Petitioner, a corporation and successor in interest to a partnership in a 1957 transaction qualifying under sec. 351, was a manufacturer of gages and gage blocks. It and its predecessor valued inventory by including only direct costs of labor and materials. Overhead expenses were deducted in the year spent.
48 T.C. 190">*190 Respondent determined deficiencies in petitioner's income tax for the taxable years ended November 30, 1960, 1961, and 1962, in the amounts of $ 32,962.47, $ 4,218.02, and $ 979.78, respectively.
Petitioner having conceded all other items in 1967 U.S. Tax Ct. LEXIS 104">*105 the deficiency notice, two issues remain for our consideration:
(1) Was respondent entitled to require petitioner to include overhead costs in inventory values instead of deducting such costs in the year spent?
(2) If so, to what extent, if any, were adjustments properly made under
48 T.C. 190">*191 FINDINGS OF FACT
Some of the facts are stipulated and are found accordingly.
Petitioner was incorporated in Michigan on May 1, 1957, and, at the time of the filing of the petition herein, had its principal office at Garden City, Mich. It filed its returns for the taxable years involved herein on the accrual basis with the district director of internal revenue, Detroit, Mich.
At the time petitioner was incorporated, the assets of a partnership, Dearborn Gage Co., of which Elmer Ellstrom, Jr., and Olaf W. Ellstrom were the sole partners, were transferred to petitioner in a transaction qualifying under section 351. Elmer, Jr., and Olaf, on June 30, 1947, and July 31, 1954, respectively, acquired their interests in the partnership from Ralph Ellstrom and Elmer Ellstrom, respectively, who were the parties referred to in
Petitioner is engaged in a manufacturing business in which substantial inventories of finished goods and work in process are maintained. In its business, petitioner has two divisions operating at separate plants -- the Standards Division and the General Gage Division.
The Standards Division is segregated into two departments, which keep separate inventories. Chromium-plated gage blocks are manufactured in the Gage Block Department while gage block accessories and special gages are manufactured in the Accessories Department.
The General Gage Division is also divided into two departments -- the Air Gage Division and the "AGD" (American Gage Design) Gage and Special Gage Department. Various types of gages are manufactered in the General Gage Division.
Petitioner, since its inception on May 1, 1957, has used the first-in, first-out (FIFO) method in valuing inventory and has included only
Petitioner's income tax returns and those of its predecessor partnership were audited by respondent's agents every 2 years prior to fiscal year 1960; the propriety of expensing overhead costs was never raised, and no change was recommended by any agent wth respect to the manner in which petitioner's inventory should be computed.
In 1963, respondent's agent audited petitioner's returns for the fiscal years 1960, 1961, and 1962 and determined that petitioner had improperly valued its inventory by failing to include overhead costs. 48 T.C. 190">*192 Accordingly, respondent determined that the following adjustments should be made to petitioner's inventory and income to reflect such costs:
Adjustment | Increase in | ||
Year ended Nov. 30 -- | Adjustment to opening | to closing | inventory |
inventory | inventory | and income | |
1960 | No adjustment shown | $ 63,389,36 | $ 63,389.36 |
1961 | $ 63,389.36 | 71,500.93 | 8,111.57 |
1962 | 71,500.93 | 73,385.11 | 1,884.18 |
The parties have stipulated that, if petitioner and its predecessor partnership had added overhead costs to inventory, the following adjustments to inventory would have resulted:
Closing | Omitted | Net increase | |
Year | inventory | cumulative | or decrease |
per tax | overhead | in income | |
return | costs | per year | |
11967 U.S. Tax Ct. LEXIS 104">*108 Dec. 31, 1953 | $ 10,087.47 | $ 10,087.47 | |
8,596.99 | (1,490.48) | ||
11,800.47 | 3,203.48 | ||
14,897.07 | 3,096.60 | ||
16,730.73 | 1,833.66 | ||
May 1, 1957 | 2 131,449.58 | 16,730.73 | 1,833.66 |
Nov. 30, 1957 | 155,915.52 | 25,596.57 | 8,865.84 |
Nov. 30, 1958 | 162,895.23 | 55,859.86 | 30,263.29 |
Nov. 30, 1959 | 143,577.91 | 39,483.79 | (16,376.07) |
Nov. 30, 1960 | 176,004.10 | 63,389.36 | 23,905.57 |
Nov. 30, 1961 | 218,513.01 | 71,500.93 | 8,111.57 |
Nov. 30, 1962 | 252,403.10 | 73,385.11 | 1,884.18 |
Of the $ 63,389.36 cumulative increase to the inventory for 1960, $ 52,112.19 was allocable to the Gage Block Department. For 1961, $ 7,098.51 of the $ 8,111.57 net increase in inventory was allocable to the Gage Block Department. For 1962, $ 923.43 of the $ 1,884.18 net increase in inventory was allocable to the Gage Block Department.
