Ohio Periodical Distributors, Inc. v. C.I.R.

• Decision Date: 29 January 1997
• Docket Number: No. 96-1136,96-1136
• Parties: -719, 97-1 USTC P 50,180, 25 Media L. Rep. 1337 OHIO PERIODICAL DISTRIBUTORS, INC., formerly known as Scott Krauss News Agency, Inc.; Ronald E. Scherer Trust and Linda S. Hayner Trust, persons other than the tax matters person, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Sixth Circuit

Page 322

105 F.3d 322

79 A.F.T.R.2d 97-719, 97-1 USTC P 50,180,

25 Media L. Rep. 1337

OHIO PERIODICAL DISTRIBUTORS, INC., formerly known as Scott Krauss News Agency, Inc.; Ronald E. Scherer Trust and Linda S. Hayner Trust, persons other than the tax matters person Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 96-1136.

United States Court of Appeals Sixth Circuit.

Argued Dec. 3, 1996.

Decided Jan. 29, 1997.

Daniel M. Davidson (argued and briefed), John F. Wester, Griffith L. Green, Sidley & Austin, Washington, DC, for Ohio Periodical Distributors, Inc., Ronald E. Scherer Trust, Linda S. Hayner Trust.

Gary R. Allen, Acting Chief (briefed), John A. Dudeck (argued), Teresa McLaughlin, U.S. Department of Justice, Appellate Section Tax Division, Washington, DC, for C.I.R.

Before: MERRITT, KENNEDY, and GUY, Circuit Judges.

GUY, J., delivered the opinion of the court, in which MERRITT, J., joined. KENNEDY, J. (pp. 327-29), delivered a separate dissenting opinion.

RALPH B. GUY, Jr., Circuit Judge.

Petitioner, Ohio Periodical Distributors, Inc., a subchapter S corporation, appeals judgment for the respondent, Commissioner of Internal Revenue, in taxpayer's petition for readjustment action. ¹ The sole issue in this case involves the validity of Treas. Reg. § 1.458-1(g), interpreting I.R.C. § 458. Section 458 authorizes distributors and publishers of periodicals to exclude from gross income the income earned for magazines and paperbacks that are returned for credit shortly after the end of the tax year in which the income was received. Petitioners contend that Treas. Reg. § 1.458-1(g), which requires taxpayers electing to exclude income under § 458 to reduce excluded income by the value of the cost of goods sold where the taxpayer is fully credited for the returned merchandise, is inconsistent with § 458. Based on our review of the record and the arguments presented, we conclude that the tax court properly determined that the regulation is valid, and we affirm.

I.

Ohio Periodical Distributors, Inc. (taxpayer) is a wholesale distributor of magazines and paperback books. Taxpayer is an Ohio corporation with its principal place of business in Dublin, Ohio. Consistent with industry practice, taxpayer sells magazines and paperbacks to its retail customers in quantities in excess of customers' expected sales. The excess merchandise, nevertheless, is used by the retail customers for display purposes as well as to satisfy unexpected consumer demand. Taxpayer and its suppliers agree to take back for credit the unsold product, known as "returns." Thus, taxpayer gives its retail customers a credit and receives a credit from its publisher suppliers.

Prior to changes in the tax laws, accrual-method taxpayers like Ohio Periodical could reduce income to reflect returned items only in the taxable year that the items were actually returned. At the same time, generally accepted methods of accounting allowed them to record sales at the time merchandise was shipped and to establish an offsetting reserve for estimated returns.

Congress viewed the disparity between tax accounting practices and generally accepted accounting methods as unfair and as inaccurately reflecting taxpayers' income. See S.REP. NO. 95-1278, at 4 (1978). Consequently, in 1978, it enacted I.R.C. § 458. That provision allows taxpayers who use the accrual method of accounting to exclude income from returns, also known as qualified sales, see id. § 458(b)(5), from gross income even though the returns are received at the beginning of the following tax year. By illustration, a distributor who sells 100 books in tax year one but receives 20 back within the first few months of tax year two could report gross income for tax year one based on only 80 books.

In 1982, Ohio Periodical elected to apply I.R.C. § 458 to its sales. Two years later it became a subchapter S corporation, allowing it to pass through its income and losses to shareholders. See id. § 1361.

On August 31, 1984, respondent promulgated proposed regulations construing § 458. These regulations were finally adopted on August 26, 1992, effective retroactively to August 31, 1984. See Certain Returned Magazines, Paperbacks or Records, 57 Fed.Reg. 38,595 (1992) (to be codified at Treas. Reg. § 1.458-1). In pertinent part, those regulations require "a cost of goods sold offset against sales revenue in determining the amount of income excluded from gross income under section 458." Id. at 38,596. The offset is only required "in situations in which the taxpayer holds returned merchandise for resale or is entitled to a credit from its supplier. In the latter case, the amount of the required adjustment is equal to the amount of the taxpayer's credit from its supplier." Id.

