                          T.C. Memo. 1997-311



                      UNITED STATES TAX COURT



          TEBARCO MECHANICAL CORPORATION, Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 153-95.                  Filed July 3, 1997.



     Matthew J. Howard, for petitioner.

     Clinton M. Fried, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     PARR, Judge:   Respondent determined a deficiency in

petitioner's Federal income tax for the taxable year ending
                                  - 2 -

September 30, 1990, of $98,314, and an accuracy-related penalty

under section 66621 of $24,851.

       After concessions by the parties, the issues for decision

are:    (1) Whether respondent's determination that petitioner must

account for inventories and use the accrual method of accounting

(accrual method) was an abuse of discretion.       We hold it was not.

(2) Whether petitioner is liable for the section 6662 accuracy-

related penalty for a substantial understatement of income tax

for 1990.    We hold it is not.

                          FINDINGS OF FACT

       Some of the facts have been stipulated and are so found.

The stipulated facts and the accompanying exhibits are

incorporated into our findings by this reference.       At the time

the petition in this case was filed, petitioner's principal place

of business was located in Alpharetta, Georgia.       Petitioner is a

corporation owned by a sole shareholder, Terrell Barden (Barden).

Petitioner files its Federal income tax return using a fiscal

year ending September 30.

       At its inception in 1983, petitioner began using the cash

method of accounting (cash method).       Then, in 1987, petitioner

began keeping its books and records on the accrual method.


1
     Unless otherwise noted, all section references are to the
Internal Revenue Code in effect for the taxable year in issue,
and all Rule references are to the Tax Court Rules of Practice
and Procedure, unless otherwise indicated. All dollar amounts
are rounded to the nearest dollar.
                               - 3 -

Thereafter, Michael L. Powers (Powers), petitioner's accountant,

would make annual or semi-annual adjusting entries to convert

petitioner's books to the percentage of completion method for

financial statement reporting, as required for bonding purposes,

and to the cash method of accounting for income tax purposes.

     Petitioner is a mechanical contractor that provides plumbing

installation, heating, and air conditioning work for general

contractors or job site owners (customers).   Petitioner's typical

jobs are for new commercial construction and its installation

sites include churches, schools, and retail complexes.

Petitioner's business is located in a 5,000-square foot building.

Of that 5,000 square feet, 2,000 square feet comprise an office

and the other 3,000 square feet comprise a warehouse.    In the

warehouse petitioner stored materials, such as large piping, duct

work, plumbing materials, sheet metal, small hardware pieces, and

materials left over from various job sites.   On occasion,

petitioner uses the warehouse to store materials that are

eventually going to a job site.    For the taxable year in issue,

the value of the materials maintained at petitioner's warehouse

was between $10,000 and $20,000.

     Petitioner procures jobs through a bid process.    The factors

that went into estimating a bid price for a job included

materials, supplies, equipment, subcontracts, and labor costs

(total direct expenses).   Prior to submitting a bid proposal,

petitioner increases the total direct expense by either 10 or 20
                                - 4 -

percent to recover overhead expenses and to make a profit on the

job.    The bid price submitted to the general contractor is a

lump-sum bid; the general contractor is not informed of the

various costs making up the bid.    If accepted, the proposal forms

the basis of the contract between petitioner and the customer.

       Once a contract is signed, petitioner orders materials

required for a particular job, such as steel piping and heating,

ventilation and air conditioning (HVAC) systems, on an as-needed

basis from various vendors.    Petitioner supplies the purchase

order to the vendor, and the vendor looks to petitioner, not the

customer, for payment.    Generally, when petitioner purchases

materials for a job, it has the items delivered directly from the

vendor to the job site, unless the weather or other exigent

circumstances require petitioner to ship the materials directly

to its warehouse.    For instance, petitioner had a contract where

the schedule originally called for the materials to be delivered

to a job site in February.    Due to inclement weather the job did

not progress as scheduled.    Petitioner, however, had already

ordered the materials for the job, so the general contractor

asked petitioner to store the items at its warehouse.    On another

occasion, petitioner was working during the summer at a school,

but the project could not be completed by the time the students

returned in September.    Under those circumstances, petitioner

ordered the materials for the job and had the items shipped

directly to its warehouse.
                               - 5 -

     Petitioner works on several jobs at a time.   Petitioner's

contracts generally provide for progress billing on the 25th day

of each month.   In most cases, petitioner sends its customers a

bill once a month until a job is complete.   Petitioner's vendors

allow 30 days for payment of any materials petitioner orders.

