                       T.C. Memo. 2000-353



                     UNITED STATES TAX COURT



        EDWARD G. SMITH AND JAN M. SMITH, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 10833-99.                 Filed November 14, 2000.


     Larry D. Vince, for petitioners.

     Timothy F. Salel, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     WELLS, Chief Judge:    Respondent determined a deficiency of

$46,283 in petitioners’ Federal income tax for 1995.   Unless

otherwise indicated, section references are to sections of the

Internal Revenue Code, as amended, and Rule references are to the

Tax Court Rules of Practice and Procedure.   The deficiency is

attributable to an adjustment to the taxable income reported by
                                 - 2 -

EJKC, Inc. (EJKC), an S corporation of which petitioner Edward G.

Smith is the sole shareholder, based on respondent’s

determination that EJKC is required to account for inventories

and use the accrual method of accounting.1     After a concession by

petitioners, the issues for decision are:     (1) Whether EJKC’s

contracts to purchase and install flooring materials constitute

sales of “merchandise”; and (2) whether respondent abused his

discretion in determining that EJKC’s use of the cash method of

accounting does not clearly reflect its income.

                        FINDINGS OF FACT

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

The stipulation of facts and attached exhibits are incorporated

herein by this reference.   At the time the petition was filed,

petitioners resided in Moreno Valley, California.

     Petitioner has 25 years’ experience installing flooring

materials such as carpeting, vinyl and ceramic tile, and hardwood

flooring (flooring materials).    In 1988, petitioner started his

own flooring installation business.      In 1990, petitioner decided

to operate the business as an S corporation and filed articles of

incorporation for EJKC with the California secretary of state.

EJKC conducts business under the fictitious business name of

Smith Floors & Installations (Smith Floors).



     1
        References to petitioner in the singular are to
petitioner Edward G. Smith.
                               - 3 -

     Initially, Smith Floors’ operations were modest and limited

to flooring installation services.     Smith Floors would dispatch

its employees to a job site to install flooring materials that

had been ordered by and delivered to the general contractor.

Running its business in this fashion exposed Smith Floors to

operational disruptions arising from errors by contractors in

ordering flooring materials and scheduling installations.    To

avoid these disruptions, and to increase Smith Floors’ range of

services, petitioner decided to expand Smith Floors’ operations

by obtaining warehouse space which would allow Smith Floors to

acquire and hold the flooring materials that it would install

pursuant to its flooring installation contracts.

     Smith Floors operates its business out of an 8,500 square

foot commercial building in Riverside, California.    Smith Floors

uses 6,000 square feet of space as warehouse area and 2,500

square feet of space as showroom and office areas.

     Smith Floors receives invitations to bid on jobs from

architects, contractors, and developers.    Prior to submitting a

bid, Smith Floors receives floor plans for the job and

specifications identifying the flooring materials to be

installed.   Although petitioner makes product recommendations,

Smith Floors generally has no discretion as to manufacturer,

type, grade, or color of the flooring materials that it installs.
                               - 4 -

     After being awarded a contract to install flooring materials

for a particular job, Smith Floors’ practice is to take delivery

at its warehouse of the flooring materials specified under the

contract, inspect the flooring materials to ensure that they

conform in both quality and quantity with the specifications for

the particular job, inspect the job site to verify that

installation may proceed, and deliver the flooring materials to

the job site a few days in advance of the installation date to

allow the materials to “acclimate” to the environment.

     Smith Floors typically bills its customers a “service

charge” ranging from 10 to 20 percent of the cost of the flooring

materials to be installed.   The service charges cover Smith

Floors’ cost of receiving, storing, inspecting, and delivering

the flooring materials to the job sites.   Smith Floors bills its

customers for the flooring materials as soon as possible to avoid

expenses associated with financing the purchase of the flooring

materials.   However, Smith Floors sometimes does not receive

reimbursement for the cost of the flooring materials for several

months.   Smith Floors does not charge interest when reimbursement

for the cost of the flooring materials is delayed.

