Consolidated Manufacturing Inc. v. C.I.R.

• Citation: 249 F.3d 1231
• Decision Date: 08 May 2001
• Docket Number: PETITIONERS-APPELLANTS,RESPONDENT-APPELLEE,No. 98-9027,98-9027
• Parties: (10th Cir. 2001) CONSOLIDATED MANUFACTURING, INC.; M.P. LONG LIVING TRUST; MERL PHILIP LONG, TRUSTEE, TAX MATTERS PERSON,, v. COMMISSIONER OF INTERNAL REVENUE,
• Court: U.S. Court of Appeals — Tenth Circuit

Page 1231

249 F.3d 1231 (10th Cir. 2001)

CONSOLIDATED MANUFACTURING, INC.; M.P. LONG LIVING TRUST; MERL PHILIP LONG, TRUSTEE, TAX MATTERS PERSON, PETITIONERS-APPELLANTS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT-APPELLEE.

No. 98-9027

UNITED STATES COURT OF APPEALS TENTH CIRCUIT

May 8, 2001

Appeal from the United States Tax Court (T.C. No. 6176-96) [Copyrighted Material Omitted] Eric S. Namee (James Scott MacBeth with him on the briefs), of Hinkle Elkouri Law Firm, Wichita, Kansas, for Petitioners-Appellants.

Charles Bricken (Jonathan S. Cohen with him on the brief), Attorneys, Tax Division, Department of Justice, Washington, D.C., for Respondent- Appellee.

Before Tacha, Chief Judge, Seymour and Ebel, Circuit Judges.

Ebel, Circuit Judge

This case involves financial accounting issues in the context of income taxation. Consolidated Manufacturing purchases used car parts, called "cores," rebuilds the cores with new components, and then sells them. Consolidated uses a pricing system that encourages its customers for the rebuilt products to send a replacement core back to it. In this way, Consolidated ensures a continuous supply of its primary raw material - the cores. The price that the company agrees to pay its customers for such replacement cores is called the "core amount" (referred to herein as "core amount" or "customer core amount"). For tax purposes, Consolidated uses the first-in, first-out (FIFO) accounting method for its inventory of these cores, but it uses the last-in, first-out (LIFO) method for its other inventory expenses - labor, overhead, and new parts. Cores in inventory that have already been integrated into a finished rebuilt part are valued by the company at the price the company would pay to purchase such a core from a professional core supplier. All other cores in inventory, either in raw inventory or integrated into partly finished products, are valued at scrap metal prices.

After auditing the company's tax returns, the Commissioner of Internal Revenue determined that several of these accounting procedures were improper. The Commissioner ruled that the company must use the FIFO method for all of its expenses, and that the inventory of cores should be valued at the customer core amounts rather than as scrap metal or at supplier core prices. Consolidated challenged these determinations, and the tax court affirmed the Commissioner's decisions. We hold that (1) the Commissioner correctly determined that Consolidated's mixed use of LIFO and FIFO was improper; (2) it was not an abuse of discretion for the Commissioner to order Consolidated to use FIFO for all inventory, rather than LIFO; and (3) the customer core amounts reflect the cost, but not the market price, of the inventory of cores. Because Consolidated chose to use the lower of cost or market price to value its inventory of cores, we remand for further findings on the market prices of the cores. We therefore AFFIRM in part, REVERSE in part, and REMAND.

BACKGROUND

I. Customer Cores

Consolidated remanufactures used car parts. The company acquires worn parts strips them down to a reusable "core," and then rebuilds them with new components. These rebuilt parts are sold to its customers, Ford dealers.

The used core is the key ingredient in the remanufacturing process. Although Consolidated buys some of its cores from professional core suppliers, it acquires most from its customers. The company uses its pricing method to ensure that it has a constant supply of cores from its customers. When it sells a remanufactured part, Consolidated charges both an "exchange amount" and a "core amount." These "exchange" and "core" amounts are used in Consolidated's price lists, invoices, and financial accounting books. The customer core amount is credited back if the customer sends a core of similar type to Consolidated for the rebuilt core that it has purchased from Consolidated. This method of obtaining used cores primarily from customers for the rebuilt parts is a standard practice in the industry.

