St. James Sugar Co-op, Inc. v. U.S.

• Decision Date: 01 May 1981
• Docket Number: No. 79-2883,79-2883
• Citation: 643 F.2d 1219
• Parties: 81-1 USTC P 9388 ST. JAMES SUGAR COOPERATIVE, INC., Plaintiff-Appellee Cross Appellant, v. UNITED STATES of America, Defendant-Appellant Cross Appellee. . Unit A
• Court: U.S. Court of Appeals — Fifth Circuit

Page 1219

643 F.2d 1219

81-1 USTC P 9388

ST. JAMES SUGAR COOPERATIVE, INC., Plaintiff-Appellee Cross Appellant, v. UNITED STATES of America, Defendant-Appellant Cross Appellee.

No. 79-2883.

United States Court of Appeals, Fifth Circuit.

Unit A

May 1, 1981.

John P. Volz, U.S. Atty., New Orleans, La., Francis P. Dicello, M. Carr Ferguson, Asst. Atty. Gen., Gilbert E. Andrews, Chief, App. Sec., Gary P. Allen, William A. Whitledge, Attys., Tax Div., U.S. Dept. of Justice, Washington, D. C., for defendant-appellant cross appellee.

Baldwin & Haspel, Joel A. Mendler, Jerome J. Reso, Jr., New Orleans, La., for plaintiff-appellee cross appellant.

Appeals from the United States District Court for the Eastern District of Louisiana.

Before AINSWORTH and SAM D. JOHNSON, Circuit Judges, and HUNTER ^*, District Judge.

AINSWORTH, Circuit Judge:

This is an appeal by the United States (Internal Revenue Service) from a judgment of the district court entered in favor of taxpayer, St. James Sugar Cooperative, Inc., for a refund of $1,818,612.55 in income taxes for St. James' fiscal year ending March 31, 1975. The court concluded that under the facts of this case and the provisions of 26 U.S.C. § 471, market not to exceed net realizable value is a permissible and accurate method of valuing ending inventory for an agricultural cooperative. Thus, the Government's conclusion to the contrary which formed the basis of the I.R.S. income tax deficiency herein was erroneous. Jurisdiction is based on 28 U.S.C. § 1291. We affirm.

I. FACTS

St. James, a Louisiana corporation, is an agricultural cooperative owned by its 25-member sugar farmers. As a cooperative, St. James purchases sugar cane from its members and processes the cane into raw sugar for sale to sugar refineries and food processors. Sugar cane is delivered to St. James in late summer and early fall for the grinding season which occurs between October and December of each year. The sugar produced is a high-grade sugar used mainly for certain industrial production of foods and liquids containing sugar. Since this sugar is delivered through September of each year, there is usually a sizable inventory on hand at the end of St. James' fiscal year which runs from April 1 to March 31.

St. James is taxed as a corporation. However, since it is a nonexempt cooperative St. James can deduct that portion of its income it returns to its members in the form of patronage dividends. Through the use of qualified patronage dividends, nonexempt cooperatives can avoid tax liability by passing their income onto their members. ¹

For the 1974-75 grinding season, just as it had in the previous four years, St. James entered into a contract with Colonial Sugars Company whereby it became obligated to sell and deliver to Colonial its entire 1974 production of raw sugar. A delivery schedule through September of 1975 was provided. However, the contract gave Colonial sole authority to accelerate or decelerate delivery for its own purposes. In addition, the contract provided a pricing formula based upon the average of each daily price quotation for sugar on the Louisiana Sugar Exchange for the calendar month in which actual shipments were made to Colonial. ² Therefore, as a result of this contract, the entire ending inventory of processed sugar on March 31, 1975 was committed to Colonial at a price to be determined when Colonial requested delivery.

Prior to 1974, fluctuations in the bid price quotations of the Louisiana Sugar Exchange had been small. However, the market experienced dramatic changes during 1974 and 1975 due in part to tight supplies, intense speculation, and expiration of government price controls. Before this period of inflated activity in the market, the highest average monthly bid on the Louisiana Sugar Exchange was $11.04 per cwt in May 1963. In 1974, the price for raw sugar rose from a monthly average of $12.60 per cwt in January to its peak at $64.47 per cwt in November. The price dropped just as dramatically to an average of $28.50 per cwt in March 1975 and $15.93 per cwt by June 1975. ³

On March 31, 1975, the bid price for raw sugar on the Louisiana Sugar Exchange was $27.47 per cwt. Approximately 70% of St. James' entire production for the 1974-75 grinding season was still on hand. However, in placing a value on this ending inventory, St. James did not use the March 31 market price of $27.47 per cwt. Instead, St. James valued its inventory at $17.07 per cwt based upon its estimate of the net realizable value the sugar would bring from Colonial in the declining market. The actual realizable value of the inventory was $17.88 per cwt based upon actual deliveries to Colonial between June 11, 1975 and September 18, 1975.

