Space Controls, Inc. v. CIR

• Decision Date: 08 August 1963
• Docket Number: No. 19818.,19818.
• Citation: 322 F.2d 144
• Parties: SPACE CONTROLS, INC., Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Court of Appeals — Fifth Circuit

322 F.2d 144 (1963)

SPACE CONTROLS, INC., Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 19818.

United States Court of Appeals Fifth Circuit.

August 8, 1963.

Leland E. Fiske, Dallas, Tex., for petitioners.

Louis F. Oberdorfer, Asst. Atty. Gen., Lee A. Jackson, Meyer Rothwacks, Richard J. Heiman, Attys., Dept. of Justice, Crane C. Hauser, Chief Counsel, John M. Morawski, Atty., Internal Revenue Service, Joseph Kovner, Atty., Dept. of Justice, Washington, D. C., for respondent.

Before RIVES, JONES and BROWN, Circuit Judges.

JOHN R. BROWN, Circuit Judge.

This appeal from the Tax Court has to do with inventories and the use of the lower of cost or market option. As the manufacturer-Taxpayer sees it, the question is whether the Taxpayer is "entitled to a deduction in the fiscal year ended February 28, 1957, for the amount by which the cost of materials and work in process for a specific Government contract, in inventory at the end of the fiscal year, exceeded the selling price which would be received for these items under the contract, when they were delivered" in the following year. The Government phrases the question quite differently to be "whether a future estimated loss on a manufacture and sales contract can be taken as a current loss in the inventory value of raw materials, work in process, and finished articles not yet delivered." The difference in statement is more than semantics. We emphasize it at the outset since we are convinced that neither in purpose nor effect is the reduction in inventory value the anticipation of a loss not yet realized. The case, therefore, is not really the one which the Government's question poses. We agree substantially with Taxpayer and reverse and remand for the necessary adjustments.

The facts are either stipulated or uncontradicted. Accepting all fact findings of the Tax Court, we differ only in the ultimate conclusions reached. The specific tax issue is whether Taxpayer is entitled to an inventory write-down for the fiscal year ending February 28, 1957. No dispute exists that the contract was unprofitable and produced a loss. The question is whether this was, as Taxpayer claims, an inventory loss in fiscal year 1956 or, as the Government contends, fiscal 1957 (year ending February 28, 1958).¹ The critical inventory date is February 28, 1957.

Taxpayer is a Texas manufacturer. In June 1956, it was awarded a contract with the Government for construction and delivery of 382 military light cargo trailers at a unit price of $804.2175, a total contract price of $307,211.09. This was designated by Taxpayer as its job No. 1120. The trailers were of a special military design and were not suitable for commercial or civilian use. Apart from the contract, their market value would be for scrap alone. As of February 28, 1957, a total of 96 units had been completed and shipped. The remaining 286 units were shipped during the period March 1, 1957 through July 31, 1957. Substantially all of the material for the completion of the contract had either been acquired or ordered by February 28, 1957. As was the finished product, this material was specially ordered for the job and was not suitable for use on Taxpayer's other contracts. It is uncontradicted that Taxpayer would not "have been able to sell these materials profitably to" anybody else. In terms of the proportion of equivalent units completed² and the proportional percentage of costs incurred,³ the contract was substantially completed as of February 28, 1957.

Taxpayer's inventories on hand pertaining to this trailer contract taken at cost and consisting of materials, direct labor, overhead and work in process totaled $194,209.49.⁴ In its tax return for year ended February 28, 1957, as well as in the financial audit statement prepared by these accountants, inventory was written down from cost ($194,209.49) to market ($91,195.34) through adjustments total $103,014.15.⁵ In reducing closing inventory, there was a like increase in cost of goods sold with a consequent decrease in taxable income.

The Commissioner disallowed the write-down of $103,014.15, the consequence being to decrease cost of goods sold by a like amount.⁶ The Tax Court did several things. First, as to inventory not in process, it sustained the Commissioner and disallowed the write-down on the ground that the Taxpayer had "failed to carry" the burden of establishing "that the market value of its inventory of materials not in process is less than its cost." Second, as to work in process, it likewise held there was "insufficient evidence * * * with respect to Taxpayer's in-process inventory to show what the fair market value thereof might be." Third, with respect to the 12 finished trailers and the four others which were 75-80% completed (note 2, supra, Item (b)), it held that they were "sufficiently complete to be in salable form" and were all in a "salable state * * * with a cost of $360.20 in excess of the market value thereof." Consequently as to these 16 finished items, it allowed an inventory write-down.⁷ The Taxpayer appeals from the first and the Government cross appeals from the second.

