                        T.C. Memo. 2000-233



                      UNITED STATES TAX COURT



       VANDRA BROS. CONSTRUCTION CO., INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 15483-96.                Filed August 2, 2000.



     Michael J. Occhionero, for petitioner.

     Joseph P. Grant, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     GALE, Judge:   Respondent determined a deficiency of

$405,017, and an accuracy-related penalty under section 6662(a)

in the amount of $81,003.40, for petitioner’s 1992 taxable year.

Unless otherwise noted, all section references are to the

Internal Revenue Code in effect for the year in issue.
                                  - 2 -

     After a concession by respondent,1 we must decide whether

respondent abused his discretion in determining that petitioner’s

use of the cash method of accounting did not clearly reflect

income.    We hold that he did.

                          FINDINGS OF FACT

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

incorporate by this reference the stipulation of facts and

attached exhibits.    At the time of filing the petition,

petitioner was an Ohio corporation with its principal place of

business in Oakwood Village, Ohio.

     Petitioner specialized in the construction of streets,

sidewalks, curbs, and similar improvements for governmental

entities.    All of petitioner’s customers were governmental and

municipal agencies, including the State of Ohio and

municipalities within the State.     Petitioner’s expertise was

construction, in particular laying concrete, on public sites such

as city streets and sidewalks that required the project to be

completed with a minimal amount of disruption in traffic flow and

in compliance with governmental regulations.     Petitioner provided

labor and equipment,2 but petitioner did not maintain a supply of

any of the materials that were used at a construction site,



     1
       Respondent concedes that petitioner is not liable for the
accuracy-related penalty.
     2
         Occasionally petitioner rented equipment to third parties.
                                 - 3 -

instead relying on suppliers to deliver needed materials to the

construction site at the appropriate time.     Petitioner only

ordered the materials it needed for the job for the particular

day.    Petitioner had no plant or other facility to store

materials and could not store materials at the construction site.

(Petitioner left no material on site overnight except,

occasionally, a negligible amount.)      Concrete could not be stored

on site for an additional reason:    Within a few hours of

delivery, it would harden and become useless and worthless.

Thus, petitioner tried to estimate as closely as possible the

amount of materials needed so there would not be anything left

over.    Petitioner bore the cost of any wasted materials if they

were the result of an over order, or, in the case of concrete, of

it not being laid in time.    If the materials were defective or,

in the case of concrete, delivered too late, the supplier was

responsible and bore the cost.

       Virtually all of petitioner’s projects required laying some

concrete.    Petitioner also engaged in related work, such as

preparing a site by removing existing concrete or stone.

Petitioner also installed items such as reinforcing steel, piping

for sewers and drainage, and guardrails.     During the year in

issue, 67 percent of petitioner’s total materials cost was due to

concrete, 16 percent was due to stone, 6 percent was due to

reinforcing material, and the remainder was due to other
                                - 4 -

materials.    In general, petitioner subcontracted for certain

parts of projects, such as electrical work, asphalt, or

landscaping.

     Bids

     Petitioner’s work was generally obtained through competitive

bids.    Petitioner’s bids comprised costs for labor, equipment,

and materials.    In computing its bid, petitioner estimated the

cost of labor and equipment and added a markup to the cost of

labor.    Further, petitioner estimated the quantity of materials,

which could include concrete, aggregate (stone and gravel),

reinforcing steel, piping for sewer and drainage, guardrail, etc.

However, petitioner did not add a markup to the cost of materials

but rather included the cost of the materials, as quoted by the

supplier, as an item in the bid.    During the year in issue, 27

percent of petitioner’s gross revenue came from the material cost

of concrete.    Petitioner would always solicit materials costs

from at least two suppliers, and sometimes three or four, and

would choose the lowest quoted cost for use in the bid.      The cost

of materials was subject to slight variations due, for example,

to the distance between a supplier and the job site.      However,

petitioner got a discount for early payment to suppliers, which

was not passed along to customers.      Occasionally a customer

itself would supply materials (e.g., concrete), but this did not

happen during the year in issue.
                               - 5 -

     Bids were calculated by estimating the cost of each

individual job that was necessary to complete the entire project.

The bid price of most of the individual jobs was calculated on a

per-unit basis.   For instance, in arriving at a total bid for the

reconstruction of a street in the City of South Euclid,

petitioner bid $28 per square yard to install 9-inch reinforced

concrete pavement, and $5 per linear foot to install 6-inch

drainage conduit, and separate amounts for numerous other items.

