Peninsula Steel Prods. v. Comm'r of Internal Revenue
| Decision Date | 17 June 1982 |
| Docket Number | Docket No. 11012-77. |
| Citation | 78 T.C. 1029 |
| Parties | PENINSULA STEEL PRODUCTS v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
Petitioner manufactures pollution control equipment under short-term and long-term purchase orders or contracts. Petitioner maintains raw materials and work-in-process inventory accounts. During the manufacturing process, costs of raw materials, labor, and overhead are accumulated in work-in-process inventory accounts. When performance is completed under a purchase order or contract, income is recognized and the associated costs are relieved from inventory and charged to cost of goods sold. A significant portion of the work performed by petitioner during the years in issue related to long-term contracts requiring advance payments during the course of manufacturing.
During the years in issue, petitioner used LIFO to value inventories. Respondent asserted deficiencies on the ground that taxpayers who report on the completed contract method may not account for costs of long-term contracts using inventories and, in particular, using LIFO. Held:
1. Petitioner failed to prove that the completed contract method was not used to determine income from long-term contracts.
2. Petitioner's method of using inventories to compute costs of long-term contracts clearly reflects income and accordingly respondent may not require petitioner to change its method of accounting for long-term contracts.
3. Petitioner's method of valuing inventories using LIFO (sec. 472, I.R.C. 1954) also clearly reflects income under the circumstances of the instant case. Clarence J. Ferrari, Jr., and Clifford M. Govaerts, for the petitioner.
Thomas G. Schleier, for the respondent.
Respondent determined deficiencies in Federal corporation income taxes against petitioner (see note 4 infra) as follows:
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¦TYE June 30— ¦Deficiency ¦
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¦ ¦ ¦
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¦1974 ¦$189,267 ¦
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¦1975 ¦432,421 ¦
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After concessions1 by the parties, the issues for decision are:
(1) Whether petitioner reported income from long-term contracts using the completed contract method of accounting or the accrual shipment method;
(2) Whether respondent may change petitioner's method of accounting for long-term contracts, which accumulates manufacturing costs in inventory accounts; and
(3) Whether respondent may change petitioner's method of accounting for inventories from the last-in, first-out (LIFO) inventory valuation method (sec. 4722 ).
Some of the facts have been stipulated; the stipulations and the stipulated exhibits are incorporated herein by this reference.
Petitioner is a California corporation. When the petition in this case was filed, petitioner's principal place of business was in San Jose, Calif.
In 1956, petitioner was established as a wholly owned subsidiary of Ferry Steel Products, a manufacturer of steel equipment. Pursuant to the reorganization of Ferry Steel Products, 100 percent of petitioner's stock was distributed in 1968 to three individuals of the Stirm family. In 1969, petitioner formed a wholly owned subsidiary, Monotech Corp. (hereinafter sometimes referred to as Monotech), which is organized under California law. Petitioner and Monotech filed consolidated Federal corporation income tax returns from 19703 through the years in issue.4
During the years in issue, petitioner's and Monotech's principal business activity was the manufacture and sale of air pollution control equipment. The principal products manufactured by petitioner and Monotech were components of large pieces of equipment called “precipitators,” used in industrial air pollution control systems.5 Petitioner and Monotech also manufactured rock drills, antennas for radar equipment, and conveyor systems.
Petitioner's and Monotech's entire manufacturing process is performed at plants in San Jose, Calif., and San Antonio, Tex. All equipment and employees utilized in the manufacturing process are petitioner's or Monotech's.
Petitioner's and Monotech's products are typically manufactured pursuant to the terms of a purchase order. The purchase order usually contains a specific identification of the goods to be manufactured, the quantities, the price, the payment terms, the destination, and the shipment date. The purchase order may provide for performance of the contract to extend over more than 1 taxable year; petitioner's and Monotech's products generally do not take more than 15 months to manufacture. During the years in issue, a small percentage of purchase orders (probably less than 10 percent) provided for advance payments; they represented a significant portion of work performed by petitioner and Monotech.