In making these adjustments, the accountants determined that the cost of manufacturing these trailers would amount to $1,164.41 per unit.⁸ This produces a loss on each unit of $360.20. The Tax Court accepted both of these figures.⁹

In assaying the correctness, either of the Tax Court's reasoning or the result, it simplifies matters to point out that Taxpayer does not now seek to justify any deductions for "estimated future cost of completing the contract" amounting to $73,840.04 as originally made on the return. The Taxpayer's brief states that Taxpayer "is conceding that no future costs should be considered" and "only actual cost incurred prior to" February 28, 1957, are now being taken into account. This is not exactly so, for on the revised computations based upon the proportion of expenses incurred and receipts earned, the percentage of completion, of costs, and sales receipts in the year ending February 28, 1957, Taxpayer necessarily has to consider the percentages (either actual or estimated) for like factors for the succeeding year ending February 28, 1958. As near as we understand these computations, this produces a proper decrease in inventory of approximately $60,000.¹⁰

In supporting the Tax Court's complete disallowance of the write-down (except as to the 16 finished units), the Government makes two principal contentions. The first is that allowance of a write-down is in effect the tax recognition of a loss not yet incurred in fact and thus it offends the time-honored principle of annual accounting for tax purposes. The second is that under the Regulations, the term market, as used in the lower-of-cost-or-market formula, relates not to what the manufacturer receives on the sale of its product (or components), but what it pays in the purchase of the raw materials and the "purchase" of direct costs, such as labor, burden, etc.

As to the first, we do not question the principle of annual accounting, or the numerous classic cases urged by the Government in its support.¹¹ There are two reasons, at least, why this principle is not determinative in this case. At the outset, it really begs the question for it assumes that no loss is incurred until the last trailer is delivered and paid for. That is an unfounded assumption as later discussion demonstrates. In the second place, and more important, the use of lower of cost or market inventory is in reality a limited exception to the principle of annual accounting. The Sixth Circuit has phrased it this way. It is "* * * well recognized that the method of valuing inventory at the lower of cost or market is an instance where the tax law permits the deduction of an unrealized loss, and is a recognized exception to the necessity of reflecting in income tax returns only closed transactions." Sharp v. Commissioner, 6 Cir., 1955, 224 F.2d 920, 924. Somewhat differently, the Second Circuit has said: "The determination of the value to be placed upon an inventory has no relation to the principle or theory affecting the determination of when income is deemed to be received and when expenses are deemed to be incurred." American Can Co. v. Bowers, 2 Cir., 1929, 35 F.2d 832, 835. The validity of this is illustrated by considering the simplified case of a trader in a commodity, such as fuel oil, which has a readily ascertainable, lively market. Though stock on hand procured earlier at a greater cost will not be sold and the loss thereby "realized" until the succeeding year, it is plain that it may be written down at the year's end to reflect the market price. This is true even though in fact no "loss" ever occurs because of an intervening subsequent rise in market value.¹²

The second contention relating to the Regulations brings us to the heart of the case. Contrary to the Government's view, we think that the Regulations sustain the Taxpayer's approach. The Statute¹³ expressly contemplates dependence on Regulations thereby investing wide scope and validity in the administrative regulations. As we shall later see, the term inventory as administratively defined is significant.¹⁴ The Regulations echo the statutory emphasis on inventory methods "conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income." 26 U.S.C.A. § 471; Regulation § 1.471-2.¹⁵ Considering the sharply defined rule that accounting may be different for business-financial purposes and for tax purposes, the Regulations here accord extraordinary tax significance to financial accounting of inventories. "An inventory that can be used under the best accounting practice in a balance sheet showing the financial position of the taxpayer can, as a general rule, be regarded as clearly reflecting his income." Regulation § 1.471-2(b).¹⁶ The Regulations recognize two principal bases, (1)...