COMPANY MUST USE INVENTORY METHOD OF ACCOUNTING FOR ELECTRICITY PRODUCED AND SOLD.

UIL Number(s) 0446.04-02, 0471.01-00

                                             Date: December 17, 1994

Must Taxpayer change to an inventory method of accounting ("inventory method" or "inventories") for the electricity it produces and sells in order to clearly reflect its income?

FACTS

Taxpayer is a privately owned partnership operating a A designed to Verb 1 B to produce both electricity and C. Taxpayer sells the electricity to an D under a 20-year contract and uses the C to Verb 2 E in a F.

As a privately owned company that sells only to an E, Taxpayer is not a "public utility." Thus, Taxpayer is not regulated by the Federal Energy Regulatory Commission or any other federal or state agency.

The meter used to measure the amount of electricity delivered to the E is located in a shed on the edge of Taxpayer's production facility. At the end of each month, a representative from the E reads the meter. Within 14 days, the E must provide Taxpayer with a statement showing both the amount of electricity provided and the applicable rate for the electricity. Taxpayer then bills the E based upon the statement and generally receives its payment within 30 days.

Taxpayer purchases B by the truckload, which are delivered to Taxpayer's A. Taxpayer pays for the B in the month following delivery. For the taxable year ended Date 6, Taxpayer deducted $ Amount 1 for B and related labor, which was approximately Amount 2 percent of Taxpayer's cost of goods sold.

Taxpayer accrues income and expenses for financial reporting purposes, but has used the cash-receipts-and-disbursements method ("cash method") consistently and accurately for federal income tax purposes since inception.

The following table shows the ending balances in Taxpayer's Accounts Receivable and Accounts Payable for the last seven years as well as the difference between these two amounts:

                     Accounts             Accounts

APPLICABLE LAW

Section 446(a) provides that 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.

Section 1.446-1(a)(2) of the Income Tax Regulations provides that the Service recognizes that no uniform method of accounting can be prescribed for all taxpayers. Each taxpayer shall adopt such forms and systems as are, in his judgment, best suited to his needs. However, no method of accounting is acceptable unless, in the opinion of the Commissioner, it clearly reflects income. A method of accounting which reflects the consistent application of generally accepted accounting principles in a particular trade or business in accordance with accepted conditions or practices in that trade or business will ordinarily be regarded as clearly reflecting income, provided all items of gross income and expense are treated consistently from year to year.

Section 446(c) provides, subject to the requirements of sections 446(a) and 446(b), that a taxpayer may compute taxable income under the cash method, an accrual method, any other method permitted by the Code, or any combination of methods permitted under regulations.

Section 1.446-1(c)(2) provides that a taxpayer generally must use an accrual method of accounting for purchases and sales if a taxpayer must use an inventory.

Section 471 provides that 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.

Section 1.471-1 provides generally that to clearly reflect taxable income, 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, in which class fall containers, such as kegs, bottles, and cases, whether returnable or not, if title thereto will pass to the purchaser of the product to be sold therein.

ANALYSIS

Taxpayer contends that inventories are not required for the electricity it produces and sells because (1) the regulations under section 471 require inventories only when a taxpayer is holding tangible personal property for sale, (2) the laws of G do not include electricity within the definition of "inventory" for property tax purposes /1/, (3) the production and delivery of electricity is a service under G law, and (4) the cash method clearly reflects Taxpayer's income. The revenue agent argues that Taxpayer's use of the cash method does not accord with generally accepted accounting principles, does not accord with standard accounting practices for a utility company, and does not clearly reflect income.

The Supreme Court has recognized that sections 446(b) and 471(a) grant the Commissioner broad authority to determine when a taxpayer must use inventories to clearly reflect income. Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 532-533, 1979-1 C.B. 167 (1979); Commissioner v. Hansen, 360 U.S. 446, 467, 1959-2 C.B. 460 (1959). Under section 1.471-1, a taxpayer must use inventories to clearly reflect income whenever the production, purchase, or sale of merchandise is an income-producing factor.