Petitioner generally tries to ship any materials ordered for a

particular job directly to the job site on or about the 20th day

of each month, so that it is not responsible for paying vendor

bills until the 20th of the following month.

     Petitioner had $2,115,291 in gross receipts for the taxable

year in issue.   Petitioner's material costs2 for the taxable year

amounted to 33 percent of its gross receipts.   Petitioner's cost

of good sold (COGS) was $1,835,723.3

                              OPINION

Issue 1. Whether It Was an Abuse of Respondent's Discretion To
Require Petitioner To Change From the Cash Method of Accounting
to an Accrual Method of Accounting

     Respondent determined that the cash receipts and

disbursements method of accounting used by petitioner for income

tax purposes does not clearly reflect income.   Specifically,

respondent claims that petitioner must use inventories, and

2
     On its tax return for the year in issue, petitioner reported
material costs of $701,320.
3
     On its tax return for the year in issue, petitioner included
the following items in its COGS computation: Material purchases,
labor, equipment, subcontractor payments, depreciation, payroll
taxes, insurance, operating expenses and other miscellaneous
expenditures.
                              - 6 -

therefore the accrual method of accounting, because petitioner

derives a substantial portion of its income from the sale of

merchandise, maintains work-in-process at yearend, maintains a

physical inventory at its business premises, and uses the accrual

method of accounting for its books and records.

     Petitioner asserts that it has no inventory, because it

never takes title in, or physical possession of, the materials it

acquires for its jobs, and thus is not required to adopt an

inventory method of accounting.   Petitioner further argues that

even if we find that it does take title in the materials

acquired, it does not have to adopt an inventory method of

accounting because the sale of merchandise is not an income-

producing factor in its business.   Finally, in reliance on

Knight-Ridder Newspapers, Inc. v. United States, 743 F.2d 781

(11th Cir. 1984), petitioner contends that even if the sale of

merchandise is an income-producing factor, section 1.471-1,

Income Tax Regs., does not apply because there are no substantial

fluctuations in petitioner's inventory, nor does petitioner

maintain a substantial amount of inventory at its warehouse.

     The principal issue for decision is whether it was an abuse

of respondent's discretion to require petitioner to change from

the cash method, which petitioner uses for income tax reporting

purposes, to an accrual method.   Subsumed in this issue is the

question of whether petitioner should be required to use
                                - 7 -

inventories for tax purposes.   To resolve these issues, we

consider sections 446 and 471 and the regulations thereunder.

     Pursuant to section 446,4 the Commissioner has broad powers

to determine whether an accounting method used by a taxpayer

clearly reflects income.   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.

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


4
     Section 446 provides in pertinent part:

          SEC. 446(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 -

T.C. 1091 (1975); Ansley-Sheppard-Burgess Co. v. Commissioner,

supra.   However, the Commissioner cannot require a taxpayer to

change from an accounting method which clearly reflects its

income to an alternate method of accounting merely because the

Commissioner considers the alternate method to more clearly

reflect the taxpayer's income.     Ansley-Sheppard-Burgess Co. v.

Commissioner, supra at 371.

     Whether an abuse of discretion has occurred is a question of

fact.    Ansley-Sheppard-Burgess Co. v. Commissioner, supra; Ford

Motor Co. v. Commissioner, 102 T.C. 87, 91-92 (1994), affd. 71

F.3d 209 (6th Cir. 1995); see Cole v. Commissioner, supra at 749.

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.     Ansley-

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

Corp. of America v. Commissioner, T.C. Memo. 1996-105.

Consequently, to prevail, a taxpayer must prove that the

Commissioner's determination is arbitrary, capricious, or without

sound basis in fact or law.   Ansley-Sheppard-Burgess Co. v.

Commissioner, supra; Ford Motor Co. v. Commissioner, supra at 92.
                                 - 9 -

     Pursuant to section 471,5 a taxpayer that has inventories is

required to use the accrual method of accounting.    An exception

to this rule exists, however, where a taxpayer can show that use

of another method (here the cash method) would produce a

substantial identity of results and that the Commissioner’s

determination requiring a change is an abuse of discretion.

Ansley-Sheppard-Burgess Co. v. Commissioner, supra at 377; see

also Knight-Ridder Newspapers, Inc. v. United States, 743 F.2d at

791-793 (11th Cir. 1984).

     By regulation, the Secretary has determined that inventories

are necessary if the production, purchase, or sale of merchandise

is an income-producing factor.    Sec. 1.471-1, Income Tax Regs.