Consolidated accepts these returned cores on the basis of a visual inspection by the pick-up driver. Even if the core later turns out to be unusable, the customer is credited for the full customer core amount. The company also sometimes accepts cores with missing parts or other defects, but at less than full credit. Consolidated's invoices provide that to receive credit a core has to be returned within a given time period, such as sixty days, but in practice the company accepts cores even after these deadlines, and even if the core has become obsolete. Gregory Gordon, the president of Consolidated, testified that the company sometimes accepts a core that does not match the type delivered to the customer, although in that case the company does not refund the full customer core amount, but rather pays the customer the price that a professional core supplier would charge for such a core. This price is usually much less than the customer core amount, which is purposely set high by Consolidated to induce customers to return their used parts.

During 1990 and 1991, approximately 77% to 97% of sales (depending on the type of part) resulted in the customer's providing a core back to Consolidated. Of the consumer cores that Consolidated accepted, about 18% to 37% had defects and were not rebuildable. Unusable cores are sold as scrap metal.

Gordon testified that Consolidated uses this method of obtaining cores because it enables the company to acquire customer cores at "virtually no cost." The delivery trucks are returning to Consolidated anyway, so the return loads with customer cores are freight-free.

Consolidated sets the price for the customer core amount on the basis of several factors, including the supply of cores in the used- parts market and the demand for the rebuilt part. Gordon testified that the company considers the current inventory levels of the type of core involved in the transaction and the cost of purchasing that type of core from a core supplier. To induce the customer to return a core, the core amount reflects an amount above the price that a professional core supplier would charge.

II. Supplier Cores

Consolidated buys some of its used cores from third-party core suppliers, businesses that specialize in supplying cores to meet specific needs. Jimmy Bishop, president of Consolidated's largest supplier, testified that suppliers buy used parts from salvage yards, car manufacturers, or consumers on the basis of a price schedule that they set. The suppliers inspect these cores and then sell them to remanufacturers like Consolidated at somewhat higher prices than they pay to buy them, but for less than the customer core amount that Consolidated is willing to credit its customers when they return cores in conjunction with the purchase of rebuilt parts.

Unlike customer cores, supplier cores are guaranteed to be usable. If Consolidated discovers a defect in a supplier core during the rebuilding process, that core can be returned to the supplier for credit. Because supplier cores are ordered to meet specific needs, they generally remain in Consolidated's inventory for a brief period of time. Consolidated's inventory, therefore, consists almost entirely of customer cores.

III. Consolidated's Accounting Practices

Manufacturing businesses must take inventory each year for tax purposes. See I.R.C. § 471. Through its choice of an accounting method for inventory, a taxpayer can manipulate its reported income and therefore its tax burden. Consequently, the tax code requires that the method both "conform[] as nearly as may be to the best accounting practices" and "clearly reflect[] the income." Id. Here, Consolidated could change accounting methods only with the consent of the Commissioner. See I.R.C. § 446(e).

One of two assumptions about the flow of goods is commonly made in calculating inventory: first-in, first-out (FIFO) or last-in, first-out (LIFO). These assumptions do not track the physical movement of actual goods, but rather are used to simplify the calculations. Under the FIFO method, the taxpayer assumes that any goods sold were the oldest in stock, so the goods remaining in inventory are the most recently procured or produced. Under the LIFO method, the reverse is assumed: The most recently procured or produced goods were sold first, and the inventory consists of the oldest remaining goods. FIFO is the default rule for tax purposes, but under some circumstances a company may opt to use the LIFO method instead. See Treas. Reg. § 1.471-2(d).

Since 1980, Consolidated has used the LIFO method for its labor, overhead costs, and new parts inventories. However, the company continues to use the FIFO method for its inventory of cores. It also uses the "component of cost" method: Rather than assigning a value to each item in its inventory, Consolidated totals the units of each raw material, labor, overhead, and other costs represented by its inventory. Thus, the cost of a finished product is calculated as the sum of its materials and other costs of production.

Items inventoried under LIFO must be valued at cost, see I.R.C. § 472(b)(2), but Consolidated has elected to value its used cores inventoried under FIFO at the lower of cost or market price as permitted by Treas. Reg. § 1-471-2(c). For tax and insurance purposes, it values the cores in its remanufactured finished products at the price that a core supplier would charge for that core, rather than at the customer core amount. The company values its inventory of cores that either have not yet been integrated into a remanufactured part or have been only partly integrated into a work in process at scrap metal prices. However, the tax court found that for its financial reports, Consolidated values its entire inventory of customer cores at supplier core prices.

IV. Administrative and Judicial Proceedings

The Commissioner audited Consolidated's returns for 1990 and 1991 and...