RACMP Enterprises, Inc., Petitioner v. Commissioner of Internal Revenue, Respondent, 114 T.C. 211

Parr, Judge: Respondent determined an $82,577 income tax deficiency for petitioner’s tax year ended August 31, 1994, and a

section 6662 accuracy-related penalty of $16,515. The issues for determination are:

(1) Whether the material provided by petitioner in accordance with its contract to construct and place concrete foundations, driveways, and walkways is merchandise within the meaning of

section 1.471-1, Income Tax Regs. We hold it is not.

(2) Whether respondent abused his discretion in determining that petitioner’s use of the cash method of accounting did not clearly reflect its income. We hold he did.

(3) Whether petitioner is liable for an accuracy-related penalty. Because of our disposition of the preceding issues, we need not address this issue. FINDINGS OF FACT Some of the facts have been stipulated and are so found. The stipulations of facts and the attached exhibits are incorporated herein by this reference. At the time the petition in this case was filed, petitioner was a California corporation with its principal place of business in Gilroy, California, where it had a small office and an equipment yard.

Petitioner is a licensed contractor in the State of California, holding a class C-8 license to construct, place, and finish concrete foundations and flatwork. The term “flatwork” means driveways and walkways. Petitioner used concrete, sand, drain rock, and various hardware items (wire mesh, rebar, anchor bolts and rods, holddowns, P.A. straps, column bases, post bases, and drain piping), to perform its contracts. The concrete, sand, rock, and hardware items were delivered to the construction site, not to petitioner’s equipment yard or office.

The invoices show that during the year at issue, the cost of sand was $6.50 per ton and drain rock $11.65 per ton. Occasionally, when the construction site became congested, petitioner would put some of the hardware items in the back of a truck, store the truck in its equipment yard overnight, and return it to the construction site the following day. Petitioner had a metal storage container similar to the type of containers used on cargo ships at its equipment yard that it used to store equipment and some hardware items. The Construction Cycle A.

The Bid During the year at issue, petitioner performed its construction activity in the following manner. Petitioner obtained a set of building plans from a developer and then visited the construction site to evaluate the soil, weather, and traffic conditions and to ascertain the location of the materials suppliers. Petitioner calculated its bid price by summing its estimates of the cost of the labor and materials required to perform the work plus a margin for profit based upon the cost of the labor, the quantity of materials, and the complexity of the job.

The following is a typical bid worksheet, prepared by petitioner: Typical bid worksheet Ready-mix concrete .’.. $547.80 Sand. 225.00 Other materials . 69.44 Other materials . 7.70 Other materials . 4.80 Total. 854.74 Tax (8.5%) . 72.65 Total materials cost . 927.39 Plus labor . 477.20 Equals . 1,404.59 Plus 15% profit . 210.69 Total. 1,615.28 B. The Contract If petitioner’s bid was accepted by the developer, a written contract was executed to construct, place, and finish the required foundations and flatwork.

The parties stipulated that a typical contract between petitioner and its clients provided the following: In consideration of the mutual agreements contained herein, Contractor and Subcontractor [petitioner] agree as follows: 1. Work. The work to be performed hereunder shall include, and Subcontractor shall perform, all duties and services necessary or inherent to the type and trade classification of FOUNDATION & FLATWORK, the scope of which is more fully defined in Exhibit A — Scope of the Work, hereto (the “Work”).

The Work shall include all work of such type and trade classification for the Project, and is to be performed in strict compliance with this Subcontract and the Contract Documents (as defined in Paragraph 9 hereof) and all addenda, amendments and changes thereto, whether or not stipulated in the Contract Documents, and shall include all work ordinarily and usually performed, and the supply of all facilities ordinarily and usually provided as part of the Work covered by this Subcontract or ordinarily and usually performed by a subcontractor doing work of such trade classification.

Subcontractor, to the entire satisfaction and approval of Contractor (or its authorized representatives and/or assigns) and all governing agencies agrees to furnish sufficient labor, materials, tools, equipment and services and to properly perform the Work in a sound workmanlike and substantial manner. Subcontractor is employed by Contractor as an independent contractor to perform the work. # if; * * * 15. Materials and Workmanship; Inspection and Testing (

a) All materials used in the Work shall be furnished in ample quantities to facilitate the proper and expeditious execution of the Work and shall be new and of the most suitable grade of their respective kinds and purpose. At the request of the Contractor, Subcontractor shall furnish to Contractor for approval, full information and/or samples concerning the materials or articles which Subcontractor intends to incorporate in the Work. The materials actually used in the Work shall conform to the information or samples approved. Machinery, equipment, materials and articles installed or used without such approval shall be used by Subcontractor at the risk of subsequent rejection by Contractor. (

b) Except as otherwise provided herein, all material and workmanship, if not otherwise designated by the Contract Documents, shall be subject to inspection, examination and test by Contractor at any and all times during manufacture and/or construction and at any and all places when such manufacturing or construction are carried on. Contractor shall have the right to reject improper or defective material or workmanship or require correction without charge to Contractor. Subcontractor shall promptly segregate and remove rejected material from the Project Site.

Nothing contained in this Paragraph 15 shall in any way restrict the rights of Contractor under any warranty by Subcontractor of material or workmanship. 16. Warranty; Customer Service (

a) Subcontractor warrants and represents to Owner and to Contractor that the workmanship of the Work, all materials and equipment furnished for the Work, and all other aspects regarding the Work to be performed under this Subcontract shall be in conformance with this Subcontract and the Contract Documents, be of finest quality, and be free from faults and defects of design, material and Workmanship for a period of two (2) years from (

i) the date of the initial occupancy of the particular residential unit for which an applicable portion of Subcontractor’s Work was performed or (ii) for such longer period as may be required by FHA, VA and/or other applicable governmental authorities. Subcontractor agrees to satisfy its warranty obligations upon receipt of written notice from Contractor requiring same without cost to Contractor. The remedies provided in this Paragraph 16(

a) shall not be restrictive but shall be cumulative and in addition to all other remedies of Contractor hereunder and under California law, including all laws related to latent defects or fraud. If Contractor reasonably deems it more expedient to correct any of the Work covered by warranty itself because of any delay by Subcontractor, a “backcharge” may be made pursuant to Paragraph 23 below.