Completing the statutory and regulatory scheme, section 1.446-

1(c)(2)(i), Income Tax Regs., provides that a taxpayer that has

inventory must also use the accrual method of accounting with

regard to purchases and sales.

     Although not specifically defined in the Internal Revenue

Code or regulations, courts have found that the term

"merchandise", as used in section 1.471-1, Income Tax Regs., is


5
     Sec. 471 provides in pertinent part:

          SEC. 471(a). General Rule.--Whenever in the opinion of
     the Secretary 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 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.
                              - 10 -

defined as an item acquired and held for sale.   Wilkinson-Beane,

Inc. v. Commissioner, 420 F.2d 352, 354-355 (1st Cir. 1970),

affg. T.C. Memo. 1969-79; Galedrige Const., Inc. v. Commissioner,

T.C. Memo. 1997-240; Honeywell Inc. v. Commissioner, T.C. Memo.

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

1994).   Whether an item was acquired and held for sale is

governed by the substance of the transaction and not its form.

Galedrige v. Commissioner, supra; Honeywell Inc. v. Commissioner,

supra.   Thus, in deciding whether the materials petitioner

acquires to perform its installation contracts are merchandise,

we examine the facts and circumstances of the case.      Wilkinson-

Beane, Inc. v. Commissioner, supra; Galedrige v. Commissioner,

supra; Thompson Elec., Inc. v. Commissioner, T.C. Memo. 1995-292;

Honeywell Inc. v. Commissioner, supra; J.P. Sheahan Associates,

Inc. v. Commissioner, T.C. Memo. 1992-239.

Material Purchases and Warehouse Items are Merchandise

     Petitioner asserts that it was an abuse of respondent's

discretion to place petitioner on an accrual method of accounting

for income tax reporting purposes, because petitioner does not

have merchandise held for sale in its business, and therefore it

does not have to use inventories.   In support of this contention,

petitioner argues that while the section 1.471-1, Income Tax

Regs. does not define inventory, it imposes one critical

requirement before a taxpayer is permitted to include an item of

merchandise in inventory, that requirement being the vesting of
                              - 11 -

title.   Petitioner relies on the following language to support

its position that it does not have to include the materials it

acquires in inventory.   Section 1.471-1, Income Tax Regs.,

provides in pertinent part:

     Merchandise should be included in the inventory only if
     title thereto is vested in the taxpayer. Accordingly, the
     seller should include in his inventory goods under contract
     for sale but not yet segregated and applied to the contract
     and goods out upon consignment, but should exclude from
     inventory goods sold, * * * title to which has passed to the
     purchaser. A purchaser should include in inventory
     merchandise purchased, * * * title to which has passed to
     him, although such merchandise is in transit or for other
     reasons had not been reduced to physical possession, but
     should not include goods ordered for future delivery,
     transfer of title to which had not yet been effected.
     [Emphasis added].

     Specifically, petitioner asserts that under Georgia law6,

title to the job site materials remains in the vendor until

delivery, and at delivery vests in the job site owner.

Petitioner claims that in essence, it was a broker or agent for

its customers, in that it merely coordinated the purchase, sale,

and delivery of materials to the job site for a fee.   Thus,

petitioner contends that title passed directly from its vendors

to its customers at the point of shipment, here the job site.     To

support its position that as a broker, it is not required to


6
     Ga. Code. Ann. sec. 11-2-401(2) (1994) provides in pertinent
part:

Unless otherwise explicitly agreed title passes to the buyer at
     the time and place at which the seller completes his
performance with reference to physical delivery of the goods
     * * *
                              - 12 -

maintain inventories, petitioner relies heavily on Simon v.

Commissioner, 176 F.2d 230 (2d Cir. 1949) (buyer and seller of

paper box-board maintained no inventory, and was not engaged in

business of "merchandising" requiring use of accrual method in

computing income for Federal income tax purposes), and stresses

the fact that generally it does not take physical possession of

any materials it orders.   Petitioner further argues that its

practices are consistent with industry customs in that other

subcontractors never take title to assigned materials, which they

provide to their customers for a particular job.

     We find petitioner's argument without merit; not only does

it lack factual support in the record, but it fails to provide a

defense for petitioner's refusal to account for inventories.

Petitioner argues in a circular fashion that pursuant to section

1.471-1, Income Tax Regs., it need not maintain inventories,

because it never had merchandise held for sale as all materials

it acquires are instantaneously applied to a contract,

segregated, and sold.   Under the facts discussed herein, however,

petitioner, in any given transaction, acts as both the buyer

pursuant to its contract with the vendor, and the seller pursuant

to its contract with the general contractor.   In relying on

section 1.471-1, Income Tax Regs., and Ga. Code Ann. sec. 11-2-

401, however, petitioner fails to address this critical fact.