    After a job is completed, Smith Floors retains (for

approximately 1 year) scrap or excess flooring materials to

ensure continuity in the dye lot for a particular job in the
                               - 5 -

event that a warranty claim or repair work request is made.2

Scrap or excess flooring materials remaining after 1 year are

either returned to the client or thrown out.

     Smith Floors uses its warehouse area to store padding and

flooring installation materials including glue/adhesives, nails,

cap metal, and cove stick.   Smith Floors purchases padding and

glue/adhesives in monthly allotments (based on work projected for

the month).   Smith Floors does not charge separately for flooring

installation materials but includes such expenses in its labor

charges.

     Smith Floors does not store any flooring materials in its

warehouse for resale to the general public.

     Smith Floors uses its showroom area to display samples of

flooring materials.   Smith Floors encourages architects,

designers, and contractors to visit its showroom to view its

samples of flooring materials for particular projects.

     Smith Floors (through petitioner) has developed an expertise

regarding the proper installation of flooring material for

particular applications.   For example, petitioner has expertise

regarding the proper installation of flooring material in

hospital operating rooms which require antibacterial surfaces,

and in schools and kitchens which require slip-resistant

surfaces.   Petitioner is also known for his skill and


     2
         Smith Floors warrants its work for 1 year.
                                - 6 -

craftsmanship in hand-cutting and incorporating custom designs,

such a corporate logos, into flooring jobs.    Smith Floors enrolls

its employees in annual training programs where the employees are

instructed (and certified) in the installation of various

flooring materials.

     During 1995, Smith Floors had a total of 836 jobs:    555 jobs

required Smith Floors to purchase and install flooring materials

and 281 jobs required Smith Floors to provide installation-only

services.    Smith Floors’ has provided flooring installation

services for a number of large companies including Albertson’s

(grocery stores), Marriott (hotels), Walgreens (drug stores),

Pacific Theaters, and Walt Disney Corporation, as well as the

U.S. General Services Administration.    Smith Floors frequently

installs either proprietary or custom-designed flooring

materials.    Normally, the companies contracting with Smith Floors

negotiate the price of such flooring materials in advance

directly with the manufacturer of the flooring materials.

     Smith Floors has consistently used the cash method of

accounting to prepare its corporate income tax returns.    Smith

Floors routinely assigns a value of $15,000 to its inventory from

year to year to account solely for flooring installation

materials on hand such as glue/adhesives, nails, cap metal, and

cove stick.    Smith Floors does not consider flooring materials

and padding on hand at the end of the year to be inventory
                              - 7 -

because they were purchased and designated for installation for a

specific job.

     For the taxable year 1995, Smith Floors reported gross

receipts of $1,693,669 and cost of goods sold of $1,252,445.

Smith Floors computed its cost of goods sold as follows:

     Beginning inventory                        $15,000
     Purchases                                  686,283
     Cost of labor                              386,135
     Other
      Back charges                  $1,632
      Contract labor                21,402
      Freight                        1,060
      Payroll taxes direct labor    37,941
      Small equipment                  719
      Supplies                      98,405
      Worker’s compensation         18,868
      Total other                               180,027

     Total                                    1,267,445
     Ending inventory                           (15,000)
     Cost of goods sold                      $1,252,445


                             OPINION

     Section 446(b) provides that, if a taxpayer’s method of

accounting does not clearly reflect income, the taxpayer’s

computation of income “shall be made under such method as, in the

opinion of the Secretary, does clearly reflect income.”    In

connection with the foregoing, section 471(a) provides the

general rule that a taxpayer is required to take inventories on

such basis as the Secretary may prescribe in order to clearly

determine the taxpayer’s income.   Thus, the Commissioner is

granted broad discretion to determine whether a taxpayer’s use of
                               - 8 -

a method of accounting clearly reflects income and, if not, to

direct the taxpayer to adopt an alternative method of accounting.

See sec. 446(b); United States v. Catto, 384 U.S. 102, 114 & n.22

(1966); Commissioner v. Hansen, 360 U.S. 446, 468 & n.12 (1959).

