Corporation Was Required to Report Notes Received on Sale of Products as Income

(Parker Tax Publishing December 2020)

The Ninth Circuit affirmed the Tax Court and held that a corporation was required use the accrual method of accounting in reporting sales of products it manufactured since it was required by Code Sec. 471 to account for inventories. The court further held that the corporation did not qualify for the small business taxpayer exception to the accrual method requirement and, thus, notes received on the sale of the corporation's products were includible in taxable income. King Solarman, Inc. v. Comm'r, 2020 PTC 381 (9th Cir. 2020).

Background

King Solarman, Inc. (KSI) is a C corporation whose sole shareholder and chief executive officer is Michael Cung. KSI is principally engaged in the manufacture and sale of mobile solar-powered lighting units (solar towers). During 2014, Mr. Cung negotiated a deal for the lease of 162 solar towers. Each tower had the same basic design and core components. On the advice of his accountant Mr. Cung structured his side of the transaction through a network of related entities. KSI executed a purchase agreement for the 162 units with Solarman (Indion) Fund I, LLC (Fund). The Fund was an investment vehicle in which income and expense items were initially allocated 99 percent to passive investors and 1 percent to King Solarman LLC, an entity wholly owned by Mr. Cung. The Fund immediately leased the towers to an intermediary company, which immediately subleased the towers to King Solarman LLC, which then subleased the towers to the end users. The transaction was structured this way in order to transfer bonus depreciation and tax credits to the Fund's passive investors while minimizing their exposure to the economic risk of the leasing transaction.

The purchase agreement between KSI and the Fund was executed on December 29, 2014, with Mr. Cung signing for both parties. The total purchase price was $7,938,000, payable in two cash installments totaling $2,143,260 and a promissory note for the $5,794,740 balance. The note was secured by the solar towers and called for 240 monthly payments of $31,388.50. During fiscal year end (FYE) 2015, the Fund paid the two cash installments and made four monthly payments on the note, yielding total cash payments of $2,268,814. At the close of FYE 2015, KSI's general ledger showed net sales to the Fund of $2,268,814, deferred sales of $5,669,186, and an accounts receivable/note of $5,669,186. The purchase agreement provided that title to (and risk of loss on) the solar towers transferred from KSI to the Fund upon delivery of the note and the Fund's first payment. Those events occurred on December 29 and 30, 2014, respectively. The Fund acquired legal possession of the solar towers and immediately recorded them as depreciable assets on its balance sheet.

Under the terms of the sublease agreement, King Solarman LLC, the sublessee, was required to perform all maintenance and repairs on the solar towers. It charged the end users for all repairs and maintenance and earned a profit by performing those services. KSI warranted to the Fund that the solar towers would remain "in good working order" for 10 years. KSI in turn had warranties from the manufacturers of the principal components of the solar towers (battery pack, battery backup system, inverter, trailer platform, etc.). These warranties had terms ranging between 2 and 25 years. KSI agreed to assign these warranties to the Fund or (if they were not assignable) to take necessary steps to exercise the warranties on the Fund's behalf.

On its FYE 2015 tax return, KSI included in its cost of goods sold 100 percent of the material costs attributable to the 162 solar towers it sold to the Fund. And it included among its deductions - either as "salaries and wages" or as "other deductions" - 100 percent of the labor costs attributable to the 162 solar towers. But it excluded from its gross receipts $5,669,186, the portion of the purchase price that it did not receive in cash during FYE 2015.

After auditing KSI's FYE 2015 return, the IRS concluded that KSI was required to include in its gross receipts, under the accrual method of accounting, the entire purchase price paid for the 162 solar towers. According to the IRS, KSI had to use an accrual method of accounting for purchases and sales since it was required to use an inventory per Code Sec. 471. Under the accrual method of accounting, KSI was required to include the entire amount of sale proceeds for the 162 solar towers, including the notes, since all the events had occurred to fix the right to receive the income with reasonable accuracy.