Moreover, we note that petitioner could have changed the nature

of its position as one of "buyer" by describing in the contracts
                              - 13 -

with its customers exactly when, where, and to whom title to the

materials was to pass.   See Miami Purchasing Service Corp. v.

Commissioner, 76 T.C. 818, 830 (1981) (the taxpayer, when

negotiating with customers over sales terms could have insisted

on a clear contractual statement of where title was to pass).

Had petitioner set out such terms pursuant to its contracts, and

had it consistently acted in accordance with such contracts,

"such provisions would have furnished clear evidence of the

parties' intention and governed the passage of title". Epic

Metals Corp. v. Commissioner, T.C. Memo. 1984-322, affd. without

published opinion 770 F.2d 1069 (3d Cir. 1985).   However, based

on the evidence submitted at trial, we find that petitioner's

contracts do not by their terms prevent petitioner from taking

title to the materials shipped directly to a job site from

petitioner's vendors to its customers.

     Moreover, petitioner's assertion that many of its material

acquisitions are identified with specific customers' construction

jobs, does not negate the fact that it purchases materials from

vendors and then sells the ordered materials to its customers.

J.P. Sheahan Associates v. Commissioner, T.C. Memo. 1992-239.

More importantly, that title in the merchandise may not repose in

petitioner for a long period of time does not negate the fact

that petitioner acquires merchandise for sale in its business.

We note that possession of title is a factor in determining when

a sale occurs together with all surrounding circumstances.
                              - 14 -

Hallmark Cards, Inc. v. Commissioner, 90 T.C. 26 (1988).

Furthermore, it is title, rather than physical possession that

determines whether merchandise should be included in inventory.

Epic Metals Corp. v. Commissioner, T.C. Memo. 1984-322; see also

Hoffman v. Commissioner, T.C. Memo. 1989-154 (taxpayer's S

corporation required to accrue income from sale of ski equipment,

even though equipment had not yet been manufactured and it never

took possession); Middlebrooks v. Commissioner, T.C. Memo. 1975-

275 (magazines were considered inventory, even where publisher

held title to them only briefly).

     In Middlebrooks, we noted that, aside from consideration of

the technical passage of title, the taxpayer exercised control

and ownership rights over the magazines after they had been

printed in that they were shipped in the taxpayer's name and at

his own expense.   Similar to the taxpayer in Middlebrooks, the

petitioner in the instant case also has the benefits and burdens

of ownership.   Here, petitioner marks up the cost of the

materials between 10 and 20 percent, acquires the materials in

its name, and the vendors look to petitioner, not the general

contractor or owner, for payment.    Petitioner's argument is

further weakened by its admission that it sometimes accepts

delivery and retains possession of the merchandise it acquires.

     Finally, we note that petitioner's reliance on Simon v.

Commissioner, supra, is misplaced.     The facts in Simon, are

clearly distinguishable from the facts in the instant case.      In
                              - 15 -

Simon, the Court of Appeals for the Second Circuit noted that one

of the conclusive facts in finding the taxpayer did not maintain

inventories was that the taxpayer had no stock or merchandise on

hand and no warehouse or storeroom for merchandise.   Simon v.

Commissioner, supra at 232.   Here, as discussed below, we find as

fact that petitioner did indeed have stock on hand and a

warehouse where it stored materials.

     In addition to the above-described materials petitioner

acquired in its business, respondent alleges that petitioner had

a warehouse where it stored materials such as large piping, duct

work, plumbing materials, sheet metal, small hardware pieces, and

materials left over from various job sites.   Petitioner admits

that its office contains a large warehouse where it keeps

materials such as scraps from old jobs, doors, and some duct

work.   Moreover, petitioner concedes that if it does maintain the

"warehouse inventory" as alleged by respondent, "then there is no

question that it will have title to it."    Petitioner contends

however, both at trial and on brief, that the warehouse space was

shared by petitioner and two corporations run by the brothers of

petitioner's president.   At trial, Barden, petitioner's

president, testified that his brother, Howell, who owned General

Mechanical Corporation (General Mechanical), had shut down his

company after being in business for 20 years.   Barden claimed

that all of the material from General Mechanical's shop was

brought to petitioner's warehouse and stored there by Howell.
                               - 16 -

Barden also testified that his other brother, Tim, who runs

Tebarco Door and Metal Services (Tebarco Door), stored his

material in the warehouse as well.