This provision shall be binding upon the successors and assigns of Subcontractor and shall benefit the successors and assigns of the Contractor; including purchasers of residences within the Project. ifc * # * * # # Exhibit A, Specific Scope of Work, of the contract provided the following: 1. General a. Subcontractor is responsible for all materials until final installation and acceptance by CONTRACTOR. Any loss due to theft or breakage prior to acceptance by CONTRACTOR shall be replaced by SUBCONTRACTOR at no additional charge to CONTRACTOR. b.

SUBCONTRACTOR agrees herein that any labor, materials, and/or workmanship that does not comply to the CONTRACTOR’S standards shall be removed and replaced to conform to the CONTRACTOR’S standards. c. SUBCONTRACTOR further agrees that the quality of his workmanship and his materials shall be in strict accordance with the plans and these specifications. * # * * í|í if: * e. SUBCONTRACTOR shall warranty all concrete foundation work for two years from acceptance of work by CONTRACTOR. C.

Performance of the Contract Petitioner began performance of the contract by constructing the concrete forms on the ground out of lumber in accordance with the developer’s blueprints. After the placement of the forms was accepted by the developer, fill sand and drain rock were spread within the forms according to the plan specifications. Petitioner cut wire mesh and rebar to size and placed them within the forms and engaged a carpenter subcontractor for the correct placement of the other hardware items.

Once the form work was inspected and accepted by the developer, petitioner ordered delivery of the ready-mix concrete. Ready-mix concrete is composed of water, cement, and aggregate, which are mixed together to a mudlike consistency. The concrete must be poured within 3 or 4 hours after the water is introduced to the cement; the concrete cannot be poured after this length of time as it changes from a liquid into a solid. Petitioner ordered concrete from a supplier that delivered it to the construction site. Petitioner did not manufacture, deliver, or store the concrete.

In a typical transaction, petitioner placed the order with the concrete supplier’s dispatcher by telephone, specifying the quantity of concrete and the time and place of delivery. The concrete supplier’s invoice provided that petitioner was liable for payment for the concrete. After the order was placed, the concrete supplier sent a California preliminary lien notice to the developer and a copy to petitioner.

The preliminary lien notice notified the developer that construction material would be or had been furnished to the construction site, and, if the bill was not paid in full, a mechanic’s lien could be placed against the developer’s real property. The mixed concrete was delivered by the manufacturer’s truck to the construction site where, if the concrete was accepted, it was poured directly into the form.

Petitioner would distribute the concrete evenly throughout the form, install the anchor bolts, and then use various tools to do finishing work. “Finishing work” includes ensuring that the foundations and flatwork are plumb and smooth and that the driveways and walkways have the proper slope to ensure drainage where appropriate. Some jobs called for decorative finishing work, such as adding a design or pattern to the finished surface. At the end of the day, petitioner did not have any concrete left on hand, and the amount wasted was de minimis.

In order to track the quantity of concrete and the time of delivery, the concrete supplier’s drivers carried “batching tickets” which showed the amount of concrete and the arrival time, pour time, and departure time of the truck. Petitioner signed the “batching ticket” to acknowledge the delivery. Acceptance of the concrete was controlled by the developer, not petitioner. The type and quality of the concrete was specified by the builder’s plans. When the concrete arrived at the developer’s building site, either petitioner or a quality control technician in the employ of the developer could reject the batch.

However, if petitioner was willing to accept the batch, but the quality control technician determined that the batch should be rejected, the batch would be rejected. The quality control technician took a sample of the concrete batch during the pour for a “slump test”. The developer had 45 days after taking the sample to reject the concrete if it failed the test. D.

Billing and Payment After the sand and drain rock had been spread, the hardware items installed, and the concrete poured and finished, petitioner received an invoice for the cost of the materials and a lien release, which also stated the cost of the materials, from each of the materials suppliers. At the end of the month, petitioner submitted the suppliers’ lien releases and a single invoice for the cost of the completed work to the developer for payment. The invoice did not itemize the costs of the labor and material or the amount of the profit. The developer paid for the construction work in a two-part process.

First, the developer issued a joint check made payable to petitioner and each supplier for the cost of the materials as stated on each suppliers’ lien release and invoice. Petitioner endorsed each joint check and forwarded it to the appropriate supplier; petitioner did not deposit or otherwise cash this check. Second, the developer issued a check made payable only to petitioner for the balance owed on its invoice. E. Method of Accounting Petitioner filed its Federal income tax returns using a fiscal year ending on August 31.

Petitioner used the cash method of accounting to report its taxable income for the first year of its incorporation, the one in issue. The parties stipulated that petitioner’s gross receipts have not exceeded $5 million per year since its incorporation. Petitioner reported as income payments that it actually received from developers during the taxable year and reported a deduction for the cost of materials for which pay-merits actually were made.

Petitioner did not report as income payments that it did not receive, nor did petitioner deduct the cost of materials for which payment had not been made during the taxable year. Petitioner reported $64,806 of taxable income, and the parties stipulated that under the accrual method of accounting petitioner’s taxable income would be $267,428. For the taxable year at issue, petitioner reported gross receipts of $1,564,045, which derived solely from the construction, placement, and finishing of foundations and flatwork.

Petitioner reported as cost of goods sold the total cost of all material used in its construction activity during the taxable year at issue, $993,777. This sum comprised the following amounts: Item Amount Percentage Concrete $642,923 ^ CO All other material 334,563 CO CO Lumber 16,291 CO rl Total 993,777 100.0 Petitioner’s accounts receivable and accounts payable at the end of the taxable year at issue were $294,436 and $60,143, respectively. OPINION We must decide whether the provision of material by petitioner in performing its service contracts is the sale of “merchandise” for purposes of

section 1.471-1, Income Tax Regs. We decide this issue in the context of whether it was an abuse of respondent’s discretion to exercise his authority under

section 446 to require petitioner to change from the cash method to the accrual method. The Commissioner is granted broad discretion in determining whether a taxpayer’s use of a method of accounting clearly reflects income. See sec. 446(b); United States v. Catto, 384 U.S. 102, 114 & n.22 (1967); Commissioner v. Hansen, 360 U.S. 446, 468 & n.12 (1959); Lucas v. American Code Co., 280 U.S. 445, 449 (1930).

