                         T.C. Memo. 2000-114



                       UNITED STATES TAX COURT



       VON EUW & L.J. NUNES TRUCKING, INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 17599-97.                 Filed March 31, 2000.



     Lawrence T. Ullmann, for petitioner.

     Peter C. Rock, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     VASQUEZ, Judge:    Respondent determined a deficiency of

$111,114 in petitioner’s Federal income tax for the taxable year

ending March 31, 1995 (1994 taxable year).     The issue for

decision is whether respondent abused his discretion by requiring

petitioner to change its method of accounting from the cash
                               - 2 -

receipts and disbursements method (cash method) to the accrual

method.1

                         FINDINGS OF FACT

     The parties submitted this case fully stipulated pursuant to

Rule 122.2   The stipulation of facts and the attached exhibits

are incorporated herein by reference.   At the time the petition

was filed, petitioner’s principal place of business was in

Fremont, California.

     Petitioner, a California corporation, acquires and

transports sand and gravel for its customers, various contractors

and developers operating in Northern and Central California.3

Petitioner’s customers use the sand and gravel to construct

foundations for streets, houses, and buildings (construction

projects).   Most of petitioner’s customers depend on petitioner

to both acquire and transport the sand and gravel from storage

sites to the customers’ construction sites.   Some of petitioner’s

customers own or acquire the sand and gravel necessary to

complete their construction projects without petitioner’s



     1
        In the notice of deficiency, respondent reduced
petitioner’s depreciation, truck, and advertising & promotion
deductions by $28,027, which petitioner does not contest in its
petition.
     2
        All section references are to the Internal Revenue Code
in effect for the year in issue, and all Rule references are to
the Tax Court Rules of Practice and Procedure.
     3
        The phrase “sand and gravel” refers to both “sand and
gravel” and “sand or gravel”.
                               - 3 -

assistance.   These customers hire petitioner only for its

transportation services.4

     Usually, a customer contacts petitioner to order sand and

gravel (measured by weight in tons) 1 day before the sand and

gravel are needed at the construction site (the order date).    On

the order date, petitioner informs the customer of petitioner’s

total charge for acquiring and transporting the sand and gravel

(contract amount).   Petitioner calculates the contract amount by

multiplying petitioner’s charge for acquiring and transporting 1

ton of sand and gravel times the number of tons of sand and

gravel ordered by the customer.   Petitioner’s charge for

acquiring and transporting 1 ton of sand and gravel consists of

four amounts:   (1) Petitioner’s costs in acquiring the sand and

gravel, (2) petitioner’s profit for acquiring the sand and gravel

(approximately 20 to 25 percent of petitioner’s costs in

acquiring the sand and gravel), (3) petitioner’s costs in

transporting the sand and gravel from the storage site to the

construction site (and petitioner’s related profit for

transporting the sand and gravel), and (4) a sales tax levied on

amounts (1) through (3).

     Petitioner, however, does not provide the customer an

itemized description of the separate amounts constituting the


     4
        The record does not reflect what revenues and expenses
relate to customers using petitioner solely for transportation
services.
                                - 4 -

contract amount.   If a customer requests only that petitioner

transport the sand and gravel, petitioner charges the customer

petitioner’s costs for transporting the sand and gravel and

petitioner’s related profit for transporting the sand and gravel.

     Petitioner acquires the sand and gravel from various

suppliers.    During petitioner’s 1994 taxable year, 20 different

entities (20 suppliers) provided petitioner with 60 percent

(evaluated by weight in tons) of its sand and gravel needs, while

the Unimin Corp. (Unimin) supplied petitioner with the remaining

40 percent.

     Unimin processes and sells a high grade of sand used

primarily in the production of wine bottles.    Processing this

high grade of sand produces a byproduct consisting of water and a

lower grade of sand, known as Byron sand.    After the water is

removed from the byproduct, the Byron sand can be used by

petitioner’s customers.    Because petitioner must provide and

maintain all the equipment and personnel necessary to filter,

gather, and remove the Byron sand from Unimin’s processing plant,

Unimin charges petitioner a lower amount than what the 20

suppliers charge for the same grade of sand.    When petitioner

computes the cost to acquire 1 ton of the Byron sand, petitioner

includes its costs in filtering, gathering, and removing the

Byron sand from Unimin’s processing plant as well as the amount

that Unimin charges petitioner for the Byron sand.
                                 - 5 -

     Petitioner owns 20 hauling trucks which it uses to transport

the sand and gravel.   If petitioner’s customers order amounts of

sand and gravel exceeding petitioner’s transportation

capabilities, petitioner hires third parties to meet customer

demand.