     At trial, Vicki Byers (Byers), a revenue agent, who

conducted an onsite audit of petitioner's business testified that

while touring the warehouse with Barden she and another agent

discussed the approximate value of the inventory in petitioner's

warehouse.   Although Barden valued the inventory at somewhere

between $10,000 and $20,000, he at no time indicated to Byers

that some of the material belonged to his brothers.   Given that

petitioner was being audited, we believe that if the materials in

the warehouse belonged to anyone other than petitioner, Barden

would have informed the agent of that fact.   Barden's failure to

do so leads us to believe that the materials in the warehouse did

indeed belong to petitioner.   Furthermore, Barden's brothers were

not called to testify regarding the inventory maintained in

petitioner's warehouse, nor did petitioner call anyone who worked

at either General Mechanical or Tebarco Door to corroborate the

validity of Barden's testimony.   We note that the absence of

testimonial evidence may lead the finder of fact to infer that

such evidence, if presented at trial, subject to respondent's

cross-examination, would not have been favorable to petitioner.

McKay v. Commissioner, 89 T.C. 1063, 1069 (1987), affd. 886 F.2d

1237 (9th Cir. 1989); Wichita Terminal Elevator Co. v.

Commissioner, 6 T.C. 1158, 1165 (1946), affd. 162 F.2d 513 (10th
                              - 17 -

Cir. 1947).   This is especially true where, as here, the party

failing to produce such evidence has the burden of proof.      Id. at

1165.

     Moreover, numerous invoices found in petitioner's books and

records clearly establish that petitioner stored materials in its

warehouse, which it used to complete its work at various job

sites.   At trial, petitioner objected on the grounds of hearsay

to the inclusion in the record of numerous exhibits placed in the

stipulation by respondent.   We received the exhibits subject to

oral reservation.   The exhibits referred to and included in the

stipulation were petitioner's business records produced pursuant

to respondent's subpoena duces tecum.   On brief, petitioner

withdrew its objections to all of the exhibits except the

following: 72-BT, 73-BU, 84-CF, 85-CG, and 86-CH.

     Petitioner contends that respondent is using hearsay

statements from several of the exhibits to prove that petitioner

maintains a warehouse full of materials, and that petitioner sold

such materials from its warehouse to customers.   Petitioner

admits that the stipulated exhibits, which are composed mostly of

petitioner's purchase orders, are not inherently untrustworthy.

Rather, petitioner contends that they are merely untrustworthy

when offered by respondent to prove matters that are collateral

to the material information conveyed by the documents.

Furthermore, petitioner argues that its "control over the

stipulated business records does not negate the hearsay that is
                              - 18 -

found therein, nor does it establish as fact respondent's

interpretations of the hearsay statements."

     The business record exception to the hearsay rule expressly

authorizes the introduction of the exhibits into the record.

Fed. R. Evid. 803(6).7   The exhibits were all maintained in

petitioner's files and were maintained in the ordinary course of

business.   The fact that notations, terms, and directives may be

contained in the business records, which express certain acts,

events, conditions, or opinions, does not per se render the

records inadmissible.

     Petitioner does not dispute the material facts contained

within the invoices, but asserts that there are certain

notations, terms, and directives found within some of the

documents in issue, e.g., invoices which show that materials used

by petitioner on a particular job either are being shipped to, or

picked up from, "the shop."   Petitioner argues that if the

7
     Fed. R. Evid. 803 provides in pertinent part:

     The following are not excluded by the hearsay rule, even
though the declarant is available as a witness:
     *      *      *        *    *      *          *
     (6). Records of regularly conducted activity.--A * * *
     record, * * * in any form, of acts, events, conditions,
     opinions, or diagnoses, made at or near the time by, or from
     information transmitted by, a person with knowledge, if kept
     in the course of a regularly conducted business activity,
     and if it was the regular practice of that business activity
     to make the * * * record * * *, all as shown by the
     testimony of the custodian or other qualified witness,
     unless the source of information or the method or
     circumstances of preparation indicate lack of
     trustworthiness. * * *
                              - 19 -

declarants of the statements had been able to testify as to the

statements' meanings, it would be clear that they were taken out

of context and that any reference to "the shop" was not a

reference to petitioner's shop, but to the shop at the job site.

Petitioner had the opportunity to present evidence or witnesses

at trial to explain any ambiguity in the statements found in

petitioner's business records.   Petitioner's failure to do so

leads us to believe that the presentation of such evidence would

have been unfavorable to petitioner.   McKay v. Commissioner,

supra; Wichita Terminal Elevator Co. v. Commissioner, supra.