A prerequisite to the Commissioner’s exercise of authority to require a taxpayer to change its present method of accounting is a determination 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). 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); Ford Motor Co. v. Commissioner, 102 T.C. 87, 91-92 (1994), affd. 71 F.3d 209 (6th Cir. 1995).

The reviewing court’s task is not to determine whether, in its own opinion, the taxpayer’s method of accounting clearly reflects income but to determine whether there is an adequate basis in law for the Commissioner’s conclusion that it does not. See Ansley-Sheppard-Burgess Co. v. Commissioner, supra at 371; Hospital Corp. of Am. v. Commissioner, T.C. Memo. 1996-105. Consequently,

section 446 imposes a heavy burden on the taxpayer disputing the Commissioner’s determination on accounting matters. See Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 532-533 (1979). To prevail, a taxpayer must establish that the Commissioner’s determination was “clearly unlawful” or “plainly arbitrary”. Id. Despite the broad language of

section 471, the Secretary’s discretion to require inventory accounting is not unlimited. See Hewlett-Packard Co. v. United States, 71 F.3d 398, 403 (Fed. Cir. 1995); Hallmark Cards, Inc. v. Commissioner, supra; see also Transwestern Pipeline Co. v. United States, 225 Ct. Cl. 399, 639 F.2d 679, 681 (1980) (distinguishing Thor Power Tool Co. v. Commissioner, supra, because in that case “it was an uncontested fact that the property in issue consisted of an inventory of goods held for sale”).

Respondent determined that the material petitioner used in its construction activity was merchandise that was income producing, and, therefore, petitioner must use the accrual method of accounting to clearly reflect its income. Petitioner asserts that it is in the business of providing service and that its clients purchase its expertise in constructing, placing, and finishing foundations, driveways, and walkways, not merchandise. Therefore, petitioner contends that its use of the cash method of accounting is proper. We agree with petitioner. Issue 1.

Whether the Material Provided by Petitioner in Accordance With Its Contract To Construct and Place Concrete Foundations, Driveways, and Walkways Is Merchandise Whether petitioner is required to report its income on the accrual method of accounting instead of the cash method depends on whether petitioner is in the business of selling merchandise to customers in addition to providing service or whether the material provided by petitioner is a supply that is incidental to the provision of the contracted service. See Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d 352, 353-354 (1st Cir. 1970), affg. T.C.

Memo. 1969-79; Osteopathic Med. Oncology & Hematology, P.C. v. Commissioner, 113 T.C. 376 (1999). By regulation, the Secretary has determined that 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, * * *. [Sec. 1.471 — 1, Income Tax Regs.; emphasis added.] Therefore, a determination of whether the taxpayer produces, purchases, or sells “merchandise” is preliminary to any determination of whether the taxpayer must account for inventory. See Homes by Ayres v. Commissioner, 795 F.2d 832, 835 (9th Cir. 1986), affg. T.C. Memo. 1984-475.

Neither the Internal Revenue Code (the Code) nor the regulations define “merchandise” or “inventory” or clearly distinguish between “materials and supplies” that are not actually consumed and remain on hand, and inventory. Wilkinson-Beane, Inc. v. Commissioner, supra at 354 (noting “the lack of any clearly pertinent definition of ‘merchandise’ in the relevant tax sources”); Osteopathic Med. Oncology & Hematology, P.C. v. Commissioner, supra at 382. Furthermore, the differences that distinguish supplies from merchandise are determined by context and therefore not always readily discernable.

See Wilkinson-Beane, Inc. v. Commissioner, supra at 354 (“Clearly, the meaning of the term must be gathered from the context and the subject.”). Courts have held that “merchandise”, as used in

section 1.471 — 1, Income Tax Regs., is an item acquired and held for sale. See, e.g., Wilkinson-Beane, Inc. v. Commissioner, supra at 354-355 (a canvassing of authorities in the accounting field yields several

definitions, such as “goods purchased in condition for sale”, “goods awaiting sale”, “articles of commerce held for sale”, and “all classes of commodities held for sale”; the “common denominator * * * seems to be that the items in question are merchandise if held for sale”); Honeywell Inc. v. Commissioner, T.C. Memo. 1992-453 (rotable spare parts are merchandise if they were acquired and “held for sale”), affd. without published opinion 27 F.3d 571 (8th Cir. 1994); see also Grant Oil Tool Co. v. United States, 180 Ct.

Cl. 620, 381 F.2d 389, 397 (1967) (inventory is, simply stated, property that is held for sale); Forrester v. Americus Oil Co., 19 S.E.2d 328, 330 (Ga. Ct. App. 1942) (inventory includes property held for sale to customers in the ordinary course of trade or business). It is important to note that all the

definitions refer to property that is held for sale, not simply property that is sold. Congress did not intend by the predecessor of

section 471 that all businesses, including some businesses that hold property primarily for sale, use inventories. See W.C. & A.N. Miller Dev. Co. v. Commissioner, 81 T.C. 619, 630 (1983); Atlantic Coast Realty Co. v. Commissioner, 11 B.T.A. 416, 419-420 (1928). As indicated by the legislative history, Congress intended the

section to apply to manufacturing and merchandising concerns. In Osteopathic Med. Oncology & Hematology, P.C. v. Commissioner, supra, we held that where the inherent nature of the taxpayer’s business is that of a service provider, and the taxpayer uses materials that are an indispensable and inseparable part of the rendering of its services, the materials are not “merchandise” under

section 1.471 — 1, Income Tax Regs. Petitioner is inherently a service provider. Petitioner’s clients, real property developers, engage petitioner to complete foundations, driveways, and walkways.

