Sierracin Corp. v. Comm'r of Internal Revenue, Docket No. 28569-83.
| Decision Date | 09 March 1988 |
| Docket Number | Docket No. 28569-83. |
| Citation | 90 T.C. No. 27,90 T.C. 341 |
| Parties | SIERRACIN CORPORATION, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
Petitioner used the completed contract method to account for income from several of its manufacturing divisions. HELD: (1) Items produced by two of petitioner's divisions were ‘unique items‘ within the meaning of section 1.451-3(b)(1)(ii), Income Tax Regs., and petitioner's use of the completed contract method to account for income from these two divisions consequently was proper; and (2) contracts entered into by those two divisions need not be severed by delivery because each delivery was not independently priced. HELD FURTHER: Respondent's determinations as to petitioner's other divisions sustained. McGee Grigsby, Linda F. Powers, and Joseph A. DeFrancis, for the petitioner.
Charles O. Cobb and Ross W. Paulson, for the respondent.
Respondent determined deficiencies in petitioner's corporate income tax as follows:
+----------------+
¦Year¦Deficiency ¦
+----+-----------¦
¦1976¦$519,726 ¦
+----+-----------¦
¦1977¦359,422 ¦
+----+-----------¦
¦1979¦421,040 ¦
+----+-----------¦
¦1980¦1,361,312 ¦
+----------------+
After concessions, the issues for decision are (1) whether, during the years in issue, petitioner was entitled to use the completed contract method of accounting for three of its divisions, and, if so, (2) whether certain contracts must be severed by delivery in order to clearly reflect income.
Some of the facts have been stipulated, and the facts set forth in the stipulation are incorporated in our findings by this reference. Although set forth in the present tense, facts found are determined only as of the years in issue. Petitioner, Sierracin Corporation, is a Delaware corporation with its principal offices and principal place of business in Sylmar, California.
Petitioner has five product divisions that are relevant to this case: the Sylmar division, the Transtech division, the Magnedyne division, the Harrison division, and the Thermal Products division. The Sylmar division (Sylmar) manufactures aircraft transparencies. The Transtech division (Transtech) manufactures laminated security glazings. The Magnedyne division (Magnedyne) manufactures electromagnetic devices, principally DC torque motors, DC (direct current) tachometers, low inertia motors, and tachometers. The Harrison division manufactures hydraulic seals and fittings. The Thermal Products division manufactures heating elements, heat controllers and related products. Petitioner has not disputed respondent's determination with respect to Harrison and Thermal Products.
For financial purposes, petitioner reports sales and cost of sales at the time of shipment with losses recognized at the time such losses are identified. Prior to 1979, petitioner used the same method for reporting sales and cost of sales for tax purposes as it used for financial purposes.
In 1979, petitioner applied for permission from the Internal Revenue Service (IRS) to change to the completed contract method of accounting. Permission was granted in a letter stating that ‘the determination as to whether or not the taxpayer's contracts fall within the definition of section 1.451-3 of the regulations * * * »is† subject to verification of the District Director upon examination of its return.‘
On its 1979 Federal income tax return, petitioner employed the completed contract method of accounting for long-term contracts that were entered into in or prior to 1979 and that had not been completed by the end of that year. Petitioner continued to use the completed contract method in 1980 and 1981. The conversion from the accrual method to the completed contract method was reflected on the Schedule M-1 to petitioner's 1979, 1980, and 1981 returns.
Petitioner's Sylmar division manufactures advanced technology transparencies (windshields, canopies, and windows) for military and commercial aircraft. Although some aircraft transparencies are relatively simple products, the Sylmar division does not manufacture such transparencies.
