After concessions,1 the issues for decision are (1) whether

respondent determined that the method of accounting used by

Addison Engineering, Inc. (AEI), did not clearly reflect income,

and (2) whether AEI must change from the cash method to the

accrual method of accounting for its tax years ending on October

31, 1992 and 1993.2

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

The stipulations of facts, the stipulation of settled issues, and

the attached exhibits are incorporated herein by this reference.

At the time petitioners filed their petitions, AEI and Addison

Distribution, Inc. (Distribution), each had their principal

places of business in San Jose, California, and Win H. Emert (Mr.

Emert) resided in San Carlos, California.

1

Respondent concedes that petitioners are not liable for

the accuracy-related penalties.

2

The parties filed a stipulation of settled issues which

resolved all other issues. Our decision regarding these issues

affects the flowthrough tax consequences to petitioner Win H.

Emert, AEI's sole shareholder.

- 3 In 1983, Mr. Emert founded and incorporated AEI, and it

commenced business.

AEI is an S corporation, and Mr. Emert has

always been its sole shareholder and corporate officer.

AEI

sells silicon wafers3 and printed circuit boards (the electronic

materials) to high-technology companies.

In 1986, Mr. Emert incorporated Distribution.

maintains an inventory of goods.4

Distribution

Distribution and AEI have

never had any written contract describing the business

transactions between them.

During the years in issue, a typical transaction among AEI,

vendors, subcontractors, and customers occurred as follows:

Customers contacted AEI for the sale of electronic materials from

AEI to the customer.5

The customer executed a purchase order for

the purchase of electronic materials, and the customer forwarded

the purchase order to AEI.

The purchase order identified AEI as

the seller and the customer as the buyer.

3

Silicon wafers are thin slices of silicon that are used

for making semiconductor devices.

4

In a small number of transactions, Distribution had goods

which subcontractors could manufacture into electronic materials

for AEI's customers. In these cases, upon AEI's acceptance of a

customer's purchase order, AEI purchased the goods for the

customer's order from Distribution, AEI shipped the goods to a

subcontractor, and the subcontractors used these goods to

manufacture electronic materials for AEI's customers.

5

AEI also solicited orders from customers.

- 4 Upon acceptance of the customer's purchase order, AEI placed

a firm order with a vendor or subcontractor for the production of

the electronic materials for the customer.

Vendors and

subcontractors sent AEI invoices for the electronic materials,

and AEI paid the invoices.

When the electronic materials were

ready, vendors and subcontractors shipped them to AEI.

AEI

received silicon wafers and printed circuit boards as finished

products.

AEI inspected the electronic materials that vendors and

subcontractors shipped to AEI.

After inspection, AEI placed its

own labels on the goods identifying AEI as the "vendor".

AEI

then repackaged and shipped the electronic materials to the

customer.

AEI sent an invoice to the customer, and the customer

paid AEI's invoice for the electronic materials.

AEI has always used the cash method of accounting.

AEI

treated the transaction between itself and vendors,

subcontractors, or Distribution as a sale of goods and/or

services by the vendors, subcontractors, or Distribution to AEI.

AEI treated the transaction between itself and the customer as a

sale of goods by AEI to the customer.

During the years in issue, AEI included all payments it

actually received from customers in those years in its gross

receipts.

AEI also included all purchases from vendors,

subcontractors, and Distribution it actually paid in those years

- 5 in cost of goods sold (COGS), and AEI subtracted COGS from its

gross receipts to determine its gross income.

OPINION

Petitioners first argue that respondent did not make a

determination that the cash method did not clearly reflect AEI's

income.

Petitioners contend that section 446 requires the

Commissioner to make an express finding that the method of

accounting used by the taxpayer does not clearly reflect income.

Respondent counters that a determination was made that the cash

method did not clearly reflect AEI's income. Pursuant to section

446,6 the Commissioner has broad powers to determine whether an

6

Sec. 446 provides in pertinent part:

(a) GENERAL RULE.--Taxable income shall be computed

under the method of accounting on the basis of which the

taxpayer regularly computes his income in keeping his books.

(b) EXCEPTIONS.--If no method of accounting has been

regularly used by the taxpayer, or if the method used does

not clearly reflect income, the computation of taxable

income shall be made under such method as, in the opinion of

the Secretary, does clearly reflect income.