     On the delivery date, petitioner’s employees travel to the

supplier’s storage site, load the sand and gravel purchased onto

petitioner’s trucks, and transport the sand and gravel to the

customer’s construction site.5    As to the Byron sand, once

petitioner’s employees load it onto petitioner’s trucks and

Unimin creates a “weighmaster certificate”, Unimin considers the

Byron sand to be petitioner’s property.    Because petitioner

acquires and delivers the sand and gravel to its customers during

the same business day, petitioner does not possess any sand and

gravel at the beginning or end of its business day.

     On petitioner’s 1994 Federal corporate income tax return

(1994 tax return), petitioner described its business activity as

“sales” and its product as “construction materials”.    Petitioner

maintained its books and records on the accrual method of

accounting and reported its income for Federal tax purposes on

the cash method.   On its 1994 tax return, petitioner reported

gross receipts of $3,483,206 and cost of goods sold of


     5
        Petitioner’s employees perform similar tasks for
customers who only request petitioner to transport (and not
acquire) sand and gravel.
                               - 6 -

$1,867,497.   In computing its cost of goods sold, petitioner

reported $1,080,774 of “purchases”, $786,723 of “cost of labor”,

and no beginning or ending inventories.   In addition to its cost

of goods sold, petitioner separately deducted its expenses

related to the filtering, gathering, and removing of the Byron

sand at the Unimin processing plant.

     As of March 31, 1995, petitioner had accounts receivable of

$426,389 and accounts payable of $143,846.

     In the notice of deficiency, respondent determined that

petitioner’s use of the cash method of accounting did not clearly

reflect income.   Respondent, therefore, changed petitioner’s

method of accounting to the accrual method.   Further, with regard

to the change in accounting method and petitioner’s concessions,

respondent made a section 481(a) adjustment and determined a

deficiency of $111,114 in petitioner’s tax liability for its 1994

taxable year.

                              OPINION

     The principal issue for decision is whether respondent

abused his discretion by requiring petitioner to change from the

cash method to the accrual method of accounting.   Subsumed in

this issue is the question of whether petitioner should be

required to use inventories for tax purposes.
                                 - 7 -

       Under section 446,6 the Commissioner has broad powers to

determine whether an accounting method used by a taxpayer clearly

reflects income.     See Commissioner v. Hansen, 360 U.S. 446, 467

(1959); Ansley-Sheppard-Burgess Co. v. Commissioner, 104 T.C.

367, 370 (1995).     Courts do not interfere with the Commissioner’s

determination under section 446 unless it is clearly unlawful.

See Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 532

(1979); Cole v. Commissioner, 586 F.2d 747, 749 (9th Cir. 1978),

affg. 64 T.C. 1091 (1975); Ansley-Sheppard-Burgess Co., supra at

370.

       Whether respondent abused his discretion is a question of


       6
           Sec. 446 provides in pertinent part:

            (a) General rule.--Taxable income shall be computed
       under the method of accounting on the basis of which the
       taxpayer regularly computes his income in keeping his books.

            (b) Exceptions.--If no method of accounting has been
       regularly used by the taxpayer, or if the method used does
       not clearly reflect income, the computation of taxable
       income shall be made under such method as, in the opinion of
       the Secretary, does clearly reflect income.

            (c) Permissible methods.--Subject to the provisions of
       subsections (a) and (b), a taxpayer may compute taxable
       income under any of the following methods of accounting--

                  (1) the cash receipts and disbursements method;

                  (2) an accrual method;

                  (3) any other method permitted by this chapter; or

                  (4) any combination of the foregoing methods
             permitted under regulations prescribed by the
             Secretary.
                                 - 8 -

fact.   See Ansley-Sheppard-Burgess Co. v. Commissioner, supra at

371; Ford Motor Co. v. Commissioner, 102 T.C. 87, 91-92, affd. 71

F.3d 209 (6th Cir. 1995).     The reviewing court's task is not to

determine whether, in its own opinion, the taxpayer's method of

accounting clearly reflects income but to determine whether there

is an adequate basis in law for the Commissioner's conclusion

that it does not.   See Ansley-Sheppard-Burgess Co. v.

Commissioner, supra at 371.     Consequently, to prevail, a taxpayer

must prove that the Commissioner’s determination is arbitrary,

capricious, or without sound basis in fact or law.    See Ansley-

Sheppard-Burgess Co. v. Commissioner, supra at 371; Ford Motor

Co., supra at 92.

     To resolve this dispute, we consider sections 446 and 471

and the regulations thereunder.    Under section 446(a), a taxpayer

computes taxable income based on the method of accounting

utilized by the taxpayer in keeping its books.    Section 446(c)

describes the various accounting methods that a taxpayer may use

in computing taxable income, including the cash and accrual

methods.

