In the past, the IRS prevented taxpayers who maintained inventories from using the cash method of accounting for federal income tax purposes. Instead, Treasury regulations section 1.446–1(c)(2)(i) forced taxpayers to use the accrual method to account for purchases and sales.
Under section 1.471–1, the use of inventories is required “in every case in which the production, purchase, or sale of merchandise is an income-producing factor.” The determination of whether “merchandise” is an income- producing factor has long been a source of controversy between taxpayers and the IRS.
The IRS had successfully argued that it had the authority to require taxpayers to use the accrual method even when they were predominantly service providers and did not maintain inventories per se. For example, in Commissioner v. Thompson Electric, Inc. (TC Memo 1995–292), the IRS contended an electrical contractor had inventories and was, therefore, required to use the accrual method of accounting. This argument prevailed, even though Thompson Electric
- Did not offer its supplies for sale to the public.
- Did not separately itemize supplies on its invoices.
- Did not separately charge for its services.
- Did not usually permit the customers to select the materials to be used in connection with the provision of services.
Traditionally, taxpayers, such as physicians, who engaged strictly in the provision of services, were not affected by these rules because none of their revenue was attributable to merchandising activities.
In Osteopathic Medical Oncology and Hematology, PC v. Commissioner (113 TC no. 26), a divided Tax Court determined when supplies or goods would be considered “merchandise.” The case involved a professional services corporation that provided oncology services and administered chemotherapy treatment to patients (see “Cash Accounting Okay for Drugs,” JofA , Mar.00, page 77). The taxpayer used the cash method of accounting, and the IRS challenged it.
When the case went to the Tax Court, the court focused on the unique characteristics of the chemotherapy drugs and treatment. Under applicable state law, the taxpayer could not sell the drugs to a patient, the medication was administered in the taxpayer’s office under a doctor’s supervision and the medication could not be self-administered.
The court compared the facts of Osteopathic Medical to other cases. It found that, in contrast to cases such as Thompson Electric, the chemotherapy patients could not choose to obtain the drugs and services separately.
After a review of existing case law, the court concluded that there was no clear precedent in this area because of the overriding service aspect of the taxpayer’s activities: “The service provider is using the items as supplies which are essential to the provision of its services. A medical practice such as the petitioner’s is inherently a service business, and the drugs administered in the practice are subordinate to the provision of the medical services.”
Observation. While this decision is certainly good news for taxpayers, until further precedent is established along these lines, CPAs must recognize that its unique and highly specific facts will make it applicable to only a few taxpayers. The finding, however, will give CPAs and taxpayers another angle from which to argue against IRS claims that taxpayers who are essentially service providers, but who have inventories, must use the accrual method of accounting.
—Vinay S. Navani, CPA, tax manager,
Wilkin & Guttenplan, PC, East Brunswick, NJ.