We believe that the electricity produced at Taxpayer's A is merchandise under section 1.471-1. The production of electricity involves manufacturing or the process of manufacturing, and the weight of authority holds that electricity produced by machinery for commercial purposes is personal property or a commodity. Minnesota Power & Light Co. v. Personal Property Tax, 182 N.W.2d 685, 690-691 (Minn. 1970). See Spillman v. Interstate Power Co., 226 N.W. 427, 433 (Neb. 1929); Curry v. Alabama Power Co., 8 So.2d 521 (Ala. 1942). See also Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d 352, 354-355 (1st Cir. 1970), aff'g T.C. Memo. 1969-79 (caskets are merchandise because they played a central role in the sale of the taxpayer's funeral services ²); Knight-Ridder Newspapers, Inc. v. United States, 743 F.2d 781, 790 (11th Cir. 1984) (newspapers sold to public are merchandise); Surtronics, Inc. v. Commissioner, T.C. Memo. 1985- 277 (precious metals electroplated to component parts of electronic equipment owned by customers are merchandise).

We recognize that Taxpayer provides a service with the electricity it produces -- that is, Taxpayer delivers the electricity to the E. The courts, however, have sustained the Commissioner's determination that taxpayers must change to an inventory method to clearly reflect income even when they sell a combination of property and services. See Wilkinson-Beane; Knight-Ridder; Surtronics. In addition, section 1.446-1(c)(2) requires Taxpayer to use an accrual method. Boynton v. Pedrick, 136 F. Supp. 888, 891 (S.D.N.Y. 1954) (the power of the Commissioner to require the use of inventories to compute income carries with it the power to require the use of a method of accounting in which the use of inventories has substance and meaning).

Many, if not most, people view their local electric, gas, water, telephone, and cable television companies as providers of services. In fact, a number of states have enacted laws to proscribe the "theft of services." See, e.g., State Law 2; Cal. Penal Code section 498 (West 1988); N.Y. Penal Law section 165.15 (McKinney 1988); People v. McLaughlin, 402 N.Y.S.2d. 137, 139 (1978) (metered electricity is of sufficient "concreteness" to be the subject of larceny). We believe, however, that labeling something a "service" does not necessarily make it one under state law. For example, under G law concerning the theft of services,

"services" includes, but is not limited to, labor, professional services, toll facilities, transportation, communications service, entertainment, the supplying of FOOD, lodging or other accommodations in hotels, restaurants or elsewhere, the supplying of equipment for use, and THE SUPPLYING OF COMMODITIES OF A PUBLIC UTILITY NATURE SUCH AS GAS, ELECTRICITY, STEAM AND WATER.

State Law 3 (emphasis added).

Moreover, state law does not necessarily control for federal income tax purposes. Burnet v. Harmel, 287 U.S. 103, 110 (1932) (state law creates legal interests but the federal statute determines when and how they shall be taxed). United States v. Mitchell, 403 U.S. 190, 197 (1971). Thus, whether G law specifically includes electricity within the definition of inventory for property tax purposes is irrelevant because section 471 and section 1.471-1 do not empower the Commissioner to require a taxpayer to maintain an inventory of merchandise. Rather, section 471 and section 1.471-1 empower the Commissioner to require a taxpayer to use an inventory method for the property it produces and sells whenever in the Commissioner's opinion the use of an inventory method is necessary to clearly reflect income.

Finally, Taxpayer contends that its use of the cash method clearly reflects income because it has used the cash method consistently and accurately for almost 10 years. We believe, however, that Taxpayer's use of the cash method does not clearly reflect income under section 446(b), and our conclusion is supported by the magnitude of the revenue agent's proposed section 481(a) adjustment, $955,404.

In summary, the Supreme Court recognized in Hansen and Thor Power that section 471 and section 1.471-1 grant the Commissioner broad authority to determine when a taxpayer must use an inventory method to clearly reflect income. We believe that requiring Taxpayer to use an inventory method, and hence an accrual method, is warranted because Taxpayer produces property to sell to the D and because Taxpayer's current method of accounting mismatches Taxpayer's gross receipts and costs of production.

CONCLUSION

To clearly reflect income, Taxpayer must change to an inventory method for the electricity it produces and sells and, accordingly, must change from the cash method to an accrual method.

A copy of this Technical Advice Memorandum is to be given to the taxpayer. Section 6110(j)(3) provides that it may not be used or cited as precedent.

² Though Wilkinson-Beane did not separately state the price of the caskets in its bill for funeral services, this fact did not prevent the court from requiring Wilkinson-Beane to use inventories for the caskets.