The following table reflects per-unit costs and revenues of the Gage Block Department under the so-called "net profit" test:
1961 | 1962 | 1963 | 1964 | |
Labor cost per unit | $ 2.28 | $ 2.04 | $ 2.28 | $ 2.39 |
Cost of materials per unit | .17 | .14 | .13 | .16 |
Per unit expense for sales, administrative and | ||||
11967 U.S. Tax Ct. LEXIS 104">*109 delivery | 1.76 | 1.89 | 2.30 | 2.29 |
Overhead per unit | 2.33 | 2.26 | 2.18 | 1.91 |
Total cost | 6.54 | 6.33 | 6.89 | 6.75 |
Per unit sales price | 6.52 | 6.72 | 7.00 | 6.93 |
Profit (or loss) | (.02) | .39 | .11 | .18 |
2 Percentage profit | 5.8 | 1.6 | 2.6 |
48 T.C. 190">*193 ULTIMATE FINDING OF FACT
By excluding overhead from inventory, petitioner's method of accounting did not clearly reflect income.
OPINION
Since its incorporation in 1957, petitioner has valued its inventory at cost, including only direct labor and material and excluding overhead. Overhead costs were deducted in the year spent. Petitioner's predecessor similarly valued its 1967 U.S. Tax Ct. LEXIS 104">*110 inventory except that it used the lower of cost or market. Respondent audited the returns of petitioner's predecessor and of petitioner on several occasions but, until the audit of petitioner's return for the taxable year 1960, respondent did not object to petitioner's excluding overhead from inventory.
Two basic areas of problems are involved herein. First, is respondent entitled to change petitioner's method of accounting by requiring it to include overhead 21967 U.S. Tax Ct. LEXIS 104">*111 costs in valuing its inventory for the purpose of determining the cost of goods sold rather than treat it as a deductible expense? Second, if respondent can require such a change, what adjustments, if any, stemming from the expensing of overhead in prior years by the taxpayer and its predecessor, should be made with respect to the valuation of petitioner's inventories either under
We can dispose of the problems involved in the first area rather easily.
Petitioner deducted overhead in the year spent instead of including it in inventory. Respondent argues that the effect of this treatment of overhead is to postpone income, citing
48 T.C. 190">*194 Petitioner submits a two-pronged counter-argument. The first prong is based on petitioner's claim that its predecessor's method of valuing inventory was determined in a prior proceeding (
In the prior proceeding (
In
Petitioner's second prong is premised on the assertion that the key standard under the statute 5 is whether a method of accounting clearly 48 T.C. 190">*195 reflects income, that each case must be judged on its own facts, and that its method of expensing overhead costs satisfies this standard. To prove its point, petitioner relies upon two "tests" which it ran to check its method. Both "tests" were applied only to petitioner's Gage Block Department. 1967 U.S. Tax Ct. LEXIS 104">*115 Petitioner claims that, because the major portion of respondent's adjustments are allocable to that department, they are therefore wrong in their entirety and, in any event, the "tests" preclude a change in the accounting method of that department.
