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Taxpayer With No Gross Receipts Can't Recover Cost of Goods Sold

(Parker Tax Publishing June 2021)

The Tax Court held that a newly-formed natural gas drilling company could not report estimated drilling costs for natural gas exploration and mining as costs of goods sold in tax years in which the company had no gross receipts from the sale of natural gas. The Tax Court held that cost of goods sold is an offset against gross receipts and is therefore not allowable unless and until the taxpayer actually sells or disposes of goods. BRC Operating Company LLC v. Comm'r, T.C. Memo. 2021-59.


Bluescape Resources Co., LLC (Bluescape), was organized as a Delaware limited liability company in 2008. During tax years 2008 and 2009, Bluescape paid approximately $180 million to acquire hundreds of thousands of acres of minerals and lease interests in West Virginia, Pennsylvania, Ohio, and Kentucky (i.e., leases). Bluescape planned to explore for, mine, and produce natural gas for sale. On its 2008 and 2009 tax returns, Bluescape reported, as costs of goods sold, a total of approximately $160 million of estimated drilling costs for natural gas exploration and mining. Bluescape did not drill, receive drilling services from third parties, or receive drilling property, and reported no gross receipts or sales during these years attributable to the sale of natural gas. The IRS disallowed the claimed costs of goods sold in their entirety, determining that Bluescape had not established that it satisfied the all events test and the economic performance requirement in Code Sec. 461(h)(1). Bluescape took its case to the Tax Court.

Under Reg. Sec. 1.61-3(a), gross income is generally calculated by subtracting the cost of goods sold from gross receipts. Cost of goods sold is determined under Code Sec. 471 and the accompanying regulations and is calculated as the sum of (1) the cost of beginning inventory and purchases (and other acquisition or production costs) during the tax year less (2) the cost of ending inventory. Under Code Sec. 461(h)(1), an amount cannot be taken into account in the computation of cost of goods sold any earlier than the tax year in which economic performance occurs with respect to the amount deducted as cost of goods sold. Under Code Sec. 446(b), the IRS has broad authority to challenge a taxpayer's method of accounting as failing to clearly reflect income.

In a motion for partial summary judgment, the IRS argued that economic performance under Code Sec. 461(h)(1) did not occur with respect to the reported cost of goods sold during the years at issue. Alternatively, the IRS asserted that Bluescape's reported cost of goods sold should be disallowed because it was derived from the use of a method of accounting that failed to clearly reflect income. Bluescape responded that the economic performance requirement did not apply to the amounts it claimed as costs of goods sold because cost of goods sold offsets gross receipts for purposes of computing gross income under Reg. Sec. 1.61-3(a), and hence is an "item" of gross income, the timing of which is governed by Code Sec. 451. Bluescape asserted that cost of goods sold need not "match" gross receipts. Bluescape cited Hezel v. Comm'r, T.C. Memo. 1985-10, as an example where the Tax Court allowed a taxpayer to adjust cost of goods sold for labor costs associated with the taxpayer's business, even though the taxpayer had no sales of inventory during the tax year at issue. Additionally, Bluescape relied on Garth v. Comm'r, 56 T.C. 610 (1971), as an example where the taxpayer was allowed to claim the costs of raising chickens in years prior to the years in which the taxpayer's inventory of chicken eggs or chickens were sold.

Bluescape also attempted to block partial summary judgment by arguing that this was a fact-intensive issue dealing with the clear-reflection-of-income standard and that it would present evidence at trial bearing on whether its method of accounting clearly reflected income, including: the precise terms of the leases, actions it took to preserve and enhance the values of the leases, including drilling test wells, work done by third party engineering companies to evaluate the test wells, generally accepted principles for the particular trade or business, and how Bluescape's method of accounting was consistently applied over the years.


The Tax Court granted the IRS's motion for partial summary judgment after finding that Bluescape was not entitled to recognize cost of goods sold for the years at issue. In the court's view, the real issue before the court was not whether the economic performance requirement applied, but rather whether Bluescape could recognize costs of goods sold before it had any gross receipts from the sale of goods.

The Tax Court found that its decisions in Bernard v. Comm'r, T.C. Memo. 1998-20 and Weaver v. Comm'r, T.C. Memo. 2004-108, illustrated what is obvious from the phrase "cost of goods sold" itself: "goods sold" are generally a prerequisite to recognizing cost of goods sold. In Bernard, the Tax Court held that a taxpayer starting a model train store was not entitled to deduct cost of goods sold because the model train store had not yet begun selling goods to customers during the tax year at issue. In Weaver, the Tax Court treated a taxpayer's claim for cost of goods sold for a business that had zero gross receipts in the relevant year as a claim for additional Code Sec. 162 business expense deductions. In that case, the court explained that cost of goods sold generally is not allowable with respect to goods that have not been sold or otherwise disposed of during the tax year.

The Tax Court also disagreed with Bluescape's reading of the holding in Hezel. The court noted that, in that case, the IRS conceded a deduction for labor costs that had been claimed by the taxpayer as part of cost of goods sold, and thus the labor costs were not even before the Tax Court. Further, the court ruled in the IRS's favor with respect to the claimed cost of goods sold remaining after concessions. Additionally, the court found that Bluescape's reliance on Garth was misplaced because the taxpayer in that case had already been in business for five years and was actively engaged in the production and sale of eggs and hens in the year at issue. The court said that there was no indication that the taxpayer in Garth attempted to recognize cost of goods sold for a tax year in which the taxpayer had no gross receipts from the sale of inventory.

The court also found Bluescape's argument that this was a fact-intensive issue not appropriate for summary judgment unavailing. According to the court, the only facts material to its analysis were that Bluescape did not receive or report any gross receipts from the sale of natural gas or other goods or inventory during the years at issue. In the court's view, none of the evidence that Bluescape intended to present at trial was material to the issue of whether Bluescape had any gross receipts from the sale of goods during the years at issue. The court further noted that in Bernard and Weaver, it rejected, without reference to the clear-reflection-of-income standard, the argument that a taxpayer may recover cost of goods sold when the taxpayer had no gross receipts from the sale of goods. Bluescape could not fend off partial summary judgment on this fundamental legal question, the court concluded, by invoking a clear-reflection-of-income argument.

For a discussion of determining gross income derived from business, see Parker Tax ¶70,500.

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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