Paving contractor was not required to use accrual method.

• Author: Fiore, Nicholas J.

The T Corporation provides paving services. When bidding on a contract, T prices the asphalt at cost. Another company ships the asphalt just before a paving job. The physical properties of emulsified asphalt demand that T use it within several hours of shipment; otherwise, it hardens and becomes useless. Once T completes a job, it generally receives payment within 10-30 days of billing.

T used the cash method of accounting, deducting the cost of the asphalt for a paving job immediately on paying for it. T recognized income for a job when it received payment.

The IRS determined that the asphalt was "merchandise" under Regs. Sec. 1.471-1, such that T had inventories and thus was required to use the accrual method. The Tax Court concluded that the Service had abused its discretion, and the Court of Appeals (opinion Tashima, J.) affirm.

Under Regs. Sec. 1.471-1, a taxpayer must use inventories and the accrual method of accounting when the "production, purchase or sale of merchandise is an income-producing factor," to "reflect taxable income correctly." The rationale behind Sec. 471 and Regs. Sec. 1.471-1 is straightforward: If a taxpayer holds sizable inventories for resale, under a cash method, it could defer income by purchasing all of its goods at the end of one year, taking deductions for the purchase at that time, and then selling the goods in subsequent years, without recognizing income until receiving proceeds from sales.

This rationale does not apply to paving companies, as they must lay asphalt immediately on purchase. Thus, we agree with the Tax Court that asphalt is not merchandise and T should not have been required to use the accrual method because Regs. Sec. 1.471-1 does not apply.

The IRS's argument that T failed to adopt an accounting method that clearly reflected income is wholly unrelated to the inventory issues of Regs. Sec. 1.471-1. Rather, the disparity in taxable income that the Service calculated for the paving jobs stems from the mismatch of deductions and income attributable to the fact that T had outstanding accounts receivable at the end of each tax year that were not immediately recognized under the cash method. These accounts receivable did not stem from T's misuse of inventories, but were merely run-of-the-mill debts for collection. The failure of a taxpayer to include accounts receivable in taxable income is not a sufficient basis for the IRS to require the use of the accrual method. We thus agree with the Tax...