                         T.C. Memo. 1998-84



                       UNITED STATES TAX COURT



                WARD AG PRODUCTS, INC., Petitioner v.
            COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 4508-95.               Filed February 26, 1998.



     Frank R. Keasler, Jr., for petitioner.

     William R. McCants, for respondent.



               MEMORANDUM FINDINGS OF FACT AND OPINION


     COLVIN, Judge:    Respondent determined deficiencies in

petitioner's income tax of $173,261 for its taxable year ending

October 31, 1990, and $123,873 for its taxable year ending

October 31, 1992.1

     1
         Respondent determined that petitioner must use the accrual
                                                     (continued...)
                               - 2 -


     Petitioner sold seeds, fertilizer, and other supplies to

farmers during the years in issue.     Petitioner's owner provided

advice and some financial assistance to petitioner's customers.

The issue for decision is whether respondent committed an abuse

of discretion in determining that petitioner must use the accrual

method of accounting during the years in issue.    To decide this,

we must decide:

     1.   Whether petitioner's purchase and sale of merchandise

was a material income-producing factor in 1990 and 1992.    We hold

that it was.

     2.   Whether petitioner qualifies as a farmer for purposes

of using the cash method of accounting for 1990 and 1992.    We

hold that it does not.

     3.   Whether respondent's determination was an abuse of

discretion because, in determining that petitioner's use of the

cash method did not clearly reflect income, respondent compared

only 3 years of petitioner's income under the cash and accrual

methods of accounting.   We hold that respondent need not have

considered more than the 3 years in issue.

     Thus, we hold that petitioner must use inventories and the

accrual method of accounting for 1990 and 1992.


     1
      (...continued)
method of accounting for 1990, 1991, and 1992 and that petitioner
had a deficiency in income tax for 1990 and 1992. Respondent
determined that petitioner overpaid tax for 1991.
                                - 3 -


     Unless otherwise indicated, section references are to the

Internal Revenue Code in effect in the years in issue.     Rule

references are to the Tax Court Rules of Practice and Procedure.

                        I.   FINDINGS OF FACT

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

     Petitioner is a Florida corporation the principal place of

business of which was in St. Augustine, Florida, during the years

in issue and when it filed the petition.

A.   Robert E. Ward, Jr.

     Robert E. Ward, Jr. (Ward), was raised on a dairy farm in

Eufala, Alabama.    He attended Auburn University.   He was married

around 1962.   He and his family moved from Eufala to Hastings,

Florida, in 1965.    In Hastings, he worked as a sales

representative for an agricultural chemical company.     In 1975,

Ward decided to start his own business of selling supplies to

farmers, in part because he had become close to the farmers

there.   Ward began by selling fertilizer from the back of a

truck.   He did not have an office for the first 3 years.    Ward

borrowed money to keep his business going.

     Ward's son, William David Ward (W.D. Ward), began to work

for Ward in 1983.    W.D. Ward was petitioner's warehouse manager.

     Ward and his family owned an interest in a farm in Alabama.
                                - 4 -


B.   Petitioner

     Ward incorporated his business (petitioner) in 1986.      Ward

bought a building for petitioner around 1988 and remodeled it.

     Petitioner sold seeds, herbicides, fertilizers, and

pesticides to farmers in the Hastings, Florida, area.    Petitioner

also sold farm hardware, tools, and implements.    The vast

majority of payments that petitioner received were from the

retail sale of farming products to farmers.

     Most of petitioner's customers grew potatoes.    Some grew

corn or cotton.    Petitioner's customers could not always pay

currently for their purchases from petitioner.    Customers paid

interest to petitioner on their unpaid accounts.    Petitioner

often required its customers to sign written contracts which gave

petitioner a lien against the farm or other assets.    Those

contracts provided a security interest to petitioner in both the

current crop and crops to be grown in the future on specified

real property.    The contracts typically provided that the

collateral was not subordinate to other loan agreements.

Petitioner's customers sometimes provided land as collateral.