(c) PERMISSIBLE METHODS.--Subject to the provisions of

subsections (a) and (b), a taxpayer may compute taxable

income under any of the following methods of accounting-(1) the cash receipts and disbursements method;

(2) an accrual method;

(3) any other method permitted by this chapter; or

(4) any combination of the foregoing methods

permitted under regulations prescribed by the

(continued...)

- 6 accounting method used by a taxpayer clearly reflects income.

Commissioner v. Hansen, 360 U.S. 446, 467 (1959); AnsleySheppard-Burgess Co. v. Commissioner, 104 T.C. 367, 370 (1995).

The Commissioner, however, cannot require a taxpayer to change

his method of accounting unless the Commissioner makes a

determination that the accounting method used by the taxpayer

does not clearly reflect income.

See sec. 446(b); Asphalt Prods.

Co. v. Commissioner, 796 F.2d 843, 848 (6th Cir. 1986), affg. in

part, revg. in part and remanding Akers v. Commissioner, T.C.

Memo. 1984-208, revd. on another issue 482 U.S. 117 (1987);

Hallmark Cards, Inc. & Subs. v. Commissioner, 90 T.C. 26, 31

(1988).

Section 1.446-1(c)(2)(i), Income Tax Regs., provides that a

taxpayer who is required to use inventories must also use the

accrual method of accounting with regard to purchases and sales.

A taxpayer who is required to use inventories, and thereby the

accrual method, violates the clear reflection of income

requirement by reporting purchases and sales under the cash

method.

See Asphalt Prods. Co. v. Commissioner, supra at 848.

AEI uses the cash method of accounting.

Respondent, in the

notice of deficiency, determined that AEI is required to use

inventories.

6

Respondent's determination means that AEI's use of

(...continued)

Secretary.

- 7 the cash method of accounting violates section 1.446-1(c)(2)(i),

Income Tax Regs.

We conclude that respondent's determination

that AEI is required to use inventories is a determination that

AEI's use of the cash method of accounting does not clearly

reflect income.

Petitioners next assert that AEI is not required to account

for inventories because it does not take title to the electronic

materials.

Respondent claims that AEI has title to the

electronic materials, they are merchandise which AEI held for

sale, and they are an income-producing factor.

Therefore,

respondent claims that the regulations under sections 446 and 471

require AEI to use inventories and the accrual method of

accounting.

The issue for decision is whether it is an abuse of

respondent's discretion to require AEI to change from the cash

method, which AEI uses for income tax reporting purposes, to the

accrual method.

Subsumed in this issue is the question of

whether AEI should be required to account for inventories for tax

purposes.

To resolve these issues, we consider sections 446 and

471 and the regulations thereunder.

Courts do not interfere with the Commissioner's

determination under section 446 unless it is clearly unlawful.

Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 532 (1979);

Cole v. Commissioner, 586 F.2d 747, 749 (9th Cir. 1978), affg. 64

- 8 T.C. 1091 (1975); Ansley-Sheppard-Burgess Co. v. Commissioner,

supra.

The Commissioner, however, cannot require a taxpayer to

change from an accounting method which clearly reflects its

income to an alternate method of accounting merely because the

Commissioner considers the alternate method to more clearly

reflect the taxpayer's income.

Ansley-Sheppard-Burgess Co. v.

Commissioner, supra at 371.

Whether an abuse of discretion has occurred is a question of

fact.

Id.; Ford Motor Co. v. Commissioner, 102 T.C. 87, 91-92

(1994), affd. 71 F.3d 209 (6th Cir. 1995); see Cole v.

Commissioner, supra at 749.

The reviewing court's task is not to

determine whether, in its own opinion, the taxpayer's method of

accounting clearly reflects income, but to determine whether

there is an adequate basis in law for the Commissioner's

conclusion that it does not.

Ansley-Sheppard-Burgess Co. v.

Commissioner, supra at 371; Hospital Corp. of Am. v.

Commissioner, T.C. Memo. 1996-105.

Consequently, to prevail, a

taxpayer must prove that the Commissioner's determination is

arbitrary, capricious, or without sound basis in fact or law.

Ansley-Sheppard-Burgess Co. v. Commissioner, supra at 371; Ford

Motor Co. v. Commissioner, supra at 92.

Pursuant to sections 446 and 471, and the regulations

thereunder, a taxpayer that has inventories is required to use

- 9 the accrual method of accounting.7

By regulation, the Secretary

has determined that inventories are necessary if the production,

purchase, or sale of merchandise is an income-producing factor.