It is the general rule in this country for most areas of the law (including the Uniform Commercial Code (ucc), the Uniform Sales Act (USA), State sales tax laws, the statute of frauds, and the Robinson-Patman Antidiscrimination Act) that a contractor is the consumer of materials and a supplier of services, not the seller of personal property; the courts have invariably found construction contracts that provide for the furnishing of labor and materials to constitute agreements for work, labor, and services rather than the sale of goods.

For example, under the UCC, a highway construction contract requiring a construction company to furnish gravel and other road building materials in the quantities specified and to turn over to the Commonwealth of Massachusetts a completed highway was a contract for work and labor and not a contract for the sale and purchase of personal property. See Saugus v. B. Perini & Sons, Inc., 26 N.E.2d 1, 3-4 (Mass. 1940). The main objective of a contract to construct a horse barn, which required the provision of materials, was the construction of the barn, not the sale of goods. See Hunter’s Run Stables, Inc. v.

Triple H Constr. Co., 938 F. Supp. 166, 168 (W.D.N.Y. 1996). In the construction of such improvements, the labor predominates with the materials being merely an incident thereto. See Cork Plumbing Co. v. Martin Bloom Associates, Inc., 573 S.W.2d 947, 958 (Mo. Ct. App. 1978). Under the USA, a contract to “furnish the necessary labor and material” for a radiant heating system was a contract for labor and material, not a contract for sale of material. See Aced v. Hobbs-Sesack Plumbing Co., 55 Cal. 2d 573, 580-581 (1961).

Furthermore, an agreement to build a structure according to another’s plans and specifications is not an agreement of sale of any of the materials which may enter into its composition. See United States v. San Francisco Elec. Contractors Association, 57 F. Supp. 57, 67 (D. Cal. 1944). For purposes of State sales tax, the general rule views a building contractor as a supplier of services and a consumer of the building material. See Levine v. State Bd. of Equalization, 299 P.2d 738 (Cal. Ct. App. 1956).

In considering whether a contract is within the statute of frauds, a contract to “cut, furnish, and deliver” the stonework for a building is essentially one of labor, the “material upon which the work and labor were to be done was simply the incident”. Flynn v. Dougherty, 27 P. 1080 (Cal. 1891).

For purposes of the Robinson-Patman Antidiscrimination Act, ch. 592, 49 Stat. 1526 (1936), current version at 15 U.S.C. sec. 13(a) (1994), which prohibits discriminatory pricing in the sale of goods, a construction contract for the provision of labor and materials including 2 million bricks was not a contract for the sale of personal property. See General Shale Prods. Corp. v. Struck Constr. Co., 132 F.2d 425, 428 (6th Cir. 1942).

It is clear from the case law that in the case at hand, the essence of petitioner’s typical contract with its clients was for the provision of services, not for the sale of personal property. The fact that the cost of the materials is substantial is insufficient to transmute the sale of a service to the sale of merchandise and a service. See Osteopathic Med. Oncology & Hematology, P.C. v. Commissioner, 113 T.C. at 386; see also North Am. Leisure Corp. v.

A & B Duplicators, Ltd., 468 F.2d 695, 697 (2d Cir. 1972) (when service predominates, the incidental sale of items of personal property does not alter the basic transaction); Aced v. Hobbs-Sesack Plumbing Co., supra at 580; Filmservice Labs., Inc. v. Harvey Bernhard Enters., 256 Cal. Rptr. 735, 738 (1989); Alonzo v. Chifici, 526 So. 2d 237, 241 (La. Ct.

App. 1988) (in applying a “value test” to determine whether the labor expended in constructing the item, or the materials incorporated therein, constitute the principal value of the contract, it is clear that building or construction contracts involve primarily the furnishing of labor and contractual skills). Material may be either merchandise or supplies depending upon whether it is held for sale or consumed in performing a service. The differences that distinguish a supply material from a merchandise material are determined by context.

Thus, the same material in different contexts may be either an inventory item or a supplies item. For instance, although the paper and ink used to prepare blueprints are inventory in the hands of the paper and ink manufacturers, they are supplies in the hands of an architect. See, e.g., sec. 1.263A-2(a)(2)(ii)(B)(2), Income Tax Regs, (the cost of materials used by an architect to prepare blueprints provided to clients may be deducted as an expense because the blueprints are de minimis and incident to the provision of service).

This is so even though the architect purchases the paper and ink from a manufacturer, the architect’s sale of services and materials to his or her clients includes the paper and ink, and the clients purchase the blueprints from the architect. The essence of the architect’s business is providing the service of designing buildings, not the sale of blueprints. Cf. Knight-Ridder Newspapers, Inc. v. United States, 743 F.2d 781 (11th Cir. 1984) (paper and ink held by newspaper publisher for use in producing newspapers for sale to customers is inventory).

We hold that the inherent nature of petitioner’s business is that of a service provider. Accordingly, we must determine whether the materials petitioner uses are an indispensable and inseparable part of rendering its services. A. The Liquid Concrete Petitioner relies upon our decision in Galedrige Constr., Inc. v. Commissioner, T.C. Memo. 1997-240, for its argument that the materials are not merchandise. We agree that the rationale of Galedrige applies to the liquid concrete in this case.

In construing the word “merchandise” in Galedrige, we applied the rule that “‘the natural and ordinary meaning of the words used will be applied * * * unless the Congress has definitely indicated an intention that they should be otherwise construed’”. Wilkinson-Beane, Inc. v. Commissioner, supra at 354 (quoting Huntington Sec. Corp. v. Busey, 112 F.2d 368, 370 (6th Cir. 1940)). In Galedrige Constr., Inc., for the first time, this Court considered the issue of whether a person in the business of only laying emulsified asphalt sold merchandise or maintained an inventory of emulsified asphalt.