The bid price for some individual jobs was calculated on a per-

item basis (for instance, $23 per each 9-foot guardrail post) or

on a lump-sum basis (for instance, $60,000 for clearing and

grubbing a certain area indicated in the project plan).    The bid

calculation also included the estimated number of units or items

that the project required.   However, petitioner would bill the

customer on the basis of the number of units or items actually

used on the project, not the number shown in the bid.     In some

cases, petitioner was required by the customer to state

separately the cost of materials (i.e., without labor), and when

so required, petitioner did so on a per-unit or per-item basis.

Even if two jobs used the same amount of material, the amount of

the bid could have differed substantially, due to different cost

of labor and equipment.   For instance, to maintain traffic flow,

petitioner might be limited in the amount of work it could

complete in one day, thus increasing costs of labor.    Petitioner
                                 - 6 -

did not begin any work without a written contract for that

particular project.    There were penalties if petitioner did not

comply with the contract.

     When petitioner subcontracted, the subcontractor was

responsible for labor, equipment, and materials for its part of

the project.    Petitioner took bids on the subcontractor work and

did not mark up the subcontractor’s bids, except to cover its own

bond costs and insurance.    When petitioner subcontracted, if the

subcontractor did not pay its suppliers, those suppliers could

file liens against petitioner.    Thus, petitioner took care in

selecting subcontractors, trying to ensure they could pay their

suppliers.

     The construction season in general lasted from April to

November.    Generally petitioner bid in the spring and finished

the projects by November or December.       Occasionally work carried

over to the next year.

     Governmental Regulations

     Petitioner’s business was strictly regulated by its

customers.    Both the State of Ohio and local governments

stationed an engineer at each construction site to inspect

materials and oversee the project.       Petitioner was required to

pour concrete within 1 hour after the concrete supply truck left

the supply plant.    If this condition was not met, the onsite

engineer had the right to reject the load of concrete.       Further,
                               - 7 -

the engineer inspected the concrete to make sure it was not

defective and had the right to reject it if it was.   If concrete

was rejected, the party responsible assumed the loss.     For

instance, if the supplier delivered defective concrete or did not

deliver the concrete to the site in time to lay it within 1 hour

of leaving the supplier’s plant, the supplier assumed the loss.

However, if petitioner failed to pour properly delivered concrete

in time, petitioner assumed the loss.   The governmental entity

worked with petitioner and the supplier but ultimately held

petitioner responsible for any failure to meet contractual

obligations.   Petitioner signed for the concrete after the

government’s inspector found it to be acceptable.   The

government’s engineer gave permission to pour the concrete.

Thus, for instance, if permission was given and concrete was

poured, and then the concrete was damaged by rain before it

dried, the governmental entity assumed responsibility.     For State

projects, the governmental regulation was so strict that

petitioner did not need to guarantee materials; if the State

allowed use of the materials, the State assumed responsibility

for defects.   For city projects petitioner guaranteed some

materials, but the city would be responsible in some cases, for

instance if its engineer had advised petitioner to pour concrete

that was later damaged because of rain.   During the 1990’s, 30 to

40 percent of petitioner’s work was for the State of Ohio.
                                - 8 -

     Accounting Method, Payments, and Billing

     From its inception through the year in issue, petitioner

kept its books and records and reported its income using the cash

receipts and disbursements method of accounting.    Prior to and

including the year in issue, petitioner’s annual gross receipts

did not exceed $5 million.    Starting in 1991, petitioner prepared

financial reports using an accrual method of accounting, the

completed contract method.    These financial reports were required

by petitioner’s bonding company.    (Petitioner was often required

to be bonded for its work.)

     Petitioner’s suppliers billed petitioner, not petitioner’s

customers, and petitioner made payment to the suppliers.    If

petitioner had the money on hand, petitioner would pay when

billed.    If not, petitioner would wait until the money was

available.    For some projects, petitioner paid for all materials

before receiving any payment from its customer.    Petitioner made

payments for its labor costs on a weekly basis.    The schedule on

which petitioner billed and received payment from its

governmental entity customers was regulated by them; there was a

set schedule of payments over which petitioner had little or no

control.   The State paid biweekly, whereas other governmental

entities paid monthly.    Petitioner normally received payments

based on the amount of the project that was completed.    On at

least one occasion during the year in issue, petitioner paid for
                              - 9 -

all materials in 1992, but petitioner did not receive a check

from the customer until February 1993.   However, the project was

completed in October 1992, and the delay in payment was beyond

petitioner’s control.