Sec. 1.471-1, Income Tax Regs.

The parties stipulated that AEI's

sale of electronic materials was the sale of merchandise, that

AEI determined its gross income from sales by subtracting COGS

from total sales, and that, during the years in issue, AEI's sale

of merchandise to customers was an income-producing factor.

Possession of title to goods, even if only for an instant,

is sufficient to require a taxpayer to inventory the goods as the

taxpayer's stock-in-trade under the Commissioner's regulations.

See, e.g., Middlebrooks v. Commissioner, T.C. Memo. 1975-275; see

also sec. 1.471-1, Income Tax Regs.

Petitioners argue that AEI

is not required to account for inventories because it does not

take title to the merchandise.

Specifically, petitioners assert

that under California law title to the electronic materials

passed directly from the vendors and subcontractors to AEI's

customers.

Petitioners, in essence, claim that AEI was a broker

or agent for its customers and that AEI merely coordinated the

purchase, sale, and delivery of the electronic materials to its

7

An exception to this rule exists, however, where the

taxpayer can show that use of another method (e.g., the cash

method) would produce a substantial identity of results. See

Ansley-Sheppard-Burgess Co. v. Commissioner, 104 T.C. 367, 377

(1995). Petitioners do not address this point in their opening

or reply briefs; therefore it is not before the Court. See

Petzoldt v. Commissioner, 92 T.C. 661, 683 (1989).

- 10 customers for a fee.

Petitioners' argument is without merit.

AEI, in any given

transaction, acted as both the buyer pursuant to its contract

with the vendor or subcontractor and the seller pursuant to its

contract with its customers.

California Commercial Code section

2106 provides that a "sale" consists in the passing of title from

the seller to the buyer for a price.

Thus, it would be

impossible under California law for AEI to have purchased and

resold the electronic materials without title having passed from

the vendors or subcontractors to AEI and then from AEI to its

customers.

See also Tebarco Mechanical Corp. v. Commissioner,

T.C. Memo. 1997-311.

Additionally, the parties stipulated a

typical purchase order between AEI and its customers that

provided:

title to * * * all items shipped by Seller [AEI] to

Buyer [AEI's customers] shall pass to Buyer at the

F.O.B. point designated on the face of this Order but

only after inspection and acceptance of the goods by

Buyer in accordance with the terms of this Order. * * *

Furthermore, the purchase order warranted that AEI conveyed good

title to the electronic materials to the customer.

These

provisions provide clear evidence of AEI's intentions and govern

the passage of title.

See Epic Metals Corp. & Subs. v.

Commissioner, T.C. Memo. 1984-322, affd. without published

opinion 770 F.2d 1069 (3d Cir. 1985).

Petitioners also rely on Simon v. Commissioner, 176 F.2d 230

- 11 (2d Cir. 1949), affg. a Memorandum Opinion of this Court, as

support for their contention that AEI, as a broker or agent, is

not required to maintain inventories.

As we stated in Epic

Metals Corp. & Subs. v. Commissioner, supra, the U.S. Court of

Appeals for the Second Circuit decided Simon on the ground that

the taxpayer was properly characterized as a broker or commission

merchant because his margin for profits and operating expenses

was the 5-percent "commission" or "trade discount" allowed him by

the manufacturers.

In the present case, as in Epic Metals, AEI

does not derive its profit from commissions or trade discounts.

Rather, AEI's profit is determined by the difference between the

price it pays vendors or subcontractors for the electronic

materials and the price at which it sells the electronic

materials to its customers.

Thus, the facts of this case are

fundamentally different from those of Simon.

See Epic Metals

Corp. & Subs. v. Commissioner, supra.

Based on our review of the entire record, we hold that AEI

had title to the electronic materials and is required to maintain

inventories.

Indeed, AEI determined gross income by subtracting

COGS from total sales.

We conclude that AEI is required to use

the accrual method of accounting, and respondent did not commit

an abuse of discretion under section 446.

1(c)(2)(i), Income Tax Regs.

See sec. 1.446-

- 12 In reaching all of our holdings herein, we have considered

all arguments made by the parties, and to the extent not

mentioned above, we find them to be irrelevant or without merit.

To reflect the foregoing,

Decisions will be entered

under Rule 155.