In Galedrige Constr., Inc. it was clear that the taxpayer, an asphalt paving contractor, provided a service to its clients; if its clients had wanted only to purchase emulsified asphalt, they could have done so by dealing directly with the emulsified asphalt supplier. Similarly, in the case at hand, it is clear that petitioner provides service to its clients; if its clients wanted only piles of fill sand, drain rock, liquid concrete, and miscellaneous hardware items, they could obtain them directly from the various suppliers.

It is evident that petitioner’s clients could order the various materials directly from the suppliers by the fact that the clients paid for the various materials separately and specifically with a joint payee check. From the moment the taxpayer in Galedrige Constr., Inc. received the “emulsified asphalt from the supplier * * * [it] was joined in a race that had an unalterable predetermined outcome; within 2 to 5 hours the emulsified asphalt would be rock hard and worthless.” Id.

The race was not to sell or to deliver the asphalt to the taxpayer’s client; rather, it was to lay the asphalt before time expired and the asphalt changed its physical state into a form that was worthless to the taxpayer; only the liquid state of the emulsified asphalt provided any utility to the taxpayer, and that state expired very quickly. Consequently, in Galedrige Constr., Inc. v. Commissioner, supra, the only form of the material that provided any value to the taxpayer was “used up” or consumed in providing service to the taxpayer’s client.

Consumption of a material in the performance of a service or in a manufacturing process is indicative that the material is a supply, not merchandise held for sale. See Osteopathic Med. Oncology & Hematology, P.C. v. Commissioner, 113 T.C. at 385; see also Rev. Rul. 75-407, 1975-2 C.B. 196 (public utility that used the accrual method of accounting should continue to deduct as a supply expense under

section 1.162-3, Income Tax Regs., the cost of fuel oil consumed and used to generate electricity distributed to customers during the taxable year); Rev. Rul. 90-65, 1990-2 C.B. 41 (the cost of unrecovered platinum from prills used in refining petroleum is a material or supply expense allowed under

section 1.162-3, Income Tax Regs.). Accordingly, in Galedrige Constr., Inc. v. Commissioner, supra, we held that in the hands of the taxpayer/paving contractor, the emulsified asphalt was a supply, not merchandise. Similarly, in this case the only form of the concrete that provides utility to petitioner is the liquid or wet form. Also, similar to the emulsified asphalt in Galedrige Constr., Inc. v. Commissioner, supra, the physical state of the concrete changes very quickly from one that provides utility to petitioner, to one that has no value at all.

The ready-mix concrete in this case is practically indistinguishable from the emulsified asphalt material in Galedrige Constr., Inc. Considering the facts of this case (and Galedrige) and the ephemeral quality of the material at issue, only a strained and unconventional

interpretation of the word “merchandise” would include liquid concrete (or emulsified asphalt) within its definition. These materials with their severely limited periods of utility that were ordered specifically for, delivered to, and paid for by the taxpayer’s client, cannot in any natural or ordinary sense be considered “held for sale” by the taxpayer. Accordingly, considered in this context, we find that the ready-mix concrete is a supply, not merchandise. B.

The Other Materials Other materials under consideration in this case — the fill sand, drain rock, and hardware items — do not share the ephemeral physical properties of liquid concrete or the emulsified asphalt in Galedrige Constr., Inc. Rather, they are durable like the replacement parts in Honeywell, Inc. v. Commissioner, T.C. Memo. 1992-453. In Honeywell, Inc. we stated that the purpose for which the property was acquired and held is determinative of whether the property is merchandise within the meaning of

section 1.471-1, Income Tax Regs. In Honeywell, Inc., we concluded that, because replacement parts were used by the taxpayer to perform its service contracts, the replacement parts were not acquired and held for sale and those parts were not merchandise within the meaning of the applicable regulation. See id. Moreover, it is apparent that the replacement parts were indispensable and inseparable from the service provided by the taxpayer. We now conclude that the fill sand, drain rock, and hardware items, like the liquid concrete, were indispensable and inseparable from the service provided by petitioner.

First, the construction material in this case, when combined with other tangible personal property, lost its separate identity to become an integral and inseparable part of the real property in the construction activity. Cf. Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d 352, 355 (1st Cir. 1970) (caskets sold as part of undertaking establishment’s funeral service retain their separate identity); Thompson Elec., Inc. v. Commissioner, T.C. Memo. 1995-292 (lighting fixtures, which by definition do not lose their separate identity, used with other materials in taxpayer’s electrical contracting business).

Thus, the materials in this case are similar to the chemotherapy drugs in Osteopathic Med. Oncology & Hematology, P.C. v. Commissioner, supra, which, though not ephemeral in the sense that their usefulness would disappear if not immediately used, when injected also lost their identity separate from that of the patient. Materials that lose their separate identity in these circumstances are not merchandise within the meaning of

section 1.471-1, Income Tax Regs.; rather, they are supplies consumed in the provision of service that are properly deducted under

section 162. Second, petitioner did not contract to sell materials to its developer clients, and the clients had no interest in. purchasing materials from petitioner. Petitioner’s contract with its real property developer clients was for the construction of foundations, driveways, and walkways. Thus, we cannot find that petitioner is a merchant that has acquired “raw materials and supplies” for sale, see sec. 1.471 — 1, Income Tax Regs., or that holds and sells “goods purchased in condition for sale”, Wilkinson-Beane, Inc. v. Commissioner, supra at 354-355.

Third, foundations, driveways, and walkways are improvements to real property. We have held previously that improvements to real property are not merchandise. See Homes by Ayres v. Commissioner, 795 F.2d 832, 835 (9th Cir. 1986) (tract houses are not merchandise), affg. T.C. Memo. 1984-475 (rejecting taxpayer’s argument that a homebuilder “manufactures” houses); see also W.C. & A.N. Miller Dev. Co. v. Commissioner, 81 T.C. at 630 (developed real property constructed and held for sale is not inventory).

Therefore, the foundations, driveways, and walkways are not merchandise, and the materials used in their construction do not “become a part of merchandise intended for sale”. See sec. 1.471-1, Income Tax Regs. Consequently, petitioner is not a manufacturer of merchandise or a merchandising concern, nor engaged otherwise in a “merchandising” activity. Because petitioner does not produce or sell merchandise, petitioner is not engaged in a business activity that requires the maintenance of an inventory. See Homes by Ayres v. Commissioner, supra. Mr.