St. James arrived at the $17.07 value by use of "market not to exceed net realizable value" method of accounting. The Government contends that St. James impermissibly changed its accounting method for fiscal year 1975 so as to undervalue its inventory; therefore, St. James overvalued the cost of goods sold and correspondingly underestimated net income. ⁴ The Government asserts that St. James' method of accounting improperly allows recognition of an unrealized, future loss. Accordingly, the Government used the March 31 bid price of $27.47 to value the inventory, thereby increasing the dollar value of the sugar on hand at March 31 by $3,282,090.71. The resulting tax deficiency plus interest was assessed in the amount of $1,818,612.35.

St. James asserts that it has consistently used the market not to exceed net realizable value method of accounting. According to St. James, it used the bid price on March 31 in previous years to value inventory only because price fluctuations were minimal and the bid price was itself a reasonably accurate approximation of the net realizable value of the sugar. Additionally, St. James contends its method clearly reflects income and is permissible when applied to the present facts under the appropriate Treasury Regulations.

The district court found that St. James was consistent in its use of the market not to exceed net realizable value and that it only became necessary to use the net realizable value in 1975 because the volatile market in 1974-75 was the first occasion in which the net realizable value was significantly lower than the current bid price. Therefore, the court held there was no violation of 26 U.S.C. § 446(e) for impermissibly changing accounting methods. The district court also held that St. James' inventory valuation clearly reflected income and did not violate the provisions of 26 U.S.C. § 471 governing use of inventories in determining income. Finally, the district court denied a request for attorneys' fees by St. James.

The district court's determination that St. James has consistently used the market not to exceed net realizable value method of accounting is a factual finding and has not been seriously challenged by the Government before this court. Since substantial evidence exists to support the court's conclusion, we find no error in this finding of fact. Therefore, we now consider the remaining two issues: 1) whether St. James' method of inventory valuation under the present facts is warranted by the Internal Revenue Code and applicable Treasury Regulations, and 2) whether St. James is entitled to an award for attorneys' fees.

II. INVENTORY

A. Requirements of the Internal Revenue Code

Any taxpayer involved in a business in which the production, purchase, or sale of merchandise is an income-producing factor must value its inventories in order to correctly determine income for tax purposes. Treas.Reg. § 1.471-1. Since inventory valuation is a method of accounting, ⁵ any method by which a taxpayer values inventory must conform to the rules for accounting methods under 26 U.S.C. § 446, as well as 26 U.S.C. § 471 which establishes the rules of inventories. According to the Government, the method used by St. James does not fit within these rules.

Under the general requirements of section 446, taxable income is to be computed by the method which taxpayer regularly uses to compute accounting income. However, no method of accounting may be used that in the opinion of the Commissioner of Internal Revenue does not clearly reflect income. ⁶ The Commissioner has been given broad discretion in determining what methods satisfy this standard. Thor Power Tool Co. v. Commissioner of Internal Revenue, 439 U.S. 522, 532, 99 S.Ct. 773, 781, 58 L.Ed.2d 785 (1979); Commissioner of Internal Revenue v. Hansen, 360 U.S. 446, 467, 79 S.Ct. 1270, 1282, 3 L.Ed.2d 1360 (1959); Lucas v. American Code Co., 280 U.S. 445, 449, 50 S.Ct. 202, 203, 74 L.Ed. 538 (1930).

Additionally, section 471 specifically establishes two distinct tests for inventory valuation. ⁷ First, a taxpayer may only use a method for valuing inventory that conforms as close as possible to the best accounting practice in the trade or business. Secondly, the method must be one that clearly reflects income. See Thor Power Tool Co., supra, 439 U.S. at 532, 99 S.Ct. at 781.

It is clear that St. James has complied with the initial requirements of both sections 446 and 471. As for section 446, the Government does not dispute that St. James used the same method to determine taxable income as it regularly did to determine accounting income. ⁸ Likewise, the Government does not contest that the market not to exceed net realizable value method of inventory valuation meets the standard of best accounting practice in the trade or practice as required in the first test of section 471. ⁹ Therefore, the sole issue left for our determination is the test common to both sections 446 and 471 whether St. James' use of net realizable value for pricing its ending inventory clearly reflects income.

Whether an accounting method will clearly reflect income depends on the facts and circumstances peculiar to each case. Lincoln Electric Co. v. Commissioner of Internal Revenue, 54 T.C....