     One of petitioner's suppliers from 1986 to 1993 was Lykes

Agri Sales.   It sold about $400,000 of merchandise on credit to

petitioner for each growing season (i.e., two or three times per

year).   Petitioner sold the merchandise to its customers.

Petitioner gave Lykes Agri Sales a security interest in
                                 - 5 -


petitioner's accounts receivables and inventory.     Lykes Agri

Sales never foreclosed on petitioner.

     Petitioner did not own any farm land.

C.   Ward's Relationship With Petitioner's Customers

     1.      Ward's Expertise

     Ward spent much of his time with farmers in the Hastings

area.     Petitioner's customers valued Ward's expertise and greatly

respected him.     They sought and relied on his advice.   They

sometimes called him at night at his home to ask for help.        He

was knowledgeable, helpful, and concerned about their problems.

Ward visited his customers' farms daily, inspected their soil and

crops, took leaf and soil samples, and advised them about

fertilizers, herbicides, and pesticides.     He showed his customers

how to apply the chemicals.     Ward charged for testing soil

samples but he did not charge for advice.

     2.      Ward's and Petitioner's Financial Assistance to Farmers

     Ward often gave financial assistance to farmers.      Many farms

in the Hastings area were heavily mortgaged during the years at

issue.     Harvest and market conditions in the Hastings area

fluctuated greatly during the years in issue.     Ward sometimes

cosigned notes for farmers and lent them money.     He often gave

farmers credit because they could not pay for merchandise.

     Ward borrowed money from a bank to pay for the merchandise

that he ordered for the farmers.     He deposited the borrowed money
                                - 6 -


in petitioner's checking account and used it to pay petitioner's

suppliers.    Petitioner paid interest on its loans from banks.

Petitioner did not execute notes to any of its suppliers.

       Petitioner had about four major competitors in the Hastings,

Florida, area which sold the same products as petitioner and

extended credit to their customers.      However, unlike petitioner,

they did not visit their customers on their farms or offer credit

terms as flexible as petitioner's.

       Many of the farmers in the Hastings area believed they would

not have been able to survive in farming without Ward's help.

Ward gave personal assistance to many farmers when they faced

severe financial problems.    Roger McDonald (McDonald) was a young

farmer who at one time had no money to buy seed or fertilizer.

He asked Ward for help around 1986 or 1987.      Ward borrowed money

to buy seed and fertilizer for McDonald and to provide an income

for McDonald and his son and obtained contracts for McDonald to

sell his potatoes.

       Jack Lee (Lee) was a farmer who needed money in the early

1990's.    Ward went to another farmer named William W. Wells

(Wells) and asked him to help Lee.      Ward and Wells obtained

contracts for Lee's crops and advanced a salary to Lee and his

son.

       Robert Larry Byrd and William Randolph Byrd II owned a farm

where they grew potatoes and corn.      At a time not described in
                                  - 7 -


the record, no one but Ward was willing to extend credit to them.

Ward did not require them to provide collateral.

     Around 1986 or 1987, Major Thomas (Thomas) was a cabbage

farmer who owed Ward some money.     Ward helped Thomas to obtain

financing by signing a bank note with Thomas.

     Charles C. Owen, Jr., and a Mr. Parker owned farms.     At a

time not specified in the record, they could not pay their bills

to petitioner.   Ward helped them to obtain financing by signing a

note (not otherwise described in the record) with Owen and Parker

Farms.

     Around 1993, Ward told Wells that a farmer named Morgan owed

money to Ward but that Morgan did not have enough equipment to

operate his farm.   Ward asked Wells to use Wells' equipment to

plant potatoes on Morgan's land so that Morgan could repay Ward.

Ward furnished all of the chemicals and advanced a salary to

Morgan.   Wells and Ward operated the harvester.    Wells agreed to

help Morgan because Ward had done a lot for Wells.     Morgan did

not pay Wells for his help.   Ward and Wells also helped two other

unnamed farmers at times not described in the record.