Martinez, a corporate officer and shareholder of petitioner, testified that the only material left over at the completion of a job is a small pile of sand or gravel. Although Mr. Martinez’ testimony may be regarded as self-serving, in this case it is consistent with the objective evidence. The operation of petitioner’s construction activity required it to use most of the materials at the time they were delivered to the construction site.

The stipulations and other evidence show that materials required to perform the work were ordered from the suppliers and delivered to the job site, where they were incorporated almost immediately into the real property improvements. Each material supplier sent the real property developer a preliminary lien notice for the materials delivered to the site. Petitioner submitted its invoice and lien releases to the real property developer for the materials used to complete its work at each residential lot.

The developer paid for the cost of the materials that had been used in completing the improvements by checks made out to each supplier and petitioner as joint payees, which petitioner forwarded to each material supplier. The joint checks were not deposited in petitioner’s bank account. Therefore, the materials were used up before petitioner sent its invoice and the lien releases for the completed work to the developer, before the developer paid for the materials, and before petitioner recorded the materials expense.

Respondent makes much of the fact that, unlike the concrete, small amounts of some of the materials may have been left over after the job. Respondent argues that these materials could have been loaded onto petitioner’s truck and moved to another job site or stored in its equipment yard. It is clear from the facts that no concrete was left over, and any leftover sand or gravel was abandoned onsite upon the completion of each job, as the expense of moving it would have exceeded its cost; moreover, only an insignificant amount of any of the other material could have been left over. Cf. J.P.

Sheahan Associates, Inc. v. Commissioner, T.C. Memo. 1992-239 (roofing materials and supplies remaining at the close of a job were returned to the supplier for credit). The parties stipulated that petitioner kept some of the hardware items in the storage container at its place of business. Since the total cost of all the hardware items was approximately 5 percent of the total cost of a typical contract, and all the materials were delivered to. the developer’s site, any amount kept on hand at the equipment yard had to be insignificant.

Petitioner’s possession of a de minimis amount of material would not be sufficient to require it to use the accrual method of accounting for inventories. See Osteopathic Med. Oncology & Hematology, P.C. v. Commissioner, 113 T.C. at 387 (taxpayer that had 2 weeks’ supply of chemotherapy drugs on hand not required to use inventory method of accounting); Honeywell, Inc. v.

Commissioner, supra (taxpayer not required to use inventory method of accounting for computer replacement parts that were stored on taxpayer’s premises and represented 11 and 12 percent of income, even though taxpayer transferred title to replacement parts to customer); see also Tech. Adv. Mem. 98-48-001 (July 16, 1998) (taxpayer that purchases and sells merchandise not required to maintain inventories because purchase and sale of merchandise was de minimis and not an income-producing factor within meaning of

section 1.471, Income Tax Regs.; therefore, taxpayer may continue to account for these merchandise items on cash basis); G.C.M. 38,288 (Feb. 21, 1980) (IRS may allow use of cash method of accounting despite fact that taxpayer may furnish some tangible product in the course of rendering a service, a reconsideration of Rev. Rul. 74-279, 1974-1 C.B. 110). We decline to attach significance to the fact that in calculating its bid, petitioner used the total cost of labor and materials as a basis to calculate the value of its service.

In calculating its potential profit, petitioner had to consider the complexity of the work, and, therefore, its potential for loss in case of errors. For instance, contracts for construction projects that use a greater amount of concrete and other materials, or involve curved rather than straight lines, are more difficult to perform. The quantity of the material used was another factor in this estimation. The consideration of such costs, however, does not dictate the classification of the material as inventory. See Osteopathic Med. Oncology & Hematology, P.C. v. Commissioner, supra; Honeywell, Inc. v.

Commissioner, supra. That petitioner used the total cost of labor and materials as a base to calculate the project profit does not mean that petitioner sold merchandise to its clients. We have found that petitioner’s contracts with its real property developer clients are service contracts, that the material provided by petitioner is indispensable to and inseparable from the provision of that service, that the materials lost their separate identity to become part of the real property in the construction activity, and that, in substance, no sale of merchandise occurred between petitioner and its clients.

The bottom line is that petitioner did not hold merchandise for sale, and there simply was no sale of merchandise between petitioner and its clients. See Osteopathic Med. Oncology & Hematology, P.C. v. Commissioner, supra; Honeywell, Inc. v. Commissioner, supra. C. Income-Producing Factor Respondent may require petitioner to use an inventory method of accounting only if we find each of the following as facts:

(1) Petitioner produced, purchased, or sold merchandise, and (2) petitioner’s production, purchase, or sale of that merchandise was an income-producing factor. See Osteopathic Med. Oncology & Hematology, P.C. v. Commissioner, supra; Honeywell, Inc. v. Commissioner, supra.

Section 1.471-1, Income Tax Regs., does not provide that any material that is an income-producing factor is ipso facto merchandise. We have found that petitioner does not produce, purchase, or sell merchandise; therefore, whether the material is an income-producing factor is irrelevant. See Osteopathic Med. Oncology & Hematology, P.C. v. Commissioner, supra. Accordingly, we find that petitioner is not required to use an inventory method of accounting. Issue 2.

Whether Respondent Abused His Discretion in Determining That Petitioner’s Use of the Cash Method of Accounting Did Not Clearly Reflect Its Income “‘The cash method of accounting has been widely used throughout the contracting industry and accepted by respondent since time immemorial.’” Ansley-Sheppard-Burgess Co. v. Commissioner, 104 T.C. 367, 375 (1995) (quoting Magnon v. Commissioner, 73 T.C. 980, 1004 (1980)); see also Magnon v. Commissioner, supra at 1004-1006 (use of cash method of accounting by electrical contractor held to clearly reflect income); National Builders, Inc. v.