     Based on the entire record, we find that petitioner's

subcontracting installation transactions involved a sale of a

service and merchandise.   The materials petitioner acquires and

assigns to particular jobs, as well as the materials petitioner

maintains in its warehouse are the merchandise sold in these

transactions.
                              - 20 -

Sale of Merchandise Is an Income-Producing Factor

     For merchandise to be classified as inventory under section

1.471-1, Income Tax Regs., it must also be an "income-producing

factor".   Whether merchandise is an income-producing factor

depends on the facts and circumstances of the case.     Thompson

Elec., Inc. v. Commissioner, T.C. Memo. 1995-292;     Wilkinson-

Beane, Inc. v. Commissioner, T.C. Memo. 1969-79.    If the cost of

the merchandise is substantial compared to the taxpayer's

receipts, the merchandise is an income-producing factor.     Knight-

Ridder Newspapers, Inc. v. United States, 743 F.2d at 790 (11th

Cir. 1984) (the cost of newsprint and ink constituted 17.6

percent of total cash receipts); Wilkinson-Beane, Inc. v.

Commissioner, 420 F.2d at 355 (for 1963 and 1965 respectively,

the cost of caskets constituted 15.4 percent and 14.7 percent of

cash basis receipts); Thompson Elec., Inc. v. Commissioner, supra

(materials varied from 37 to 44 percent of its cash basis gross

receipts).

     In this case, the facts indicate that the materials acquired

by petitioner and assigned to particular job sites, as well as

materials kept at petitioner's warehouse, were sold to its

customers as part of the subcontracting installation transaction.

The price of such materials was one of six factors making up the

price of the installation transaction; the other factors were

equipment and supply cost, labor cost, subcontractor cost, and an

overhead/profit allocation.   Petitioner's materials amounted to
                              - 21 -

38 percent of its COGS for 1990.   Since most of the components of

petitioner's COGS are the same components that go into preparing

its estimated direct expenses, a similar relationship would, and

does, appear as direct expenses in petitioner's bid estimate.

The direct expenses plus an overhead/profit allocation of 10 to

20 percent are included in petitioner's bid price.   The cost of

the materials acquired by petitioner bears a direct relationship

to the price charged for the subcontracting installation

transaction.   In fact, the cost of the materials is the most

significant factor used by petitioner in computing its bid.

Thus, we find that the price charged for the subcontracting

installation transaction was directly related to the cost of the

material purchases.   Wilkinson-Beane, Inc. v. Commissioner, T.C.

Memo. 1969-79.   That petitioner acquired the materials from a

vendor only after it obtained a signed contract from a customer

indicates that petitioner sold the materials as part of the

subcontracting installation transaction.   Cf. Honeywell Inc. v.

Commissioner, T.C. Memo. 1992-453 (fee established before

taxpayer knew the parts that would be used; thus, there was no

direct relationship between the amount charged to maintain the

computers and the cost of the parts).

     Moreover, the cost of petitioner's material purchases for

the taxable year in issue represented approximately 33 percent of

its gross receipts.   This amount clearly establishes that the

materials were an income-producing factor for petitioner.
                              - 22 -

Knight-Ridder Newspapers, Inc. v. United States, supra (sale of

newspapers was a material income-producing factor where the cost

of raw materials for such newspapers was 17.6 percent of total

revenues); Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d at 355

(for 1963 and 1965, the cost of caskets constituting 15.4 percent

and 14.7 percent, respectively of the taxpayer's cash basis

receipts was a substantial income-producing factor).

     Since petitioner's materials are both merchandise and an

income-producing factor, section 1.471-1, Income Tax Reg., is

applicable.   Respondent determined, pursuant to section 1.446-

1(c)(2)(i), Income Tax Regs.,8 that this conclusion requires

petitioner to use the accrual method of accounting.    Petitioner

argues that section 1.446-1(c)(2)(ii), Income Tax Regs., allows

respondent to authorize petitioner's use of the cash method,



8
     Sec. 1.446-1(c)(2), Income Tax Regs., provides:

     (2) Special rules. (i) In any case in which it is necessary
     to use an inventory the accrual method of accounting must be
     used with regard to purchases and sales unless otherwise
     authorized under subdivision (ii) of this subparagraph.