     Section 1.446-1(c)(2)(i), Income Tax Regs., provides that a

taxpayer who is required to use inventories must also use the

accrual method of accounting with regard to purchases and sales.

Under section 471 and section 1.471-1, Income Tax Regs., a

taxpayer must account for inventories if the production,

purchase, or sale of merchandise is an income-producing factor in
                               - 9 -

the taxpayer’s business and the taxpayer has acquired title to

the merchandise.

     We consider the facts and circumstances of each case in

deciding whether material is merchandise that is an income-

producing factor.   See Honeywell, Inc. v. Commissioner, T.C.

Memo. 1992-453, affd. without published opinion 27 F.3d 571 (8th

Cir. 1994); Wilkinson-Beane, Inc. v. Commissioner, T.C. Memo.

1969-79, affd. 420 F.2d 352 (1st Cir. 1970).   Although not

specifically defined in the Internal Revenue Code or the

regulations, courts have ruled that “merchandise”, as used in

section 1.471-1, Income Tax Regs., is an item acquired and held

for sale.   See, e.g., Wilkinson-Beane, Inc. v. Commissioner,

supra.

     Respondent contends that, because the sand and gravel is

merchandise which is an income-producing factor in petitioner’s

business, petitioner must account for inventories and report its

taxable income under the accrual method of accounting.

     Petitioner broadly argues that it does not have to account

for inventories under section 471 and section 1.471-1, Income Tax

Regs., because (1) its business consists of “procuring and

delivering * * * not acquiring and holding sand and gravel for

sale to customers”; therefore, the sand and gravel should not be

considered merchandise, and (2) even if the sand and gravel is

considered merchandise, the procurement of the sand and gravel is
                               - 10 -

not an income-producing factor in petitioner’s business.

     Petitioner makes several arguments regarding why the sand

and gravel should not be considered merchandise (i.e., items

acquired and held for sale).   On brief, petitioner positions

itself as a service provider rather than as a seller of goods.

Petitioner argues that to perform its primary business activity

of delivering sand and gravel, petitioner merely accommodates its

customers by also procuring sand and gravel.   Further, petitioner

asserts that, because it does not have any sand and gravel on

hand at the beginning or end of the business day (due to the fact

that on the same day it procures and delivers the exact amount of

sand and gravel requested by its customers), it does not hold the

sand and gravel for sale.   Petitioner also argues that it does

not mark up the cost of the sand and gravel and that “it makes

the same profit whether it procures and delivers the requested

[sand and gravel], or simply delivers [the] sand and gravel which

the [customer] already owns or has purchased separately”.7

     We reject petitioner’s contentions.   When petitioner

transports the sand and gravel that a customer already owns or

has acquired, petitioner does not realize the profit associated

with acquiring sand and gravel for a customer.   Based on the



     7
        Petitioner argues that because it designates the profit
it earns on the “procurement” of sand and gravel as a separate
element of its charge for acquiring and transporting 1 ton of
sand and gravel, petitioner does not mark up the sand and gravel.
                               - 11 -

record, petitioner generates more profits if it both acquires and

transports sand and gravel for its customer rather than solely

acting as a transporter.    Further, although not labeled by

petitioner as a markup in its business records, petitioner’s

profit for acquiring the sand and gravel is nevertheless a markup

since, in substance, the profit is based on a percentage of the

underlying cost of the sand and gravel.     Furthermore, petitioner,

on its tax return, listed its business activity as the selling of

construction materials.

     In RACMP Enters., Inc. v. Commissioner, 114 T.C. ___ (2000),

we recently held that respondent abused his discretion in placing

a construction contractor on the accrual method for Federal

income tax purposes.   In that case, we concluded that the

material provided by the contractor to its customer, pursuant to

a construction contract for concrete foundations, driveways, and

walkways, was not merchandise within the meaning of section

1.471-1, Income Tax Regs.    See id.    In reaching that conclusion,

we viewed the construction contract as a service contract,

finding that the materials were indispensable to and inseparable

from the provision of that service and that the materials lost

their separate identity during the construction activity.      See

id.; see also Osteopathic Med. Oncology & Hematology, P.C. v.

Commissioner, 113 T.C. 376 (1999) (wherein drugs used as part of

chemotherapy treatments were not considered merchandise because
                                - 12 -

their use was an indispensable and inseparable part of the

rendering of services).

     This is not such a case.    Petitioner primarily sells a

product, the sand and gravel, and incidentally provides a

service, the transportation of the sand and gravel.    Because

petitioner can generate profits from solely transporting the sand

and gravel, we do not view the sand and gravel as indispensable

to and inseparable from the provision of a service.8   Further,

because petitioner does not consume, alter, or add to the sand

and gravel, petitioner does not cause the sand and gravel to lose

its separate identity.    As the evidence shows that petitioner is

a seller of sand and gravel, we conclude that the sand and gravel

is merchandise.

