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 Rev. Rul. 79-83

1979-1 C.B. 182

Section 471

IRS Headnote

Inventories; valuation; commodity dealers in grain. A commodity dealer that buys and sells one grade of oats and uses the market value at the end of the year for computing the value of inventory may not, for purposes of section 471 of the Code, use discount values for lower-grade oats that are customarily mixed with higher-grade oats and sold as the higher grade.

Full Text

Rev. Rul. 79-83

ISSUE

Whether the taxpayer's method of computing the year end inventory value of grain is acceptable for federal income tax purposes, under the circumstances described below.

FACTS

The taxpayer, X corporation, is a commodity dealer engaged in the business of buying, selling and storing various grains, including oats. In accordance with standards developed by the United States Department of Agriculture, oats are divided into five grades (U.S. No. 1, U.S. No. 2, U.S. No. 3, U.S. No. 4, and U.S. Sample grade), depending upon such factors as test weight per bushel, percentage presence of sound cultivated oats, percentage presence of heat-damaged kernels, and percentage presence of foreign material. See 7 CFR 26.252. In commercial trade, moisture is also a pricing factor.

Oats are usually sold commercially as No. 2 oats. Although a bushel is nominally a volume measurement, in the grain industry a bushel of grain is determined on the basis of a standard weight. The weight per bushel was established long ago, and the oats grown in an average year are normally heavier than the standard weight for a bushel of oats. This is due to hybridization and fertilizers.

As a result, most oats would qualify as No. 1 grade by weight. Commercial discounts are based on test weights, moisture, foreign matter and the quantity of sound cultivated oats in a test sample of the oats. The only premium commonly paid for oats of a quality above No. 2 is due to the weight factor, so they are inventoried as No. 2 oats.

Because of weather conditions and other factors, some oats are produced that do not meet the requirements of No. 2 oats. Since most of the oats purchased qualify as No. 1 oats for which no premium is paid, it is common for grain handlers to mix the lower grade oats with the higher grade in order to achieve a blend that easily qualifies as No. 2 oats. As a result, most No. 2 oats are primarily No. 1 oats that have been mixed with lower grades of oats with varying discounts.

X owns a grain elevator that it uses in connection with its business. With an occasional exception, X buys and sells only No. 2 oats, the grade and quality of oats that is regularly listed and sold commercially in the United States. It is a natural tendency for the heavier oats in a bin to settle to the bottom of the bin and for lighter oats as well as chaff and hulls to "float" on top. Over a period of time, a bin into which commercial No. 2 oats were placed and out of which only actual No. 2 oats were loaded would end up containing low grade oats as a result of this floating phenomenon. Normal handling of oats and weather conditions, such as heat and moisture, also reduce the quality of oats. For these reasons X and other grain elevator operators often have different grades in separate bins, and mix the oats to achieve the desired grade when oats are shipped.

At year end X inspects the quantity and quality of oats in each bin and values the bin at the market value for that grade and quality of oats. A bin that contains low grade oats at year end is valued at the market price for those discounted oats, even though X expects to blend them with other oats prior to sale as No. 2 oats.

In computing the value of the oats inventory in the elevator, X consistently uses the market discount for low grade oats and the market value for the balance of the oats (No. 2 and better).

LAW AND ANALYSIS

Section 471 of the Internal Revenue Code of 1954 provides that whenever in the opinion of the Secretary the use of inventories is necessary in order to clearly 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 practices in the trade or business and as most clearly reflecting the income.

Section 1.471-2(a) and (b) of the Income Tax Regulations provides, in part, that section 471 of the Code provides two tests to which each inventory must conform: (1) it must conform as nearly as may be to the best accounting practices in the trade or business, and (2) it must clearly reflect the income.

Section 1.471-2(c) of the regulations provides, in part, that the bases of valuation most commonly used by business concerns and that meet the requirements of section 471 are (1) cost and (2) cost or market, whichever is lower. Any goods in an inventory that are unsalable at normal prices or unsalable in the normal way because of damage, imperfections, shop wear or other similar causes should be valued at bona fide selling prices less direct cost of disposition, whether subparagraph (1) or (2) of this paragraph is used.

Section 1.471-2(d) of the regulations provides, in part, that in respect of normal goods, whichever method is adopted must be applied with reasonable consistency to the entire inventory of the taxpayer's trade or business.

Revenue Ruling 74-227, 1974-1 C.B. 120, involving a dealer in commodities, provides in its answer to Question 4 that where the cost of the commodity cannot be accurately obtained the dealer may use the market value of the commodity at the date of the closing inventory, notwithstanding the fact that such market value may be above cost. Revenue Ruling 74-227 involves a taxpayer that deals in several commodities. The facts relating to Question 4 provide, in part, that the commodity trading industry practice has been to inventory each commodity at its market value at the end of the taxable year, because the identity of a particular commodity and its actual cost cannot be accurately determined. (Emphasis added.)

Consistent with Revenue Ruling 74-227, X may use the market value of No. 2 oats at the date of the closing of the inventory. However, Rev. Rul. 74-227 does not deal with any question involving the valuation of a part of a commodity, such as the different grades a commodity dealer uses in inventorying its oats.

Section 1.471-2(c) of the regulations contains a rule for valuation of goods that are unsalable at normal prices due to damage, imperfections, shop wear, or similar causes. Section 1.471-2(d) contains a valuation rule for normal goods. In X's situation, the total of the oats in the elevator are considered to be normal goods, of one grade, No. 2 oats, because the separation into different grades of oats is temporary. Because X almost consistently buys and sells No. 2 oats, the lower grade oats that X has will not affect X's income, because at the time of sale the low grade oats will be commingled with the premium oats and go out as it came in, that is, as part of a shipment of No. 2 oats. The low grade oats in X's inventory are distinguishable from the damaged or imperfect goods of the type referred to in section 1.471-2(c). The latter damaged or imperfect goods are goods that a seller would have to sell at a reduced price. X rarely sells oats at a discount, but rather upgrades them to achieve an overall acceptable level for shipment as No. 2 oats.

HOLDINGS

X may not consistently use discount values in computing the year end inventory value of oats in X's elevator for purposes of section 471 of the Code. X should treat the entire quantity of oats in the elevator as No. 2 oats and use the market value of No. 2 oats at year end for computing the inventory value for all oats in the elevator. In a special situation, if X knows that a portion of its low grade oats are unsalable as normally sold by X and offers them for sale at a discounted price that portion should be valued in accordance with the provision in section 1.471-2(c) of the regulations for such goods.

Only a dealer that regularly buys and sells various grades of oats should, on a consistent basis, separately inventory each such mixture at the year end market value for each such grade.

The change in X's present method of accounting of using discount market value for its year end inventory is a change in method of accounting to which the provisions of sections 446 and 481 of the Code and the regulations thereunder apply.