     (ii) * * * The Commissioner may authorize a taxpayer to
     adopt or change to a method of accounting permitted by this
     chapter although the method is not specifically described in
     this part if, in the opinion of the Commissioner, income
     is clearly reflected by the use of such method. Further,
     the Commissioner may authorize a taxpayer to continue the
     use of a method of accounting consistently used by the
     taxpayer, even though not specifically authorized by the
     regulations in this part, if, in the opinion of the
     Commissioner, income is clearly reflected by the use of such
     method. * * *
                               - 23 -

notwithstanding a finding that petitioner has inventory, and that

respondent's failure to authorize the use of the cash method is

an abuse of discretion.

     In general, where a taxpayer has been required to maintain

inventories, it has been held that the taxpayer must use the

accrual method of accounting in accordance with the mandate of

section 1.446-1(c)(2)(i), Income Tax Regs.   Herberger v.

Commissioner, 195 F.2d 293, 295 (9th Cir. 1952).   However, the

courts have developed, in the context of accounting for

inventory, a substantial-identity-of-results test for determining

whether respondent abused his discretion in not affording the

taxpayer the opportunity to continue to use the cash method of

accounting under section 1.446-1(c)(2)(ii), Income Tax Regs.

Asphalt Prods. Co. v. Commissioner, 796 F.2d 843, 849 (6th Cir.

1986), affg. on this issue Akers v. Commissioner, T.C. Memo.

1984-208; Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d at 356;

Ansley-Sheppard-Burgess Co. v. Commissioner, 104 T.C. at 377

(1995); Thompson Elec., Inc. v. Commissioner, T.C. Memo. 1995-

292; J. P. Sheahan Associates, Inc. v. Commissioner, T.C. Memo.

1992-239; Surtronics, Inc. v. Commissioner, T.C. Memo. 1985-277.

Whether the result under the cash method is substantially

identical with that under the accrual method is a question of

fact.   E.g., Asphalt Prods. Co. v. Commissioner, supra;

Wilkinson-Beane, Inc. v. Commissioner, supra; Thompson Elec.,

Inc. v. Commissioner, supra.
                             - 24 -

     In Asphalt Prods. Co. v. Commissioner, supra at 849, the

court noted that an insignificant increase in inventories may be

grounds for finding an abuse of discretion by the Commissioner.

However, the court found no such abuse of discretion in that case

given the size of the taxpayer's receivables combined with its

failure to account for inventories.   Id.   See also Thompson

Elec., Inc. v. Commissioner, supra (cash method did not produce

substantial identity of results where for 1988 and 1989,

petitioner's taxable income computed under the cash method was

$138,418 and $135,958, respectively, while taxable income

computed under the accrual method was $331,925 and $289,039,

respectively); Surtronics, Inc. v. Commissioner, supra (cash

method did not produce substantially identical results to the

accrual method, where the difference in net income for the period

involved was $198,000).

     For fiscal year 1990, petitioner's taxable income under the

cash method of accounting was $54,128.   Petitioner's taxable

income under the accrual method of accounting would be $328,549.

Thus, petitioner's taxable income under the accrual method

increased by $274,421 for the taxable year in issue.   This

difference is not inconsequential; the two methods do not produce

substantially identical results.   Thompson Elec., Inc. v.

Commissioner, supra; J. P. Sheahan Associates, Inc. v.

Commissioner, supra.
                                - 25 -

     The same result obtains if we examine the differences in

gross receipts computed under the accrual method and the cash

method.   For fiscal year 1990 petitioner's gross receipts under

the cash method of accounting were $2,115,291.    Petitioner's

gross receipts under the accrual method of accounting would be

$2,465,060.   Thus, petitioner's gross receipts under the accrual

method increased by $349,769.    Petitioner's use of the cash

method does not produce results that are substantially identical

to the computation of either taxable income or gross receipts

under the accrual method.   Thus, we hold that respondent did not

commit an abuse of discretion in precluding petitioner from

continuing to use the cash method of accounting for income tax

reporting purposes.9




9
     Petitioner, in reliance on Knight-Ridder Newspapers, Inc. v.
United States, 743 F.2d 781 (11th Cir. 1984), asserts that it is
not required to use the accrual method, because it does not
maintain inventory at its warehouse. In Knight-Ridder, the Court
of Appeals for the Eleventh Circuit stated that "if either the
absolute level of the inventory account or its fluctuation during
the year would be substantial, then the taxpayer must use
inventories if it meets the other requirements of sec. 1.471-1,
[Income Tax Regs]." Id. at 791 In addition to the $701,320 cost
of petitioner's material purchases during the year in issue,
petitioner maintained a warehouse with materials valued somewhere
between $10,000 to $20,000. We find that such inventory is
substantial in comparison to petitioner's reported taxable income
of $54,128. We note, that petitioner's books and records were
insufficient to establish whether there was a substantial
fluctuation in its inventory account during the year in issue,
however, because we have found that petitioner maintains
substantial inventory at its warehouse we need not address the
fluctuation issue.
                                - 26 -

     We have concluded that the materials petitioner purchased

and the materials maintained at its warehouse were merchandise

that were an income-producing factor and that petitioner is

required to use inventories.     Sec. 1.471-1, Income Tax Regs.

