Rev. Rul. 79-339

ISSUE

Must a taxpayer that converts scrap metal into more readily marketable form use the "full absorption" method of inventory costing provided by section 1.471-11 of the Income Tax Regulations?

FACTS

The taxpayer is principally engaged in the business of purchasing, processing, and selling scrap metals. The taxpayer values its inventories at the lower of cost or market value. The taxpayer's scrap operations consist of four departments: shipwrecking, shredding, shearing, and non-ferrous, which convert surplus vessels, wrecked automobile bodies, and non-ferrous and other scrap metals into smaller pieces or ingots for resale to companies that buy and recycle scrap metal in these forms.

LAW

Section 471 of the Internal Revenue Code provides that whenever in the opinion of the Secretary the use of inventories is necessary to clearly determine a taxpayer's income, the taxpayer shall take inventories on such basis as the Secretary may prescribe as conforming as nearly as may be to the best accounting practice in the taxpayer's trade or business and as most clearly reflecting income.

Section 1.471-1 of the regulations requires inventories at the beginning and end of each taxable year if the production, purchase, or sale of merchandise is an income-producing factor for the taxpayer. Section 1.471-2(c) allows the taxpayer to value inventories at cost or market value, whichever is lower. Section 1.471-3(c)(3) states that "cost" includes, in the case of merchandise produced by the taxpayer, production costs incident to and necessary for the production of the particular article. Section 1.471-11 requires both direct and indirect production costs to be taken into account in the computation of inventoriable costs in accordance with the "full absorption" method of inventory costing. Costs are considered to be production costs to the extent that they are incident to and necessary for production or manufacturing operations or processes.

ANALYSIS

In the present situation, the taxpayer incurs labor and overhead costs to transform its raw materials (surplus vessels, wrecked automobiles, etc.) into more readily marketable scrap materials. These costs are therefore costs for the production of these materials.

HOLDING

The taxpayer is required to use the full absorption method of inventory costing provided by section 1.471-11 of the regulations.