     Petitioner additionally argues that even if we conclude that

the sand and gravel is merchandise, petitioner does not have to

maintain inventories because the sand and gravel is not an

income-producing factor in petitioner’s business.    In evaluating

whether merchandise is an income-producing factor in a taxpayer’s

business, we must compare the cost of the merchandise to the

taxpayer’s gross receipts computed under the cash method of


     8
        With regard to revenues and expenses generated as a
result of customers requesting only transportation services,
petitioner has not argued in the alternative that they should be
placed on a hybrid method of accounting. In any respect,
petitioner has not presented any evidence with regard to those
revenues and expenses, and therefore it cannot meet its burden of
proof.
                              - 13 -

accounting.   See Wilkinson-Beane, Inc. v. Commissioner, supra.

In Wilkinson-Beane, Inc., we held that merchandise, the cost of

which (in different taxable years) constituted 14.7 percent and

15.4 percent of the taxpayer’s gross receipts, was an income-

producing factor in the taxpayer’s business.   See also Knight-

Ridder Newspapers, Inc. v. United States, 743 F.2d 781, 791 (11th

Cir. 1984) (wherein newspapers, the cost of which constituted

17.6 percent of the taxpayer’s total revenues, were considered an

income-producing factor).

     For its 1994 taxable year, petitioner reported cost of goods

sold in the amount of $1,867,497.   Petitioner argues that

$786,723 of the $1,867,497 amount relates to petitioner’s

transportation activities, thereby leaving $1,080,774 for the

cost associated with petitioner’s acquisition of the sand and

gravel.   Assuming arguendo that petitioner’s figures are correct,

because the cost of the sand and gravel constitutes at least 31

percent of petitioner’s gross receipts ($1,080,774 ÷ $3,483,206),

we conclude that the sand and gravel is an income-producing

factor in petitioner’s business.9

     On brief, petitioner does not address whether it acquires



     9
        Petitioner does not include in cost of goods sold the
costs involved in filtering, gathering, and removing the Byron
sand from Unimin’s processing plant. These costs would
significantly increase the cost of goods sold and the percentage
that cost of goods sold would constitute of petitioner’s gross
receipts.
                                - 14 -

title to the sand and gravel.    Petitioner and respondent

stipulate that after petitioner loads the Byron sand onto its

trucks for delivery and Unimin creates a “weighmaster

certificate”, Unimin considers the Byron sand to be petitioner’s

property.    We interpret that stipulation to mean that title to

the Byron sand passes from Unimin to petitioner at that point in

time.

     The record does not reflect whether petitioner acquires

title to the sand and gravel that petitioner purchases from the

20 suppliers.    In Addison Distrib., Inc., T.C. Memo. 1998-289, we

described a taxpayer as both a “buyer pursuant to its contract

with [a] vendor or subcontractor and [as a] seller pursuant to

its contract with its customers”.    Citing California Commercial

Code section 2106 (West 1964), which provides that “a ‘sale’

consists in the passing of title from the seller to the buyer for

a price”, we concluded that the taxpayer had acquired title to

goods which were purchased from the vendor or subcontractor for

eventual sale to the taxpayer’s customers.    See id.   In light of

California Commercial Code section 2106, our characterization of

petitioner as a seller of sand and gravel, and petitioner’s

failure to dispute the transfer of title, we see no reason to

treat petitioner’s contractual and legal relationship with the 20

suppliers differently from petitioner’s business dealings with

Unimin.     We therefore conclude that petitioner acquires title to
                              - 15 -

the sand and gravel.

     Because we hold that the sand and gravel is merchandise

which is an income-producing factor in petitioner’s business and

that petitioner acquires title to the sand and gravel, petitioner

must maintain inventories.   Pursuant to section 1.446-1(c)(2)(i),

Income Tax Regs., petitioner would therefore have to report its

taxable income on the accrual method of accounting unless an

exception applies.   A taxpayer demonstrating a substantial

identity of results between the taxpayer’s method of accounting

and the method of accounting selected by the Commissioner may

compute taxable income under its method of accounting.    See

Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d 352, 356 (1st

Cir. 1970), affg. T.C. Memo. 1969-79.     On brief, petitioner

concedes that it does not meet the substantial identity of

results test.   We, therefore, hold that respondent did not abuse

his discretion under section 446 when respondent required

petitioner to compute its taxable income based on the accrual

method of accounting.

     In reaching all our holdings herein, we have considered all

arguments made by the parties, and, to the extent not mentioned

above, we find them to be irrelevant or without merit.

     To reflect the foregoing,

                                      Decision will be entered

                                 for respondent.