In generic terms, each transparency consists of three and sometimes four major components. All transparencies made by Sylmar have structural plies, interlayers, and coatings. Some transparencies also have face plies. The structural plies determine the shape and strength of the transparency. Most transparencies have two or more structural plies. The interlayers, which have adhesive qualities, enable the structural plies to be laminated together. The coatings are applied to surfaces of the structural plies and the interlayers for a wide variety of reasons, including adhesion, hardness, heat conductivity, electrical conductivity, abrasion resistance, ultraviolet and infrared radiation protection, and radar deflection. The face plies are attached to the exterior of the transparency for additional strength or abrasion protection.
The transparencies manufactured by Sylmar are vital structural components of the aircraft in which they are installed. Failure of the transparency can cause the aircraft itself to fail. Accordingly, the performance requirements placed on the transparency, and hence its design, are functions of the mission of the aircraft. As the mission of the aircraft becomes more complex, so too do the design requirements of the transparency.
Each transparency within a particular aircraft performs different functions and has individual design requirements. For example, if an aircraft has a right and left forward windshield and a right and left side panel, each of the four transparencies must be individually designed. In many instances the difference in design requirements will result in there being different manufacturers for different transparencies within the same aircraft.
The design of a transparency begins with preliminary discussions between Sylmar and the aircraft manufacturer, proceeds through a preproduction and prototype phase, and culminates in the award of a manufacturing contract. The first formal piece of paper generated in an aircraft transparency program is a request for quote, or RFQ, directed by the aircraft manufacturer to Sylmar's marketing department. The RFQ typically contains information regarding the specifications for the transparencies and the anticipated quantities. Upon receipt of an RFQ, Sylmar initiates a TSR (Technical Sales Request), an internal document which is sent to all groups within the company that are affected by the potential contract. The TSR outlines the proposed transparency production program and asks all affected areas in the company to respond with information that will allow Sylmar to submit a proposal to the customer.
The RFQ submitted by the customer to Sylmar outlines the size of the total production program as defined by the customer. Sylmar's response is based upon the customer's definition of the size of the total program. Sylmar's cost estimates and pricing proposals are dependent upon the size of the program and the rate of production as defined by the customer.
Sylmar and the customer then typically enter a contract that establishes the basic terms for the entire program and defines the framework for doing business for a period of years, often 5 or more. The terms of this contract may or may not contain price terms. If prices are set forth, those prices are dependent on the customer's definition of the entire program. Typically, delivery schedules for transparencies are arranged to accommodate the customer's production rate for the aircraft. The price of transparencies is based on the total quantity called for in a program, and is not based upon the quantity being shipped to the customer in any specific delivery. If the price were determined on a per shipment basis, the price for the transparencies would be substantially higher.
Concurrently with the execution of the basic contract, the customer usually releases the initial purchase order under the contract. This purchase order contains fixed price terms that reflect the customer's initial definition of the size of the program and the initially estimated rate of production. Most production programs involve a single basic contract followed by the release of multiple purchase orders. Typically, purchase orders cover a time period that is shorter than the period covered by the underlying contract because it is not practical to establish fixed prices for the entire anticipated duration of a production program.
Upon the receipt of a purchase order, Sylmar issues an internal work order that reflects the terms and conditions of the purchase order. The work order is sent to every group within the company that will be involved in the production of the transparency. The work order constitutes authorization to commence work and upon receipt everyone acts in reliance on it. Sylmar maintains no inventory; it does not commence production of transparencies prior to the receipt of purchase orders from customers.
Throughout a program Sylmar is in constant contact with the customer. Subsequent purchase orders based upon these ongoing discussions and negotiations will be released by the customer on a periodic basis. These purchase orders reflect a mutually agreed upon assessment of the progress of the program. Each such purchase order contains fixed price and delivery terms and the actions taken by Sylmar are identical to those taken in response to the initial purchase order: no work is commenced prior to its receipt; upon receipt, a work order is issued; upon issuance of the work order, all affected groups in the company act in reliance thereon. For Federal income tax purposes, Sylmar treats each work order as a contract.
The preproduction and prototype — also known as ‘development‘ — phase for a transparency of the type manufactured by Sylmar normally takes 2 or more years and involves between two...
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