Commissioner, 12 T.C. 852, 858-859 (1949) (Court reviewed) (Court found that cash method of accounting clearly reflected taxpayer’s income and rejected Commissioner’s determination that construction contractor use hybrid method of accounting instead of cash method); C.A. Hunt Engg. Co. v. Commissioner, T.C. Memo. 1956-248 (use of the cash method of receipts and disbursements held to reflect income clearly). Thus, it is clear that the construction industry practice of using the cash method of accounting has long been accepted by this Court.

Respondent argues that petitioner must use an inventory method of accounting to clearly reflect its income because it sells merchandise. We have found that the materials used by petitioner are not merchandise. Respondent did not assert that petitioner attempted to unreasonably prepay expenses or purchase supplies in advance, and the evidence shows the contrary. See Ansley-Sheppard-Burgess Co. v. Commis sioner, supra at 374; Van Raden v. Commissioner, 71 T.C. 1083, 1104 (1979), affd. 650 F.2d 1046 (9th Cir. 1981).

It is irrelevant that the amount of taxable income that petitioner reported using the cash method of accounting is not the same amount that it would have reported if it used the accrual method. We previously have held that where a taxpayer is a “small” corporation permitted to use the cash method under

section 448(b)(3), is not required to maintain an inventory, consistently used the cash method of accounting since its incorporation, and has made no attempt to unreasonably prepay expenses or purchase supplies in advance, the taxpayer is not required to show a substantial identity of results between the taxpayer’s method of accounting and the method selected by the Commissioner. See Ansley-Sheppard-Burgess Co. v. Commissioner, supra at 377.

It is clear from petitioner’s billing procedure and the operation of its construction activity that the materials were used up before they were paid for by the developer and before petitioner reported their expense. Therefore, petitioner had no opportunity to report as an expense any materials that may have been delivered to a job site before the close of its taxable year but not yet used. As was the case in Osteopathic Med. Oncology & Hematology, P.C. v.

Commissioner, supra, the notice of deficiency is worded broadly as to the specific basis for respondent’s determination that the cash method does not clearly reflect petitioner’s income. However, in his answer and on brief respondent argues only that this is so because petitioner sells merchandise that must be inventoried. We have held that petitioner does not sell merchandise. Consequently, we need not and do not engage in further analysis of the clear reflection of income standard of

section 446. See id. In light of the above, we hold that respondent’s determination that petitioner’s method of accounting did not produce a clear reflection of income was an abuse of discretion. We have considered all arguments in this case for a contrary holding and, to the extent not discussed above, find those arguments to be without merit or irrelevant. To reflect the foregoing, Decision will be entered for petitioner. Reviewed by the Court. Chabot, Wells, Whalen, Colvin, Beghe, Laro, Foley, Vasquez, and Gale, JJ., agree with this majority opinion. Marvel, J., dissents. This case was reassigned to Judge Carolyn Miller Parr by order of the Chief Judge. Unless otherwise indicated, all

section references are to the Internal Revenue Code in effect for the year at issue. “All other material” is all the other material that went into construction of the foundations and flatwork, except the concrete; it includes fill sand, drain rock, and the various hardware items. According to the typical bid worksheet, the cost of the hardware items is 5.07 percent of the contract price (the total cost of the materials, other than concrete and fill sand, $81.94 ($69.44 plus $7.70 plus $4.80) divided by the contract price, $1,615.28), and 9.59 percent of the total cost of the materials ($81.94 divided by $854.74).

Respondent stipulated that the lumber is a supply. Sec. 446 provides in pertinent part: SEC. 446. GENERAL RULE FOR METHODS OF ACCOUNTING (

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. Sec. 471(

a) provides: 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. Completing the statutory and regulatory scheme, sec. 1.446 — l(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.

The original authority for the use of inventories is contained in Revenue Act of 1918, ch. 18, sec. 203, 40 Stat. 1057, 1060. Sec. 203 of that Act is almost identical to

section 471. In proposing this legislation, the Committee on Ways and Means explained: In many cases the only way that the net income can be determined is through the proper use of inventories. This is largely true in the case of manufacturing and merchandise concerns. The bill authorizes the Commissioner to require inventories whenever in his opinion the same is necessary in order to clearly reflect the income of the taxpayer. [H. Rept. 767, 65th Cong., 2d Sess. 88 (1918), 1939-1 C.B. (Part 2) 86, 89.] See Seidman, Seidman’s Legislative History of Federal Income Tax Laws 1938-1861, at 900 (1953).

Pursuant to the authority vested in him by statute, the Commissioner, with the approval of the Secretary, promulgated Art. 1581 of Regulations 45 under the Revenue Act of 1918, which essentially is the same as sec. 1.471-1, Income Tax Regs. See Regs. 62, art. 1581; Sec. 29.22(c)-1, Regs. Ill (1944); see also Burroughs Adding Mach. Co. v. Commissioner, 9 B.T.A. 938, 940 (1927) (Art. 1581 of Regulations 62 contains the same language as Art. 1581 of Regulations 45); Galedrige Constr., Inc. v. Commissioner, T.C. Memo. 1997 — 240 (sec. 1.471 — 1, Income Tax Regs., contains the same language as Regs.

Ill, sec. 29.22(c)-l). See, e.g., Department of Revenue v. Montgomery Woodworks, Inc., 389 So. 2d 510 (Ala. Civ. App. 1980); Raynor Door, Inc. v. Charnes, 765 P.2d 650 (Colo. App. 1988); H.B. Sanson, Inc. v. Tax Commissioner, 447 A.2d 12 (Conn. 1982); King's Bay Yacht & Country Club, Inc. v. Green, 173 So. 2d 509 (Fla. Dist. Ct. App. 1965); Sturtz v. Iowa Dept. of Revenue, 373 N.W.2d 131 (Iowa 1985); Pete Koenig Co. v. Department of Revenue, 655 S.W.2d 496 (Ky. Ct. App. 1983); Miedema Metal Bldg. Sys., Inc, v. Department of Treasury, 338 N.W.2d 924 (Mich. Ct. App. 1983); Blevins Asphalt Constr. Co. v.