We see no need to indulge in a detailed mathematical exposition of these "tests," because the fact is that, even if it were appropriate for us to attach critical importance to such accounting by analogy (an issue which we do not decide), the "tests" simply do not support petitioner's position. At trial, petitioner's accountant testified that the application of a "net profit test," based upon the difference between the per-unit sales price and the per-unit cost, would have produced an annual per-unit profit ranging 1967 U.S. Tax Ct. LEXIS 104">*116 from 4 to 7 percent during the years 1961 through 1964. On brief, respondent attempted a detailed reconstruction of the "net profit" test. In reply, petitioner countered with a detailed calculation showing a per-unit loss for each year, but no attempt was made to explain the obvious discrepancy between this calculation and the testimony of its accountant. As set forth in our findings of fact, our own analysis indicates that a correct application of the test would have produced a range from a slight loss to a 5.8-percent per-unit profit.
Aside from the apparent inadequacy of petitioner's calculation, the "net profit test" proves nothing except that petitioner chose an acceptable selling price for its gage blocks. Nothing in the test indicates whether overhead cost in producing each unit, or, for that matter, the cost of direct labor and materials, should be deducted in the year spent or in the year the unit is sold. Moreover, the underlying assumption of the test is that profit should be computed by lining up average expenses per unit with average sales price per unit. Such assumption is directly contrary to petitioner's main contention. Indeed, the test supports what respondent 1967 U.S. Tax Ct. LEXIS 104">*117 seeks to require of petitioner, namely, to postpone the deduction of overhead expenses until such time as the pertinent units are sold.
Petitioner's second test is called the "retail method of inventory pricing." 61967 U.S. Tax Ct. LEXIS 104">*118 In this test, petitioner attempted to derive a "value" for the November 30, 1960, closing inventory of the Gage Block Department based on petitioner's experience in fiscal years 1961-1965. As petitioner points out, the figure of $ 77,808.34 thus derived 7 is comparable 48 T.C. 190">*196 with the $ 75,541.91 figure for the gage block inventory derived by utilizing petitioner's method of accounting, as well it should. Leaving aside the question whether petitioner, who was not a retailer, can properly use the "retail method" test (see
Our analysis disposes of petitioner's suggestion that the change in accounting method proposed by respondent should in no event be applied to its Gage Block Department because to do so would cause that department to operate at a loss. Aside from the question whether that department was sufficiently separate to permit of a different accounting treatment for tax purposes (as to which the record is not clear), petitioner's calculation is based upon a simple fallacy; it has deducted overhead costs twice, by expensing them and also adding them to inventory.
In view of the foregoing, we conclude that respondent's requirement that petitioner change its accounting method so as to include overhead costs in valuing its inventories should be sustained.
We turn now to the second area of problems, namely, what adjustments should be made with respect to the valuation of petitioner's inventory.
In dealing with these problems, we are faced with a plethora of decisions involving 1967 U.S. Tax Ct. LEXIS 104">*119 both the issues directly involved herein and related issues. It would be idle to attempt to reconcile all of the cases, for some turn on fine distinctions, others reflect the difficulties which many courts have had in evolving the proper approach to the issues involved, and some were decided before, and some after, the advent of
Initially, it is necessary to clear away some of the underbrush resulting from the manner in which the deficiency notice was constructed. Respondent reconstructed petitioner's inventory for the taxable years involved herein -- namely, 1960, 1961, and 1962 -- by including overhead costs in opening and closing inventory except for 1960. For that year, respondent did not include such costs in opening inventory, on the ground that the amount thereof was precisely offset by the adjustments permitted under
We pass next to the question of the adjustments which respondent is permitted to make under
We are still left with the question of the extent to which adjustments under
But this does not settle the matter. Under
Petitioner argues that, on the basis of the agreed cumulative method utilized in computing petitioner's inventory, the refusal of respondent to make an adjustment based on overhead costs related to its opening inventory for the taxable year 1957 in effect allows respondent to tax $ 6,643.26 in overhead costs expensed by its predecessor during the period January 1, 1954, to April 30, 1957, and $ 10,087.47 in such costs thus expensed prior to January 1, 1954. Thus, petitioner insists that it is being taxed on $ 16,730.73 which is properly attributable to periods to which
The fact of the matter is that these asserted consequences are more apparent than real. In the first place, it can be argued that overhead costs are incurred only after inventory is acquired and that,
We recognize that, if petitioner had never been formed, and the predecessor partnership had continued in business, and the issue before us involved a comparable change in the latter's method of accounting for overhead costs, respondent would have been precluded by the 48 T.C. 190">*200 express provisions of
The underlying purpose of
There is no necessary conflict between
48 T.C. 190">*201 We do not have before us an attempt by the respondent to impose a tax in 1960 on amounts which had previously been taxed in barred years, with double taxation the result. Cf.