     Ward died on September 12, 1994.     Most of the farmers in the

Hastings area attended his funeral.

D.   Petitioner's Financial Statements and Tax Returns

     1.    Financial Statements

     Petitioner used the cash method of accounting for its income

tax returns and some of its financial statements.     Petitioner
                                 - 8 -


also used the accrual method of accounting for financial

statements.

     Robert Grady (Grady), petitioner's certified public

accountant, reconciled petitioner's accounts at the end of each

year.     He also prepared petitioner's general ledgers, balance

sheets, and adjusting transactions.       Grady used the accrual

method of accounting to prepare financial statements which

petitioner used to track its financial position for each farmer

and growing season.

     2.      Tax Returns

     Petitioner used a taxable year ending on October 31 for the

years at issue.

     Grady prepared petitioner's income tax returns.       Petitioner

used the cash method of accounting on its Federal income tax

returns before and during the years in issue.       Petitioner

reported opening and closing inventories to calculate costs of

goods sold on its tax returns and reported that it had accounts

receivable and accounts payable.     Petitioner reported that it had

gross income of more than $3 million per year for the years in

issue.     Petitioner reported that all of its income was from

selling farm supplies and equipment, except it reported that it

received less than $140,000 per year in interest income and less

than $300 per year in commissions.       Petitioner did not report

that it received any income from selling crops or farming.
                               - 9 -


     Petitioner's costs of sales were $2,752,954.45 for taxable

year 1990 (74.83 percent of sales), $3,200,223.61 for taxable

year 1991 (86.98 percent of sales), and $3,203,800.05 for taxable

year 1992 (81.91 percent of sales).

     Petitioner used the accrual method of accounting on its

Florida sales tax returns.   More than 95 percent of petitioner's

sales were exempt from Florida sales tax.

E.   Sale of Petitioner

     Ward sold petitioner to United Agri Products, Inc. (UAP), on

August 18, 1994.   As part of the negotiations, petitioner gave

UAP financial statements and documents which showed the amount of

petitioner's accounts receivable, accounts payable, and

inventories.

     W.D. Ward worked for UAP after the sale.   Ward's wife later

paid UAP about $70,000 because UAP could not collect some of

petitioner's accounts receivable.

F.   Comparison of Petitioner's Income Under the Cash and Accrual
     Methods of Accounting

     Petitioner's taxable income under the cash method of

accounting was $130,390 for 1990, $76,384 for 1991, and ($61,782)

for 1992.   Petitioner's taxable income under the accrual method

of accounting was $497,288 for 1990, $37,081 for 1991, and

$364,332 for 1992.
                                  - 10 -


                            II.    OPINION

A.   Contentions of the Parties and Background

     Respondent determined and contends that petitioner must use

the accrual method of accounting for its taxable years ending

October 31, 1990, 1991, and 1992.      Respondent contends that

petitioner must use inventories because petitioner's purchase and

sale of merchandise is an income-producing factor.

     Petitioner contends that its inventories are de minimis and

contends that it qualifies under section 448(b)(1), which permits

farmers to use cash accounting.

B.   Whether Petitioner's Purchase and Sale of Merchandise Was an
     Income-Producing Factor

     Respondent contends that the purchase and sale of

merchandise was a substantial income-producing factor for

petitioner.    We agree.

     A taxpayer generally must use the accrual method of

accounting with regard to purchases and sales if it must use

inventories.    Sec. 471;2 sec. 1.446-1(c)(2)(i), Income Tax Regs.3


     2
         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.
     3
         Sec. 1.446-1(c)(2), Income Tax Regs., provides in part:
                                                     (continued...)
                               - 11 -


A taxpayer must use inventories if the production, purchase, or

sale of merchandise is an income-producing factor.    Sec. 1.471-1,

Income Tax Regs.4

     Petitioner sold seed, fertilizer, pesticides, herbicides,

and farm hardware.    The purchase and sale of merchandise was a

substantial income-producing factor for petitioner; nearly all of

its income was from the sale of merchandise.    See Knight-Ridder

Newspapers, Inc. v. United States, 743 F.2d 781, 790 (11th Cir.