Commentators to the proposed regulations argued against the cost of goods sold adjustment. Id. The Commissioner rejected these arguments, however, on the ground that the exclusion is determined on the basis of gross income. Gross income, as it applies to manufacturing or merchandising trades or businesses, is determined by subtracting cost of goods sold from sales revenue. Id. (citing Treas. Reg. § 1.61-3(a)). Thus, any adjustment to gross income based on sales revenue concomitantly requires an adjustment to cost of goods sold. The Commissioner further relied upon I.R.C. § 446, which provides that accounting methods "clearly reflect income." Id. § 446(b).

Ohio Periodical, in electing to apply § 458, excluded income from returns from its gross income, but did not make any adjustment to cost of goods sold. By illustration, if it sold 100 books in tax year one at $1/each with a cost of goods sold of $0.75 per book and received 20 books back during the applicable return period in tax year two, it reported gross income of $5: ((100 X $1)-(100 X .75)-(20 X $1)).

In March 1994, the Commissioner of Internal Revenue issued to taxpayer two notices of final S corporation administrative adjustment for tax years 1985-1988. The computations in those notices recalculated taxpayer's calculations to include adjustments to cost of goods sold to reflect greater gross income. Using the above illustration, by example, taxpayer should have reported gross income of $20, instead of $5: (100 X $1)-(100 X .75)-(20 X $1) + (20 X .75).

In response, petitioners filed a petition for readjustment. In support, petitioners argued that Treas. Reg. § 1.458-1(g) is inconsistent with I.R.C. § 458. ² The tax court rejected petitioners' challenge. Ohio Periodical Distrib., Inc. v. Commissioner, 68 T.C.M. (RIA) p 95,496, 1995 WL 605422 (Oct. 16, 1995). The court noted that petitioners' counsel had represented another petitioner on this same issue in Hachette USA, Inc. v. Commissioner, 105 T.C. 234, 1995 WL 563984 (1995), aff'd, 87 F.3d 43 (2d Cir.1996), presenting a substantially verbatim argument. 68 T.C.M. (RIA) at 95-3117. Consequently, the court followed its earlier decision in Hachette, and upheld the regulation. Petitioners now appeal.

II.

We thus consider whether Treas. Reg. § 1.458-1(g) reflects a proper construction of I.R.C. § 458. The United States Supreme Court, in Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837, 104 S.Ct. 2778, 81 L.Ed.2d 694 (1984), set forth the standard for assessing challenges to regulations:

When a court reviews an agency's construction of the statute which it administers, it is confronted with two questions. First, always, is the question whether Congress has directly spoken to the precise question at issue. If the intent of Congress is clear, that is the end of the matter; for the court, as well as the agency, must give effect to the unambiguously expressed intent of Congress. If, however, the court determines Congress has not directly addressed the precise question at issue, the court does not simply impose its own construction on the statute, as would be necessary in the absence of an administrative interpretation. Rather, if the statute is silent or ambiguous with respect to the specific issue, the question for the court is whether the agency's answer is based on a permissible construction of the statute.

Id. at 842-43, 104 S.Ct. at 2781-82 (citations and footnotes omitted).

As an initial matter, therefore, we consider whether "Congress has directly spoken" to whether adjustments must be made to cost of goods sold for returns. Section 458 provides in pertinent part as follows:

Exclusion from gross income.--A taxpayer who is on an accrual method of accounting may elect not to include in the gross income for the taxable year the income attributable to the qualified sale of any magazine, paperback, or record which is returned to the taxpayer before the close of the merchandise return period.

I.R.C. § 458(a). Based on this language, we conclude there is simply nothing in the quoted language or in any other part of the statute that addresses adjustments for cost of goods sold. At most, petitioners argue that the Commissioner's interpretation requiring adjustment is "inconsistent" with the statute's language referring to the "amount excluded," see id. § 458(b)(6), or the "dollar amount of returned merchandise," see id. § 458(e)(2).

I.R.C. § 458(b)(6) provides as follows:

Amount excluded.--The amount excluded under this section with respect to any qualified sale shall be the lesser of--

(A) the amount covered by the legal obligation described in paragraph (5)(A), or

(B) the amount of the adjustment agreed to by the taxpayer before the close of the merchandise return period.

I.R.C. § 458(b)(6). Petitioners argue that this language controls subsection (a)'s reference to exclusion from gross income. While we agree that the language relates back to subsection (a), it is hardly clear that "the amount excluded under this section with respect to any qualified sale" precludes any adjustment to that amount for cost of goods sold for purposes of calculating "gross income...