Director of Revenue, 938 S.W.2d 899 (Mo. 1997); George Rose & Sons Sodding & Grading Co. v. Nebraska Dept. of Revenue, 532 N.W.2d 18 (Neb. 1995); Chicago Bridge & Iron Co. v. State Tax Commn., 839 P.2d 303 (Utah 1992); Yeargin, Inc. v. Tax Commn., 977 P.2d 527 (Utah Ct. App. 1999); Wisconsin Dept of Revenue v. Johnson & Johnson, 387 N.W.2d 91 (Wis. Ct. App. 1986); State Bd. of Equalization v. Cheyenne Newspapers, Inc., 611 P.2d 805 (Wyo. 1980). In Akers v. Commissioner, T.C. Memo. 1984—208, affd. in part and revd. in part sub nom. Asphalt Prods. Co. v.

Commissioner, 796 F.2d 843 (6th Cir. 1986), this Court considered the issue of whether a taxpayer in the business of manufacturing and selling asphalt and asphalt products, who maintained inventories including oil byproducts and other raw materials, in addition to performing some paving work, had to account for inventories and use the accrual method of accounting. In contrast, the taxpayer in Galedrige Constr., Inc. v. Commissioner, T.C. Memo. 1997—240, was not in the business of manufacturing asphalt and maintained no inventory of asphalt, oil byproducts, or other raw materials.

Moreover, unlike the taxpayer in Akers, who had large tanks in which it was able to preserve the emulsified condition, and therefore the marketable quality, of its finished product, the taxpayer in Galedrige Constr., Inc. was unable to prevent or delay the asphalt from becoming rock hard and worthless within a very few hours. We here are dealing with the physical laws of the universe, against which the laws of mere mortals cannot stand.

We note that the materials suppliers sent the California preliminary lien notices to the developer; the notices provided that if the bill for the materials was not paid in full, a mechanic’s lien could be placed against the developer’s real property. For purposes of accounting, “merchandise” is defined as “Purchased articles of commerce held for sale; the inventory of a merchant.” Kohler, Kohler’s Dictionary for Accountants 329 (6th ed. 1983).

Furthermore, “merchant” is defined as “One who buys and sells articles of commerce without change in their form.” Id. “In its commonly accepted usage, the term ‘merchandise’ is defined to encompass wares and goods, not realty.” W.C. & A.N. Miller Dev. Co. v. Commissioner, 81 T.C. 619, 630 (1983). Furthermore, “real property and the labor, materials and supplies which enter into improving real property, are generally not considered for accounting purposes to be inventoriable.” Id.

Petitioner received the invoices from the suppliers within 30 days of the delivery of the materials to the developer’s construction site. Petitioner also received within 30 days of the provision of its services a check from the developer, made to petitioner and the supplier as joint payees, for payment of the invoices, which petitioner forwarded to the supplier. Under the cash method of accounting, petitioner deducted the cost of the expense of the already consumed materials when paid, and recorded as income the payment when received.

Thus, petitioner’s method of accounting matched the receipt of the payment for the material with the deduction for the expense. Cf. Knight-Ridder Newspapers, Inc. v. United States, 743 F.2d 781, 792 (11th Cir. 1984) (inventories of paper and ink deducted at time of purchase, rather than at time of use); Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d 352, 353-354 (1st Cir. 1970) (cost of caskets held for long periods of time, some for more than one year, deducted during year in which taxpayer paid for them), affg. T.C. Memo. 1969-79; J.P. Sheahan Associates, Inc. v. Commissioner, T.C.

Memo. 1992-239 (cost of material deducted in year of purchase, not at time of use). Therefore, we cannot find that petitioner accounted for the cost of the materials incorrectly. Sec. 448 provides in pertinent part: SEC. 448. LIMITATIONS ON USE OF CASH METHOD OF ACCOUNTING. (

a) General Rule. — Except as otherwise provided in this section, in the case of a—

(1) C corporation, (2) partnership which has a C corporation as a partner, or (3) tax shelter, taxable income shall not be computed under the cash receipts and disbursements method of accounting. (

b) Exceptions.—

(3) Entities with gross receipts op not more than $5,000,000. — Paragraphs (1) and (2) of subsection (

a) shall not apply to any corporation or partnership for any taxable year if, for all prior taxable years beginning after December 31, 1985, such entity (or any predecessor) met the $5,000,000 gross receipts test of subsection (c). (c) $5,000,000 Gross Receipts Test. — For purposes of this section'—

(1) In general. — A corporation or partnership meets the $5,000,000 gross receipts test of this subsection for any prior taxable year if the average annual gross receipts of such entity for the 3-taxable-year period ending with such prior taxable year does not exceed $5,000,000.

(3) Special rules. — For purposes of this subsection— (

A) Not in existence for the entire 3-year period — If the entity was not in existence for the entire 3-year period referred to in paragraph (1), such paragraph shall be applied on the basis of the period during which such entity (or trade or business) was in existence. According to the typical bid worksheet, the only factors in petitioner’s income are materials, labor, and profit. On the worksheet the total materials cost is $927.39, and the labor cost is $477. Therefore, typically the cost of labor as a percentage of the total materials cost is 51.46 percent.

The total cost of all items purchased in the taxable year at issue was $993,777. Thus, the associated labor cost may be estimated as approximately $511,360. The sum of these amounts is $1,505,137. Petitioner received $1,564,045 in gross receipts for the year at issue and reported $64,806 as taxable income. The difference between the gross receipts and the sum of the materials and the approximate cost of labor is $58,908; this amount is very close to the amount petitioner reported as income. The profit percentage varied depending on the job, but it was usually between 10 and 20 percent.

The difference between the amount of income as calculated above and the amount reported by petitioner is probably attributable to the different profit percentages charged by petitioner for jobs of different levels of complexity. Thus, the “typical” profit of 15 percent is a rough average of the various profit percentages actually charged. Therefore, petitioner’s method of accounting clearly reflected the amounts that it actually received and the actual costs incurred to perform the work.