     Section 446 imposes a heavy burden on a taxpayer disputing

the Commissioner’s determination on accounting matters.     See Thor

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

review the Commissioner’s exercise of authority under section

446(b) for abuse of discretion.   See Ford Motor Co. v.

Commissioner, 102 T.C. 87, 91 (1994), affd. 71 F.3d 209 (6th Cir.

1995).   The Commissioner’s determination is entitled to more than

the usual presumption of correctness.     See id. and cases cited

therein.   Whether an abuse of discretion has occurred depends

upon whether 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).      To prevail, a taxpayer

must establish that the Commissioner’s determination was “clearly

unlawful” or “plainly arbitrary”.      Id. at 370.

     Section 1.471-1, Income Tax Regs., 25 Fed. Reg. 11724 (Nov.

26, 1960), provides that a taxpayer must use inventories “in

every case in which the production, purchase, or sale of

merchandise is an income-producing factor.”     Section 1.446-

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

inventories generally must use the accrual method of accounting.
                              - 9 -

Relying on the foregoing regulations, respondent determined that

the flooring materials that Smith Floors purchased and installed

during 1995 were merchandise, that such merchandise was an

income-producing factor, and that Smith Floors therefore must use

the accrual method of accounting to clearly reflect its income.

     Petitioners contend that Smith Floors is a service provider

and that it purchases flooring materials solely as an

accommodation to those contracting for its services.    Therefore,

petitioners contend that Smith Floors’ use of the cash method of

accounting is proper.

     Whether Smith Floors must use the accrual method of

accounting instead of the cash method depends on whether Smith

Floors is in the business of selling merchandise (within the

meaning of sec. 1.471-1, Income Tax Regs.) to customers in

addition to providing flooring installation services or whether

the flooring material provided by Smith Floors is a supply that

is incidental to Smith Floors installation services.

     The term “merchandise” is not defined in either the Internal

Revenue Code or the regulations.   See RACMP Enters., Inc. v.

Commissioner, 114 T.C. 211, 221 (2000).    To resolve whether

particular materials constitute merchandise, we look to the

context in which the materials are used.   See id.   The high cost

of materials relative to labor costs is insufficient, standing

alone, to transform the sale of a service to the sale of
                               - 10 -

merchandise and a service.   See Osteopathic Med. Oncology &

Hematology, P.C. v. Commissioner, 113 T.C. 376, 386 (1999).     We

distinguish between materials held for sale and materials that

are consumed by the taxpayer in performing a service.    See RACMP

Enters., Inc. v. Commissioner, supra at 224.

     In RACMP Enters., Inc. v. Commissioner, supra, we were

presented with the question whether the raw materials (concrete

mix, sand, and drain rock) that a concrete contractor used in

completing contracts for the construction of foundations,

driveways, and walkways constituted merchandise within the

meaning of section 1.471-1, Income Tax Regs.   Relying on

Osteopathic Med. Oncology & Hematology, P.C., v. Commissioner,

supra, we concluded that construction materials generally will

not be considered merchandise within the meaning of the

regulation if the inherent nature of the taxpayer’s business is

that of a service provider and the materials are an indispensable

and inseparable part of the rendering of the services.    See RACMP

Enters., Inc. v. Commissioner, supra at 222.

     In RACMP Enters., Inc. v. Commissioner, supra, we initially

concluded that the taxpayer/concrete contractor was a service

provider.   See id.   In reaching that conclusion, we noted that

construction contracts involve primarily the furnishing of labor

and contractual skills, and in the context of that case, the
                               - 11 -

taxpayer did not hold concrete materials for sale but rather

consumed the materials in performing a service.    See id.

     We further concluded:    (1) The ephemeral quality of liquid

concrete precluded such material from being considered

merchandise; and (2) the remaining materials used by the

taxpayer, including sand, drain rock, and hardware, were

incorporated into the particular project to such a degree that

they lost their separate identity, and likewise should not be

considered merchandise within the meaning of the regulation.     Id.

at 225-229.