Whether one adopts respondent's short-cut method or utilizes a two-step technique, as we have done, in making the
1. All references are to the Internal Revenue Code of 1954.↩
1. Partnership inventory.
2. Opening balance of petitioner on May 1, 1957.↩
1. Respondent's figures for sales expenses, in its computation under the "net profit" test, are substantially different because of its misreading of one of the exhibits. Respondent derived its figures by dividing the sales costs for the whole Standards Division by the number of gage blocks sold rather than dividing the sales costs for only the Gage Block Department by the number of gage blocks sold. Respondent's error resulted in a substantial overstatement of selling expenses.
2. We note that in one of the stipulated exhibits the cost of materials per unit was stated to be .17 cents, .14 cents, .13 cents, and. 16 cents, respectively, for the years in question. However, in light of the other exhibits, these figures seem unreasonably low, and we assume, as apparently did respondent, that the exhibit was in error in stating the figures as cents instead of dollars. However, if we assume the stipulated figures for cost of materials per unit are correct, net profit for the years tested becomes 15 cents, 53 cents, 24 cents, and 34 cents, respectively. In percentage terms, the net profit would be 2.3 percent, 7.9 percent, 3.4 percent, and 4.9 percent, respectively.↩
2. Petitioner has raised no objection to respondent's computation of overhead so that we do not have before us any question of "direct cost" versus "absorption cost." Cf.
3.
Cost means:
* * * *
(c) In the case of merchandise produced by the taxpayer since the beginning of the taxable year, (1) the cost of raw materials and supplies entering into or consumed in connection with the product, (2) expenditures for direct labor, (3)
4.
(a)
(1) It must conform as nearly as may be to the best accounting practice in the trade or business, and
(2) It must clearly reflect the income.
(b) It follows, therefore, that inventory rules cannot be uniform but must give effect to trade customs which come within the scope of the best accounting practice in the particular trade or business. In order clearly to reflect income, the inventory practice of a taxpayer should be consistent from year to year, and
5.
Whenever in the opinion of the Secretary or his delegate the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer on such basis as the Secretary or his delegate may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income.↩
6. The retail method was used by the taxpayer in
7. Respondent came up with a quite different result in applying this test. Respondent's version is in error, however, because respondent failed to include overhead costs anywhere in its figures.↩
8.
(a) General Rule. -- In computing the taxpayer's taxable income for any taxable year (referred to in this section as the "year of the change") -- (1) if such computation is under a method of accounting different from the method under which the taxpayer's taxable income for the preceding taxable year was computed, then (2) there shall be taken into account those adjustments which are determined to be necessary solely by reason of the change in order to prevent amounts from being duplicated or omitted, except there shall not be taken into account any adjustment in respect of any taxable year to which this section does not apply unless the adjustment is attributable to a change in the method of accounting initiated by the taxpayer.
9.
10. We note that, with respect to years in which a subchap. S election (see secs. 1371-1378) has been made, it may be possible to confine respondent's adjustments in a case of the type involved herein to post Jan. 1, 1954, periods. Cf.