Rev. Rul. 81-272

ISSUE

Are the taxpayers discussed below required to use the full absorption method of inventory costing described in section 1.471-11 of the Income Tax Regulations?

FACTS Situation (1) Taxpayer sells printed towels. Taxpayer purchases white towels and contracts with an unrelated party to furnish the dye work and design work. Taxpayer has title to the towels at all times. When the dye work and design work are completed taxpayer stores, packages, and markets the towels.

Situation (2) The facts are the same as in Situation (1), except that the unrelated contractor, in addition to dyeing and designing the towels, also stores, packages, and distributes the finished product to the taxpayer's customers.

Situation (3) Taxpayer is the unrelated party in Situation 1 that furnishes the dye work and design work for the white towels. Taxpayer does not have title to the towels.

Situation (4) Taxpayer purchases individual parts of dolls, assembles them, and markets the finished product.

Situation (5) Taxpayer is a printer and engraver. Taxpayer purchases raw paper and, when a customer orders paper, prints or engraves the paper in accordance with the customer's specifications.

Situation (6) Taxpayer operates a machine shop and provides stampings in accordance with customers' specifications on goods provided by customers. Taxpayer does not manufacture or sell any items over the counter, nor does it furnish any additional materials. Taxpayer does not have title to the goods on which it works.

LAW AND ANALYSIS

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 the income of any taxpayer, inventories shall be taken by the taxpayer on such basis as the Secretary may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income.

Section 1.471-1 of the regulations provides that inventories are required when the production, purchase, or sale of merchandise is an income-producing factor. The inventory should include all finished or partly finished goods and, in the case of raw materials and supplies, only those that have been acquired for sale or that will physically become a part of merchandise intended for sale. Merchandise should be included in the inventory only if the taxpayer has title to it.

Under section 1.471-2(c) of the regulations inventories may be valued at (1) cost or (2) the lower of cost or market.

Section 1.471-3(c) of the regulations provides that in the case of merchandise produced by the taxpayer since the beginning of the taxable year, cost means (1) the cost of raw materials and supplies entering into or consumed in connection with the product, (2) expenditures for direct labor, and (3) indirect production costs incident to and necessary for the production of the particular article.

Section 1.471-11 of the regulations provides that both direct and indirect production costs must 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 of manufacturing operations or processes.

Under section 1.471-1 of the regulations merchandise is included in a taxpayer's inventory only if the taxpayer has title to it. It a taxpayer produces merchandise, instead of purchasing merchandise, section 1.471-3(c) requires that cost of the inventory to which a taxpayer has title must include the cost of both direct production costs, that is, direct materials and direct labor, and indirecct production costs. Section 1.471-11 describes how direct and indirect production costs should be included in a taxpayer's inventory.

Production costs include costs that are incurred as a result of processes intended to add utility to a product, making it more suitable for use and consumption. For example, production costs include costs that apply to goods produced naturally, such as the aging of whiskey, as well as costs that apply to goods produced as a result of effort, such as the manufacturing of shoes. Production costs also include the costs incurred to transform already manufactured materials, such as surplus vessels and wrecked automobiles, into more readily marketable scrap materials. See Rev. Rul. 79-339, 1979-2 C.B. 218.

Section 471 of the Code does not apply to taxpayers such as those in Situations 3 and 6 who do not have title to the goods.

Section 471 of the Code applies to taxpayers such as those in Situations 1, 2, 4, and 5 who have title to the goods. In Situations 1, 2, 4, and 5 the taxpayers incurred production costs because costs were incurred as a result of processes that added utility to the products. The fact that a critical part of the processing (Situation 1) or a majority of the processing (Situation 2) is not performed by the taxpayer is not determinative as to whether the taxpayer has incurred production costs. Situations 4 and 5 illustrate that processes that add utility to a product include processes not necessarily associated with the term "manufacturing," such as the assembling of finished parts and the printing or engraving of paper.

Holding

The taxpayers in Situations 1, 2, 4, and 5 are required to use the full absorption method of inventory costing described in section 1.471-11 of the regulations.