Despite Having No Adjustment in Prior Two Exams, Taxpayer's Use of Gross Profit Method Found to Significantly Misstate Income

A taxpayer’s appeal of a Tax Court decision upholding an IRS assessment regarding a method that had survived two prior IRS audit failed to win relief from the First Circuit Court of Appeals in the case of Transupport, Inc. v. Commissioner, CA1, No 17-1265.

The taxpayer in this case is a wholesaler of engine and engine parts used in military vehicles.  The issue in this case involved a portion of the business where the taxpayer bought parts in bulk from the U.S. Government and resold them.

The taxpayer did not take physical inventories of this equipment to determine cost of goods sold, rather using a gross profit method.  As the appellate opinion explains:

So, instead of calculating the cost of goods sold by tracking changes in its inventory, Transupport selected a percent profit that it claimed to make on the sale of goods and used that figure to generate its cost of goods sold as well as estimates of its beginning and ending inventory. Id. Transupport allegedly used a percent profit consistent with industry standards. See Transupport I, 2015 WL 5729787, at *6. Transupport's cost of goods sold "varied without explanation" from year to year, and Transupport kept no records indicating how it selected its gross profit percentage.

Despite using such a “unique” system of maintaining inventories, the IRS had passed twice on adjusting the taxpayer’s income for the issue.  As the opinion continues:

Transupport was audited by the IRS in 1984, and “the examining agent was aware that petitioner did not maintain a physical inventory of the unsold parts in its warehouse and backed into the closing inventory, reported in its returns, by using a percentage of sales as costs of goods sold.” Transupport II, 2016 WL 6900913, at *2. The IRS expressed disapproval of Transupport’s methodology, but did not meaningfully adjust Transupport’s cost of goods sold for the years under audit. Id. Transupport was audited again in 1992. Id. The IRS was again aware of Transupport's practice of not taking a physical inventory, and again the IRS auditor did not require changes.

This author has often heard taxpayers and advisers justify a position being taken by pointing to the fact the position had survived exam—and in this case had done so twice.  But any belief that a position surviving exam means there is no risk in continuing the position is simply not justified if the position itself cannot be supported under the law—and both the Tax Court and the appellate panel found this one could not be supported.

The Court pointed out that the evidence presented made it clear that Transupport’s method had grossly understated inventory and, necessarily, had also grossly overstated cost of goods sold.  The Court noted:

Foote testified at trial that Transupport’s inventory was worth approximately $100 million at cost, while Transupport claimed to have an ending inventory worth just $1,867,257 in 2007. Transupport II, 2016 WL 6900913, at *2. As the Tax Court recognized in its first opinion in this case, those two figures “cannot be reconciled.” Transupport I, 2015 WL 5729787, at *6. A list of the parts in Transupport’s inventory (the “Honeywell list”) that was prepared by W. Foote, and is “reasonably accurate” according to J. Foote, indicated that a portion of Transupport’s inventory had an original retail value of $312,413,889. Transupport II, 2016 WL 6900913, at *4. Transupport did not pay the original retail price, but “[t]he lower of cost or market value of the items on the Honeywell list alone far exceeded the total inventory values reported on petitioner's financial statements and tax returns.”

So how did the taxpayer attempt to justify this $98,000,000 difference in inventory?  The taxpayer argued that their inventory suffered from a significant amount of obsolescence.  But the Court found proof of that amount of obsolescence was lacking.

But Transupport did not track or quantify that obsolescence, and the Tax Court is permitted to “bear[ ] heavily if it chooses upon the taxpayer whose inexactitude is of his own making.” United Aniline Co. v. Comm'r, 316 F.2d 701, 703 (1st Cir. 1963) (alteration in original) (quoting Cohan v. Comm'r, 39 F.2d 540, 544 (2d Cir. 1930) (L. Hand, J.)). Given the lack of evidence on obsolescence, the evidence demonstrating a large understatement of inventory, Foote's admissions, and that the burden of proof remained on Transupport at all times, the Tax Court did not clearly err by upholding the notice's gross profit percentage.

No doubt the taxpayer had believed that, given its experience in prior exams, that they were free to use their gross profit method, since even though the IRS had objected to it in a prior exam, at the end of the exam the IRS did not pursue the matter.  But each exam stands on its own, and the fact that the IRS had failed to assess tax previously on the issue did not impact their ability to so on a new exam.

While there is something to be said for “practical experience” in understanding what issues are and are not likely to be challenged on exam, it’s crucially import for CPAs to recognize that such experience does not serve to overturn the law or make it somehow inapplicable to the taxpayer in question.  The fact the IRS may not have applied the law in a prior exam is no guarantee the agency will not do so in the future.

The CPA should also understand that taking a position that goes against the law, even though it survived a prior IRS exam, can expose both the CPA and the taxpayer to significant penalties.