Do service providers have inventoriable merchandise?

• Author: Smith, Sharilee

Whether materials used in a service business are merchandise within the meaning of Regs. Sec. 1.471-1 has been the subject of considerable debate lately, particularly in the Tax Court. The determination of whether materials are merchandise or supplies is significant; a taxpayer that holds merchandise and, thus, inventory is required to use the accrual method of accounting for purchases and sales, even if it is not otherwise required by virtue of the Sec. 448(c) $5 million gross receipts test.

The issue arises most often in service provider contexts, because they frequently transfer tangible personal property to customers in connection with services rendered. The issue, therefore, is what is the taxpayer actually selling? If the taxpayer is deemed to be selling services, with the property transfer an incidental or insignificant aspect of the transaction, the materials will most likely be characterized as supplies. If, however, the transfer of property is deemed to be an important part of the transaction, the taxpayer will likely be required to maintain inventories and, thus, use the accrual method of accounting for purchases and sales.

There is an expansive body of caselaw on the subject of whether materials are supplies or inventory, but some recent Tax Court cases highlight the difficulty both the IRS and courts have had in properly and uniformly classifying materials based on the nature of a particular transaction. This has led to two opposing but equally undesirable consequences--taxpayers improperly using the cash method and the IRS improperly requiring taxpayers to use the accrual method.

In Osteopathic Medical Oncology and Hematology, P.C., 113 TC No. 26 (1999), the taxpayer specialized in the treatment of cancer through chemotherapy. As part of the chemotherapy regime, drugs were administered to patients, but the patient was unable to select the type or quantity of drugs administered. Further, patients were only administered the drugs as part of the overall chemotherapy services. Therefore, the Tax Court ruled that drugs used in the taxpayer's chemotherapy medical practice were supplies, not inventory.

Among the factors that led to the court's conclusion were the fact that an individual, by virtue of state law, was unable to purchase the drugs and unable to direct how the drugs were administered. In addition, the necessity for the specialized expertise provided by the taxpayer to administer the drugs to the patient meant that the...