The principal raw material used in the manufacture of products by petitioner and Monotech is “raw” steel in the form of coil, plate shape, and structural shape. Typically, the manufacturing process involves bending, rolling, punching, and cutting the raw steel into components in the needed shapes. Because of their enormous size, petitioner's and Monotech's precipitators are manufactured in stages and are shipped in kit form. The product is assembled at the customer's site and is not accepted until after it has been put together at the site. On occasion, petitioner and Monotech are required to perform additional work after the product reaches the site; such additional work might result in back charges. Petitioner and Monotech are responsible for acceptance of the product by the customer.
Petitioner's and Monotech's general purchasing policy for raw steel is to make frequent purchases, taking into consideration market fluctuations in price and in supply, as well as the desirability of maintaining good relationships with steel mills. Petitioner and Monotech usually maintain substantial stock of raw steel on hand. At times, petitioner and Monotech purchase raw steel for a particular purchase order. In that event, the job number would be designated on petitioner's or Monotech's order sent to the steel supplier. However, depending on the need for raw steel in petitioner's or Monotech's other jobs, the steel so designated might not actually be used on that job.
Because of petitioner's and Monotech's purchasing policy for raw steel and stock of raw steel on hand, petitioner and Monotech have a reputation in their industry of having a continuous supply of raw steel, thereby enabling them to manufacture orders in times of steel shortages, such as occurred during the years in issue. As a result, petitioner's and Monotech's competitive positions were enhanced. The price of raw steel fluctuated widely in the years in issue, with prices generally increasing. Approximately 60 to 65 percent of the raw steel purchased by petitioner and Monotech during the years in issue was purchased for stock on hand, and substantial amounts of raw steel were maintained on hand. Thus, it was necessary for petitioner and Monotech to maintain physical inventories of raw steel on hand.
Petitioner and Monotech maintained inventory accounts for raw materials and work in process. During the manufacturing process, costs of raw materials, labor, and overhead attributable to unfinished purchase orders (or long-term contracts) were accumulated in work-in-process inventory accounts. When performance was completed under a purchase order (or long-term contract), income was recognized and the associated costs were relieved from the inventory accounts and charged to cost of goods sold. Petitioner and Monotech did not recognize income upon receipt of advanced payments under a purchase order or long-term contract. (See note 8 and accompanying text infra.) Petitioner first adopted this method of accounting for 1969, and has since consistently used it.
Schedules attached to petitioner's Federal corporation income tax return for 1969,6 and to petitioner's and Monotech's consolidated Federal corporation income tax returns for 1970, 1971, 1972, 1973, 1974, and 1975, indicate that cost of goods sold claimed therein was calculated by adding materials purchased, direct labor, and overhead to beginning inventory (including work-in-process inventory) and subtracting ending inventory (including work-in-process inventory). Thus, the costs attributable to a purchase order (or long-term contract) reduced gross receipts/sales (in computing gross profit) in the year of completion.
For 1970, 1971, 1972, and 1973, petitioner and Monotech used the lower of cost (determined on a first-in, first-out (FIFO) basis) or market method to value inventories.7 For the years in issue, petitioner and Monotech used the last-in, first-out (LIFO) method to value inventories. A Form 970 (Application to Use LIFO Inventory Method) was filed with petitioner's and Monotech's consolidated income tax return for 1974, properly electing to use LIFO to value inventories. That application indicates that petitioner and Monotech used the dollar-value method based on one natural business unit to determine the value of LIFO inventories and the most recent purchases method to determine the cost of the goods in closing inventories in excess of those in opening inventories. A schedule showing raw materials and work-in-process inventories for 1972, 1973, and 1974 was attached to the Form 970.
Total ending inventory balances shown on the balance sheets attached to petitioner's income tax return for 1969 and to petitioner's and Monotech's consolidated income tax returns for 1970 through 1975 are indicated in table 1.
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¦TABLE 1 ¦
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