     Consistent with our analysis in RACMP Enters., Inc. v.

Commissioner, supra, we hold that the flooring materials that

Smith Floors purchases and installs in fulfilling its contracts

do not constitute merchandise within the meaning of section

1.471-1, Income Tax Regs.    Like the concrete contractor in RACMP

Enters., Inc. v. Commissioner, Smith Floors is inherently a

service provider.    Smith Floors’ stock in trade is its expertise

in installing flooring materials in a variety of unique

applications and petitioner’s skill and craftsmanship in hand-

cutting and incorporating specialized designs into flooring

materials.    The companies contracting with Smith Floors are

primarily interested in the firm’s labor and contractual skills.

     Smith Floors purchases and takes delivery of the flooring

materials required for a particular job to better manage the
                               - 12 -

project and to provide additional services to the companies

contracting for the installation of the flooring materials.       In

particular, Smith Floors takes delivery of flooring materials at

its warehouse, inspects the materials to ensure that they conform

in both quality and quantity with the specifications for the

particular job, inspects the job site to verify that installation

may proceed, and delivers the flooring materials to the job site

in advance of the installation date to allow the materials to

“acclimate” to the environment.   Smith Floors charges its

customers for those services as a percentage markup on the cost

of the flooring materials.

     Smith Floors frequently installs either proprietary or

custom-designed flooring materials.     Normally, the companies

contracting with Smith Floors negotiate the price of such

flooring materials in advance directly with the manufacturer of

the flooring materials.   Smith Floors is neither a manufacturer

of merchandise nor a retail seller of flooring materials.

     Based on the foregoing, we hold that Smith Floors does not

produce, purchase, or sell merchandise within the meaning of

section 1.471-1, Income Tax Regs.   Smith Floors’ practice of

purchasing the flooring materials for a particular job is

incidental and secondary to Smith Floors’ provision of flooring

installation services.    Accordingly, considering all of the facts

and circumstances of the instant case, we hold that respondent’s
                              - 13 -

determination that Smith Floors is required to use the accrual

method of accounting was an abuse of discretion.

     We recognize that the cash method of accounting may result

in mismatching for income tax purposes when an expense is

incurred in one taxable period and the related income is not

realized until a later period.   See RLC Indus. Co. v.

Commissioner, 98 T.C. 457, 493 (1992), affd. 58 F.3d 413 (9th

Cir. 1995).   Nonetheless, some mismatching of income and expense

is tolerated under the law governing income tax accounting if the

taxpayer uses the cash method of accounting consistently and

makes no attempt to prepay expenses unreasonably or stockpile

supplies at the end of the taxable year.   See Ansley-Sheppard-

Burgess Co. v. Commissioner, supra at 375; Van Raden v.

Commissioner, 71 T.C. 1083, 1104 (1979), affd. 650 F.2d 1046 (9th

Cir. 1981).

     In the instant case, Smith Floors has consistently used the

cash method of accounting for tax purposes as permitted under

section 446(c).   The cash method of accounting for tax purposes

is widely used throughout the contracting industry.   See RACMP

Enters., Inc. v. Commissioner, supra at 232, and cases cited

therein.   Furthermore, there is no evidence that Smith Floors

ever attempted to prepay expenses unreasonably or accumulate

excess supplies at the end of its taxable year.    See RACMP

Enters., Inc. v. Commissioner, supra at 233; Ansley-Sheppard-
                             - 14 -

Burgess Co. v. Commissioner, supra at 375.     Considering these

factors, we see no justification for respondent’s determination

that Smith Floors must use the accrual method of accounting.3

     To reflect the foregoing,


                                      Decision will be entered

                                 pursuant to Rule 155.




     3
        Because we have already concluded that Smith Floors was
not required to use inventories, Smith Floors is not obliged to
satisfy the substantial-identity-of-results test in this case.
See Ansley-Sheppard-Burgess Co. Commissioner, supra at 377.