     3
      (...continued)
          (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) No method of accounting will be regarded as
     clearly reflecting income unless all items of gross
     profit and deductions are treated with consistency from
     year to year. * * *
     4
         Sec. 1.471-1, Income Tax Regs., provides in part:

          Need for inventories.--In order to reflect taxable
     income correctly, inventories at the beginning and end
     of each taxable year are necessary in every case in
     which the production, purchase, or sale of merchandise
     is an income-producing factor. The inventory should
     include all finished or partly finished goods and, in
     the case of raw materials and supplies, only those
     which have been acquired for sale or which will
     physically become a part of merchandise intended for
     sale * * *. Merchandise should be included in the
     inventory only if title thereto is vested in the
     taxpayer. * * * A purchaser should include in
     inventory merchandise purchased (including containers),
     title to which has passed to him, although such
     merchandise is in transit or for other reasons has not
     been reduced to physical possession, but should not
     include goods ordered for future delivery, transfer of
     title to which has not yet been effected. * * *
                               - 12 -


1984) (newsprint and ink which cost 17.6 percent of the

taxpayer's total receipts were a substantial income-producing

factor).

     Ward provided many services to petitioner's customers in

connection with selling farm products to them.    However,

businesses that provide both services and merchandise may be

required to use inventories.    Knight-Ridder Newspapers, Inc. v.

United States, supra at 790 n.16; Fred H. McGrath & Son, Inc. v.

United States, 549 F. Supp. 491 (S.D.N.Y. 1982) (funeral

services); sec. 1.471-1, Income Tax Regs.

     We conclude that buying and selling merchandise was a

substantial income-producing factor for petitioner.

C.   Whether Petitioner Qualified as a Farmer for Purposes of
     Using the Cash Method of Accounting

     A farming business may use the cash method of accounting to

compute its taxable income.    Sec. 448(b)(1).   Petitioner contends

that it qualifies as a farming business because it was

significantly involved in the growing process and bore a

substantial risk of loss from the growing process.       Maple Leaf

Farms, Inc. v. Commissioner, 64 T.C. 438, 448 (1975).      We

disagree.

     For purposes of section 448(b)(1), the "farming business" is

the trade or business of farming.    Secs. 263A(e)(4),

448(d)(1)(A).   A taxpayer is a farmer if it cultivates, operates,

or manages a farm for profit, either as owner or tenant.        See
                                - 13 -


Maple Leaf Farms, Inc. v. Commissioner, supra at 447-448

(defining a farm); secs. 1.61-4(d),5 1.175-3,6 Income Tax Regs.

A corporation that cultivates, operates, or manages a farm for

profit is a farmer.    Maple Leaf Farms, Inc. v. Commissioner,

supra at 447; sec. 1.61-4(d), Income Tax Regs.

     Petitioner did not cultivate, operate, or manage a farm for

profit as an owner or tenant.    Ward regularly visited farms and

gave advice and financial help to farmers.    However, neither

petitioner nor Ward operated a farm as an owner or a tenant.

Petitioner's business was merchandise sales, not farming.

     Petitioner contends that it was as involved in farming as

any Hastings farmer.    Petitioner also contends that it bore a


     5
         Sec. 1.61-4(d), Income Tax Regs., provides in part:

           (d) Definition of "farm". As used in this
     section, the term "farm" embraces the farm in the
     ordinarily accepted sense, and includes stock, dairy,
     poultry, fruit, and truck farms; also plantations,
     ranches, and all land used for farming operations. All
     individuals, partnerships, or corporations that
     cultivate, operate, or manage farms for gain or profit,
     either as owners or tenants, are designated as farmers.
     * * *
     6
         Sec. 1.175-3, Income Tax Regs., provides in part:

     A taxpayer is engaged in the business of farming if he
     cultivates, operates, or manages a farm for gain or
     profit, either as owner or tenant. For the purpose of
     section 175, a taxpayer who receives a rental (either
     in cash or in kind) which is based upon farm production
     is engaged in the business of farming. However, a
     taxpayer who receives a fixed rental (without reference
     to production) is engaged in the business of farming
     only if he participates to a material extent in the
     operation or management of the farm. * * *
                              - 14 -


substantial risk from farming because it (or Ward) lent money to

farmers and petitioner often sold items on credit to its

customers.   We agree with petitioner that, to be a farmer, the

taxpayer must have participated to a significant degree in the

growing process and borne a substantial risk of loss from that

process.   Maple Leaf Farms, Inc. v. Commissioner, supra at 448.

However, petitioner does not meet that standard because it did

not bear a substantial risk of loss from farming.    Farmers had no

recourse if their crops failed or the market for their crops was

poor.   Petitioner had liens, collateral, security interests, and

other rights and protections that farmers did not have.

Petitioner's liens and other security were not limited to the

current crop.

     Petitioner contends that it had more than $600,000 in

uncollected accounts receivable when it was sold in August 1994.

Petitioner provided no details about those accounts.    Even if

petitioner had $600,000 in uncollected accounts, the nature of

its risk was not like that of a farmer for the reasons stated in

the previous paragraph.

     Petitioner contends that we should not consider the fact

that it had liens or other security interests because its

customers were 100-percent mortgaged and petitioner's claims were

subordinated to those mortgages.   We disagree.   There is only

vague and general testimony that all of petitioner's claims were
                                 - 15 -


subordinated or that all of its customers were 100-percent

mortgaged.

     Petitioner contends that Ward farmed at least three times

when he helped Morgan and two other farmers.     However, there is

no evidence that either Ward or petitioner received any income

from those activities.

     Petitioner contends that it was as much a farmer as the

taxpayer in Maple Leaf Farms, Inc. v. Commissioner, supra.       We

disagree.    The taxpayer in Maple Leaf Farms grew some ducklings

and also paid others to grow ducklings.     It selected and bought

ducklings and their feed and medicine.      Id. at 448.   It owned all

of the ducks, feed, and medicine it and its growers used.       Id.

It set standards for the growers who grew the ducklings.       Id. at

448-449.     It provided fire insurance, feed, and medicine for the

ducklings.     Id. at 450.   We concluded that the taxpayer was a

farmer.    Id. at 448.   In contrast, petitioner did not keep title

to the seed, fertilizer, or pesticides; it sold merchandise to

farmers.     Thus, petitioner is unlike the taxpayer in Maple Leaf

Farms, Inc.    See Estate of Wallace v. Commissioner, 965 F.2d

1038, 1046-1047 (11th Cir. 1992), affg. 95 T.C. 525 (1990)

(taxpayer who lacked control of the management and operations and

had limited liability for cattle-feeding losses, and did not work

on feedlot, hire or fire employees was not a farmer under sec.

446); compare Hi-Plains Enters., Inc. v. Commissioner, 496 F.2d

520, 523 (10th Cir. 1974), affg. 60 T.C. 158 (1973), in which the
                              - 16 -


Court of Appeals indicated that a grain elevator or feed store

that sells grain or feed to farmers, and that has no control or

management of the farm operation, does not qualify as a farm or

farmer).

     Petitioner cites several other cases which it contends

support its position that it is a farmer.   However, in none of

these cases were the taxpayers in the business of making retail

sales to farmers.   The taxpayers owned or operated a cattle-

feeding or feed lot business in Frysinger v. Commissioner, 645

F.2d 523 (5th Cir. 1981), affg. T.C. Memo. 1980-89; Hi-Plains

Enters., Inc. v. Commissioner, supra; Packard v. Commissioner, 85

T.C. 397 (1985); and Van Raden v. Commissioner, 71 T.C. 1083

(1979), affd. 650 F.2d 1046 (9th Cir. 1981).   The taxpayers

raised poultry or livestock in United States v. Chemell, 243 F.2d

944 (5th Cir. 1957); Duggar v. Commissioner, 71 T.C. 147 (1978);

and Maple Leaf Farms, Inc. v. Commissioner, supra.