Furthermore, we have found that respondent did not commit an

abuse of discretion in not allowing petitioner to continue to use

the cash method of accounting.     Sec. 1.446-1(c)(2)(i), Income Tax

Regs.     Thus, we must now decide whether petitioner is liable for

the section 6662 accuracy-related penalty for a substantial

understatement of income for 1990.

Issue 2. Whether Petitioner Is Liable for the Section 6662
Accuracy-Related Penalty

        Respondent determined that petitioner was liable for an

accuracy-related penalty pursuant to section 6662 for fiscal year

1990.     Respondent asserts that the section 6662(a) penalty for

1990 is due to a substantial understatement of tax.     Petitioner

asserts that it is not liable for the section 6662 penalty

because it relied on its accountant in using the cash method of

accounting.

        Section 6662(a) imposes a penalty in an amount equal to 20

percent of the portion of the underpayment of tax attributable to

one or more of the items set forth in subsection (b).     The

accuracy-related penalty does not apply with respect to any

portion of the underpayment if it is shown that there was

reasonable cause for such portion and that the taxpayer acted in
                                  - 27 -

good faith with respect to such portion.    Sec. 6664(c)(1).    The

determination of whether a taxpayer acted with reasonable cause

and in good faith is made on a case-by-case basis, taking into

account all the pertinent facts and circumstances.    Sec. 1.6664-

4(b)(1), Income Tax Regs.    The most important factor is the

extent of the taxpayer's effort to assess its proper tax

liability for the year.     Id.

     Petitioner contends that the accuracy-related penalty is

inappropriate in this case, because it relied on its certified

public accountant, Michael Powers, to prepare its tax return

accurately.   Generally, the duty of filing accurate returns

cannot be avoided by placing the responsibility on a tax return

preparer.   Metra Chem Corp. v. Commissioner, 88 T.C. 654, 662

(1987).   However, reliance on a qualified adviser may demonstrate

reasonable cause and good faith if the evidence shows that the

taxpayer relied on a competent tax adviser and provided the

adviser with all necessary and relevant information.    Jackson v.

Commissioner, 86 T.C. 492, 539-540 (1986), affd. 864 F.2d 1521

(10th Cir. 1989); Daugherty v. Commissioner, 78 T.C. 623, 641

(1982); Magill v. Commissioner, 70 T.C. 465, 479 (1978), affd.

651 F.2d 1233 (6th Cir. 1981); Pessin v. Commissioner, 59 T.C.

473, 489 (1972).

     At trial, Powers testified that he had prepared petitioner's

tax returns from the time of its inception in 1983, and that

subcontractors similar to petitioner comprised approximately 50
                              - 28 -

percent of his clientele.   Powers spent 8 to 12 days a year

actually at petitioner's place of business.   As petitioner's

accountant, Powers' duties involved preparing semi-annual

financial statements and annual tax returns for petitioner,

hiring and training petitioner's accounting personnel, and

solving any accounting problems that petitioner may incur

throughout the year.   Powers claimed that to his understanding, a

mechanical contractor is a service provider. Moreover, Powers

testified that petitioner did not have inventory, because it

acted merely as an agent when it ordered materials pursuant to a

particular contract.

     There is nothing in the record to indicate that petitioner

withheld any relevant information from Powers.   We note that

Powers testified that he did not take a physical inventory of

petitioner's warehouse.   That fact alone, however, does not

establish that petitioner failed to provide Powers with all the

necessary and relevant information he needed to prepare

petitioner's tax returns.   Powers spent time at petitioner's

offices, he actually viewed petitioner's warehouse, and he

admitted that it was ultimately his decision, and not

petitioner's, to define what inventory is.

     Thus, given the facts discussed herein we find that

petitioner relied in good faith on the advice of its accountant

in filing its returns on the cash method.    Accordingly, we hold
                             - 29 -

that petitioner is not liable for the accuracy-related penalty

under section 6662(a) for the fiscal year 1990.

     To reflect the foregoing,

                                      Decision will be entered

                                 for respondent as to the

                                 deficiency, and for petitioner as

                                 to the accuracy-related penalty.
