Rev. Rul. 78-382

ISSUE

Does section 1.162-3 of the Income Tax Regulations require a taxpayer using the cash receipts and disbursements method of accounting to defer its deduction for amounts paid to purchase rental uniforms until the taxable year they are placed in service?

FACTS

The taxpayer, a domestic corporation, is engaged in the business of supplying, servicing, laundering and repairing uniforms for industrial and commercial establishments on a rental contract basis. The rental contracts are generally for a period of one year, and one fee is charged for the above-described services. The useful life of the uniform varies because of usage and damage. Most uniforms do not remain in use for 12 months. The taxpayer computes its income under the cash receipts and disbursements method of accounting.

Each customer has its own style and color of uniform and each employee of each customer has his or her particular measurements. In order for the taxpayer to give efficient service, it is necessary to maintain a supply of uniforms on hand to replace worn or damaged uniforms. The replacing of uniforms is a constant and continuous process. The taxpayer also keeps a supply of uniforms on hand for new customers so that their service can begin immediately. The taxpayer maintains a detailed record of the uniforms not placed in service and deducts the cost of such uniforms at the time they are purchased and paid for.

LAW AND ANALYSIS

Section 1.162-3 of the regulations provides that taxpayers carrying materials and supplies on hand should include in expenses the charge for materials and supplies only in the amount that they are actually consumed and used in operation during the taxable year for which the return is made, provided that the costs of such materials and supplies have not been deducted in determining the net income or loss or taxable income for any previous year. If a taxpayer carries incidental materials or supplies on hand for which no record of consumption is kept or for which physical inventories at the beginning and end of the taxable year are not taken, it will be permissible for the taxpayer to include in expenses and to deduct from gross income the total cost of such supplies and materials as were purchased during the taxable year for which the return is made, provided the taxable income is clearly reflected by this method.

The uniforms used by the taxpayer in its business are not considered incidental in nature because they are not an item that is of minor or secondary importance in the operation of the taxpayer's business, and the deduction of their cost in the year of purchase would not clearly reflect income. Thus, under section 1.162-3 of the regulations the taxpayer is required to treat such uniforms as a material item for which a record of consumption is kept.

The purpose of section 1.162-3 of the regulations is to prevent the current deduction upon acquisition of or payment for materials and supplies that are not held for sale and therefore not inventoriable. The regulations provide that if the materials and supplies are incidental then such a deferred rule is not necessary to clearly reflect income and is therefore not invoked. This rule is similar to the rules in sections 1.446-1(a)(4)(i) and 1.446-1(c)(2)(i) requiring a taxpayer using the cash receipts and disbursements method to inventory goods held for sale and to otherwise treat them on the accrual basis. Section 1.162-3 does not require an accrual method of accounting with respect to such materials and supplies, but rather operates to allow deductions only in the year in which the materials and supplies are placed in service unless they are incidental and otherwise meet the requirements of that section.

Section 1.162-3 of the regulations gives no indication that a taxpayer using one method of accounting is to be treated differently from a taxpayer using another method of accounting. Thus, section 1.162-3 applies to taxpayers using either the cash receipts and disbursements method of accounting or an accrual method of accounting.

HOLDING

The taxpayer using the cash receipts and disbursements method of accounting must deduct the cost of uniforms in the taxable year the uniforms are placed in service.

If a taxpayer using the cash receipts and disbursements method of accounting regularly places nonincidental materials and supplies in service in a taxable year earlier than the taxable year payment for such materials and supplies is made its income would not be clearly reflected, and the costs of materials must be deducted in accordance with an accrual method of accounting. Any change in the taxpayer's present method of accounting to a method of accounting described herein is a change in method of accounting to which the provisions of section 446(e) of the Internal Revenue Code of 1954 and the applicable regulations thereunder apply.