     We conclude that petitioner was not a farmer for purposes of

section 448(b)(1) and sections 1.471-6(a) and 1.61-4, Income Tax

Regs.

D.   Whether Respondent Should Have Compared Petitioner's Income
     Under the Cash and Accrual Methods for More than 3 Years

     Petitioner contends that respondent's determination that it

must use the accrual method of accounting was an abuse of

discretion because respondent considered petitioner's income for

only 3 years (1990, 1991, and 1992).
                                - 17 -


     The taxpayer bears the burden of proving there has been an

abuse of discretion by the Commissioner.       Asphalt Prods. Co. v.

Commissioner, 796 F.2d 843, 848 (6th Cir. 1986), affg. on this

issue Akers v. Commissioner, T.C. Memo. 1984-208, revd.

on another issue 482 U.S. 117 (1987).       Taxpayers must show that

the Commissioner’s action was arbitrary, capricious, or without

sound basis in fact.     Capitol Fed. Sav. & Loan Association & Sub.

v. Commissioner, 96 T.C. 204, 213 (1991); Buzzetta Constr. Corp.

v. Commissioner, 92 T.C. 641, 648 (1989); Mailman v.

Commissioner, 91 T.C. 1079, 1084 (1988); Pulver Roofing Co. v.

Commissioner, 70 T.C. 1001, 1011 (1978).       Petitioner has not made

that showing; there is no evidence that respondent's

determination was arbitrary.

     Petitioner contends that its total income for its 1988 to

1993 taxable years was about the same under the cash and accrual

methods of accounting.    Petitioner contends that from 1988 to

1993 under the cash method of accounting its total sales were

$25,523,854, taxable income was $1,157,437, and income tax was

$375,940.   Petitioner also contends that from 1988 to 1993 under

the accrual method of accounting its total sales were

$25,573,570, income before taxes was $1,084,420, and its

estimated income tax was $361,618.       These comparisons do not

establish that respondent committed an abuse of discretion.

Petitioner must use the accrual method of accounting and

inventories because merchandise is a material income-producing
                               - 18 -


factor for petitioner and because petitioner is not a farmer.

Tax liability is based on an annual system of accounting; whether

cash and accrual methods produce comparable results over a 6-year

period is not controlling.   See Knight-Ridder Newspapers, Inc. v.

United States, 743 F.2d at 792-793; Lucas v. Kansas City

Structural Steel Co., 281 U.S. 264, 271 (1930).

     Petitioner's reliance on Van Raden v. Commissioner, 71 T.C.

at 1095-1096, is misplaced because the years chosen for audit

were not an issue.    Petitioner has failed to carry the burden of

proving that there was an abuse of discretion by respondent.

E.   Conclusion

     We conclude that petitioner does not qualify as a farmer for

purposes of using the cash method of accounting and that it must

use inventories.   Sec. 448(b)(1); secs. 1.446-1(c)(2)(i), 1.471-

1, Income Tax Regs.   We also conclude that it was not an abuse of

respondent's discretion to require petitioner to change from the

cash method of accounting to the accrual method of accounting for

the years in issue.   Thus, petitioner must use the accrual method

of accounting.7



     7
       In light of our conclusion that petitioner must use the
accrual method of accounting because merchandise is a substantial
income-producing factor and because it is not a farmer, our
result is not affected by the fact that: (1) Petitioner
regularly used the cash method to compute its income, and (2)
accrual method documents were only for petitioner's internal
review and were not used for any significant purpose. Petitioner
contended that some of its accounts receivable were too
indefinite to be accrued. However, petitioner did not identify
those accounts.
                        - 19 -


For reasons stated above,


                                  Decision will be entered

                             for respondent.