KSI challenged the deficiency in Tax Court, arguing (among other things) that: (1) it properly used the cash method of accounting for FYE 2015, (2) the IRS premised the deficiency on an asserted change of accounting method, and (3) the accounting method that the IRS asserted KSI had to use was improper because it would not clearly reflect KSI's income. The Tax Court held that KSI was required to include in income the sales proceeds it received in the form of a promissory note. The court noted that KSI explicitly elected the accrual method of accounting on its first tax return in 2012 and confirmed its adoption on each of its subsequent returns.

KSI appealed to the Ninth Circuit, arguing that it was a qualifying small business taxpayer and thus was excepted from the requirement in Reg. Sec. 1.446-1(c)(2)(i) to use an accrual method of accounting under Code Sec. 446 and to account for inventories under Code Sec. 471. For a C corporation to qualify for this exception for the year at issue and elect the cash method, its annual gross receipts for the three years before the year in question must be $5 million or less. In addition, the corporation must meet one of the following three additional requirements: (1) it does not fall within certain NAICS industry codes, (2) its principal business activity is the provision of services, or (3) its principal business activity is the fabrication or modification of tangible personal property upon demand in accordance with customer design or specifications.

Analysis

The Ninth Circuit affirmed the Tax Court and held that KSI was required to use the accrual method of accounting and was not free to use either the cash method or an installment method of accounting. The court cited Reg. Sec. 1.446-1(c)(2)(i) and Jim Turin & Sons, Inc. v. Comm'r, 219 F.3d 1103 (9th Cir. 2000), which provide that the accrual method is required for purchases and sales that are income-producing factors when it is necessary to use an inventory under Code Sec. 471, unless the taxpayer receives authorization from the IRS.

The necessity to use an inventory, the court noted, turns on whether the merchandise sold could be "stored" and was thus "susceptible to being inventoried" if there had been any remainder on hand at year end. According to the court, KSI was restricted to the accrual method because it was necessary for KSI to use an inventory and it did not receive permission from the IRS to use a different method. KSI's solar towers and related equipment can be stored, and thus are susceptible to being inventoried, the court said. The court also noted that the cost of this merchandise was plainly a significant "income-producing factor," as evidenced by the fact that the costs of solar tower merchandise in FYE 2015, represented 44 per cent of KSI's gross receipts as calculated by the IRS.

The court found KSI's argument that it qualified for a small business exception unpersuasive. While KSI's average gross receipts were only $2.6 million over the relevant period and thus cleared the initial hurdle for qualifying for the small business exception, the court found that it did not meet any of the three options for the final requirement.

First, the court said, the NAICS industry code that best fit KSI was 423990 (wholesale trade), precluding KSI's success under the first option which requires that a taxpayer not have an NAICS code for "wholesale trade within the meaning of NAICS code 42." Second, the court noted, KSI did not argue that its principal business activity is the provision of services and thus it had waived any argument under option two. Finally, while KSI did allow some customization of its solar towers, its principal business activity was not the fabrication or modification of tangible personal property upon demand in accordance with customer design specifications. While KSI allowed "minor modifications," which were merely "pre-selected options," this did not rise to a "principal business activity" that included fabricating or modifying the solar towers upon customer demand.

Under the accrual method and Reg. Sec. 1.446-1(c)(1)(ii)(A), the court noted, KSI must recognize income when all the events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy. Here, the court said, KSI had earned the entirety of the note amount by performance when it delivered all 162 solar towers and title to the towers in FYE 2015. And the amount of the note that KSI was set to receive, the court observed, was determinable with reasonable accuracy upon completion of the sale, despite KSI's potential warranty obligations. Because the potential warranty claims were uncertain and were not finalized in FYE 2015, the court said they were conditions subsequent which did not prevent this result. As a result, the court concluded that KSI should have included the balance of the note in its gross receipts for FYE 2015.

Observation: For tax years beginning after 2017, the Tax Cuts and Jobs Act significantly expanded the universe of taxpayers eligible to use the cash method.

For a discussion of taxpayers exempt from keeping inventories for post-2017 years and pre-2018 years, see Parker Tax ¶242,315 and ¶242,318, respectively.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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