CCC'S 'FIRST HANDLER PAYMENTS' AND 'INVENTORY PROTECTION PAYMENTS' ARE A REDUCTION IN THE COST OF COTTON, NOT GROSS INCOME.

Rev. Rul. 88-95

ISSUE

Whether inventory protection payments and first handler payments received by a taxpayer with respect to cotton under Title V of the Food Security Act of 1985 are treated as an item of gross income or as a reduction in the cost of the cotton giving rise to the payments.

FACTS

Title V of the Food Security Act of 1985, Pub. L. No. 99-198, section 501, 99 Stat. 1354, 1407-18 (codified in relevant part at 7 U.S.C. Section 1444-1(a)(5)(D) (1982; Supp. III 1985)) (the "Act") authorized the Commodity Credit Corporation ("CCC") to make payments available with respect to upland cotton produced in the United States purchased by certain persons regularly engaged in purchasing and selling upland cotton. These payments ("first handler payments") were designed to reduce the price of domestic upland cotton to the prevailing world market price, and thus to encourage the export of cotton and cotton-based products. Because the first handler payments apply only to cotton purchased after August 1, 1986, Congress anticipated that there would be a sudden decrease in the market value of raw cotton held in inventory on August 1, 1986. In order to compensate the holders of raw cotton on August 1, 1986, for the decrease in value resulting from the first handler payments, Congress authorized the CCC to make payments with respect to all domestically produced raw cotton held as of that date ("inventory protection payments"). The taxpayer, a textile manufacturer using an accrual method of accounting, received first handler payments and inventory protection payments under the Act.

LAW AND ANALYSIS

Section 61(a) of the Internal Revenue Code provides generally that gross income means all income from whatever source derived.

Section 471(a) of the Code provides that inventories shall be taken 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 income.

Sections 1.471-2 and 1.471-3 of the Income Tax Regulations provide general rules for the valuation of inventories at cost.

In Rev. Rul. 65-17, 1965-1 C.B. 207, the Service held that cotton equalization payments under Title I of the Agricultural Act of 1964 were includible in gross income, and that no adjustments were to be made in the cost of inventories of cotton.

Generally, price rebates received by a taxpayer are not includible in gross income, but instead are treated as a reduction in purchase price, where such rebates do not represent an accession to the taxpayer's wealth. Thus, in Rev. Rul. 85-30, 1985-1 C.B. 20, refunds of a federal manufacturers excise tax received by a taxpayer with respect to floor stocks on hand at the time that the tax was repealed, were held not to be includible in gross income, but instead reduced the taxpayer's inventory cost.

The first handler payments represent price rebates that are not accessions to the taxpayer's wealth, based on the facts described above. In contrast, the inventory protection payments under the Act are not within the conventional definition of price rebates. Based on the facts described above, however, the inventory protection payments may be viewed as rebates from the federal government of a portion of the price previously paid by the taxpayer to purchase domestic cotton that was held in inventory as of August 1, 1986. Because the inventory protection payments were made to compensate the taxpayer for a decline in the value of inventory caused by the first handler payments, the inventory protection payments do not represent an accession to the taxpayer's wealth to the extent the cost of the cotton giving rise to the payments remains in inventory.

Therefore, neither the inventory protection payments nor the first handler payments are includible in gross income; instead such payments reduce the taxpayer's inventory costs to the extent such costs include the cost of the cotton giving rise to the payments.

HOLDING

Both inventory protection payments and first handler payments accrued by the taxpayer should be treated as a reduction in the cost of the cotton giving rise to the payments to the extent the cost of such cotton is deemed to remain in inventory at the date the payments are accrued under the taxpayer's method of accounting. If the payments exceed the cost of the cotton giving rise to the payments, the excess should be treated as an item of gross income.

Inventory protection payments and first handler payments accrued by the taxpayer should be treated as an item of gross income to the extent the cost of the cotton giving rise to the payments is deemed to have been relieved from inventory and accounted for through cost of goods sold as of the date the payments are accrued under the taxpayer's method of accounting.

EFFECT ON OTHER RULINGS

Rev. Rul. 65-17, 1965-1 C.B. 207, is revoked.

DRAFTING INFORMATION

The principal author of this revenue ruling is Robert Testoff of the Office of Assistant Chief Counsel (Income Tax & Accounting). For further information regarding this revenue ruling contact Robert Testoff on (202) 566-4196 (not a toll-free call).