Category: Accounting Periods & Methods
Subject: Cash Method of Accounting
Title: Contractors
IRC Sections: 446
Filename: 1109.html
Date Produced: 3/97

Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com

I refer to your memo of March 6, 1997 regarding your S corporation, general contractor client. I am painfully familiar with this problem.

The difficulty with inventory is not having it, but rather selling it. It does not matter that your client has no physical inventory on hand at the end of an accounting period. The problem is the building materials used in the taxpayer's jobs are the equivalent of merchandise, and your client is effectively selling that merchandise to his customers.

As such, the following rules apply.

Reg. Section 1.446-1(a)(4)(i).
The taxpayer is required to keep inventories in any case in which production, purchase, or sale of merchandise of any kind is an income-producing factor."

Reg. Sec. 1.471-1.
Merchandise includes all finished or partly finished goods and, in the case of raw materials and supplies . . . those which have been acquired for sale or which will physically become a part of merchandise intended for sale," including containers.

Reg. Sec. 1.446-1(c)(2)(i).
In any case in which inventories are required, it is necessary to use the accrual method of accounting for purchases and sales.

Following are some cases in which the taxpayer was forced to adopt the accrual method of accounting because of inventories.J.P. Sheahan Associates v. Comr., 63 TCM 2842
Taxpayer was a roofing contractor. He had building materials delivered to the job site earmarked for use on that particular job. The taxpayer actually took title to the materials.

Asphalt Products Co., Inc., CA-6, 86-2 USTC ¶9556, 796 F2d 843. Rev'd on another issue, SCt, 87-1 USTC ¶9341, 107 SCt 2275.
Taxpayer was in the asphalt paving business. Due to weather conditions in the area in which the taxpayer operated, no paving activities took place during the winter months. The end of the tax year fell during these months. Accordingly, the taxpayer had little or no inventory on hand at the end of any given year.

Thompson Electric, Inc., 69 TCM 3045, Dec. 50,727(M), TC Memo. 1995-292.
Taxpayer was an electrical contractor. The cost of materials ranged from 37% to 44% of gross receipts. The facts that the contractor did not display supplies to its customers or the public, did not itemize its supplies on bids or invoices, did not sell materials separately from its services, and did not generally allow customers to select materials did not change the outcome of the case.

Epic Metals Corporation, 48 TCM 357, Dec. 41,297(M), TC Memo. 1984-322
Taxpayer was required to maintain inventories and to change to the accrual method of accounting. Taxpayer momentarily had bare legal title to the goods it sold although the goods never came into the taxpayer's possession.

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I think the only way to beat this is to avoid taking legal title to the building materials. If that happens, then the taxpayer is simply providing a service. As far as I can tell, however, this is not industry practice and may not be feasible at all. Perhaps the problem could be avoided if the contractor under local law were viewed as purchasing the building materials as agent for the owner of the project. Of course, that would make it rather difficult for the contractor to mark up his materials as is the normal case. A CPA in Georgia tells me he believes that under local law, a contractor does not actually take title to building materials. I find this hard to believe. I am following up on this one.

There are some legal questions we need answered as follows.

1. Normally, a contractor or subcontractor obtains building materials to be used in the construction project. I would assume the materials are the property of the contractor, at least initially. Obviously, at some point, the materials are incorporated into the finished project and become the property of the owner. When does that change in legal ownership occur? I would assume that the contractor (or his subcontractor) actually owns the materials between the time they are purchased and the completion of the project. Alternatively, perhaps the contractor owns the material until they are delivered to the job site. In the latter case, I would assume the goods are sold f.o.b. shipping point such that the contractor has title and risk of loss for the goods in transit.

2. Who bears the risk of loss with respect to building materials while they are in transit? Same question for building materials prior to installation.

3. What is the exact legal relationship between a general contractor and a subcontractor? Is the subcontractor an agent of the general contractor?

4. When the general or a subcontractor purchases building materials, do they typically use a resale certificate for sales tax purposes?

Please call me to discuss all this.