     Petitioner made no attempt to defer income to a later year,

and there were no prepayments of expenses.   Business decisions

were made on the basis of the cash method financial records, even

though the completed contract records were available.

     In the notice of deficiency, respondent determined that

petitioner was required to use an accrual method of accounting.

By amendment to answer and stipulation of the parties, the

parties agree that if petitioner was not entitled to use the cash

method of accounting, then petitioner will elect to use, and

respondent will allow the use of, the completed contract method

of accounting.3




     3
       The parties further stipulate that under the completed
contract method of accounting, petitioner’s income for the
taxable year 1992 would be $433,862, which would result in a
current year adjustment of $385,755 (after consideration of
$48,107 in income reported on the cash basis) and adjustment
required to be taken into account in 1992 under sec. 481 of
$1,005,077. Thus, the total increase in petitioner’s taxable
income for 1992 would be $1,390,832.
                              - 10 -

                              OPINION

     We must decide whether respondent’s determination that

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

reflect income was an abuse of respondent’s discretion.   We hold

that it was.

     In order to require a taxpayer to change its method of

accounting, the Commissioner must determine that the method used

by the taxpayer does not clearly reflect income.   See sec.

446(b); Hallmark Cards, Inc. v. Commissioner, 90 T.C. 26, 31

(1988).   While the Commissioner’s discretion is broad, see Thor

Power Tool Co. v. Commissioner, 439 U.S. 522, 532-533 (1979), it

is not absolute, see Hallmark Cards, Inc. v. Commissioner, supra,

and we find an abuse of discretion when the Commissioner’s

determination is without sound basis in fact or law.   See Ansley-

Sheppard-Burgess Co. v. Commissioner, 104 T.C. 367, 371 (1995).

     In RACMP Enters., Inc. v. Commissioner, 114 T.C. 211 (2000),

we addressed these issues in a factual context indistinguishable

from the instant case.   In that case, we provided as follows:

          Whether * * * [the taxpayer] is required to report
     its income on the accrual method of accounting instead
     of the cash method depends on whether * * * [the
     taxpayer] is in the business of selling merchandise to
     customers in addition to providing service or whether
     the material provided by * * * [the taxpayer] is a
     supply that is incidental to the provision of the
     contracted service. [Id. at 220; citations omitted.]
                               - 11 -

In that case we found that the taxpayer, a company engaged in the

laying of concrete and the installation of related items, such as

sand, rock, wire mesh, and rebar, did not sell merchandise to its

customers.    Rather, relying on Osteopathic Med. Oncology &

Hematology, P.C. v. Commissioner, 113 T.C. 376 (1999), we found

that the concrete and related materials were supplies consumed by

the taxpayer.    In Osteopathic Med. Oncology & Hematology, P.C.,

we held that chemotherapy drugs furnished by a healthcare

provider in treating cancer patients were supplies rather than

merchandise because the taxpayer was a service provider and the

drugs were an “integral and inseparable part of its service.”

Id. at 384.   Similarly, in RACMP Enters., Inc. v. Commissioner,

supra, we held that the taxpayer was a service provider, and we

found that the materials used in construction were not

merchandise because they were “indispensable and inseparable from

the service provided by” the taxpayer.    Id. at 228.   In

conclusion, we held that because the taxpayer did not produce or

sell merchandise, the taxpayer could not be required to use

inventory accounting.   See id. at 229.

     In the instant case, the concrete, stone, reinforcing steel,

and other items (collectively, the materials) used by petitioner

were not merchandise for the same reasons stated in RACMP

Enters., Inc.:    First, the materials lost their separate identity

when used in a construction project.    Second, petitioner did not
                              - 12 -

contract to sell the materials but rather contracted to provide

finished walkways, repaired streets, and the like.    Third, the

construction projects that petitioner engaged in were

improvements to real property.   Fourth, petitioner did not leave

any of the materials on the construction site, or store them for

use for a later project.   See id. at 228-231.   Given our recent

holding in RACMP Enters., Inc., and the indistinguishable facts

of the instant case, we hold that petitioner was not engaged in

the production or sale of merchandise.    Therefore, petitioner

cannot be required to use inventories, and the Commissioner

abused his discretion in requiring petitioner to change from the

cash method of accounting.

     To reflect the foregoing,

                                         Decision will be entered

                                 for petitioner.
