Rev. Rul. 54-88

The purpose of this Revenue Ruling is to state the position of the Internal Revenue Service with respect to the meaning of the term `deductions' as used in section 711(b)(1) and section 433(b)(9) and (10) of the Internal Revenue Code.

The term `deductions' means `expenses' or `statutory deductions' allowable by section 23 of the Internal Revenue Code. It does not mean subtractions which are properly includible in the computation of gross income.

Subtractions, which are properly includible in computations of gross income regardless of the methods of accounting or computation used in the taxpayer's books or returns, include inventory adjustments for shortages ( Fremont Cake and Meal Company v. Commissioner , Tax Court Memorandum Opinion dated November 20, 1950), abandoned or unsaleable merchandise ( Mrs. C. J. Barnard v. Commissioner , 18 B.T.A. 1022), and price fluctuations and changes in methods of valuation ( Colorado Milling and Elevator Company v. Commissioner , 17 T.C. 1280 appealed on another issue).

No part of cost of goods sold as such may be treated other than as a subtraction in computing gross income. However, whether a particular expenditure is properly includible in cost of goods sold, depends upon the nature of the expenditure. In a manufacturing business, cost of goods sold includes the cost of raw materials and supplies entering into or consumed in the production of the articles sold, expenditures for direct labor, and indirect expenses incident to and necessary for the production of the articles. Cf. section 39.22(c)-3, Regulations 118. However, for the purposes of section 711(b)(1) and section 433(b)(9) and (10) of the Code, it does not include allowances for depreciation, rentals, taxes, insurance, other recurring charges, or losses incurred or accrued with respect to land, buildings, machinery, and equipment or other facilities used in production of articles irrespective of whether these items may be included as part of cost of goods sold under an acceptable accounting practice.

Though expenditures allowable as deductions by section 23 of the Code have been claimed and allowed as a part of cost of goods sold pursuant to an acceptable accounting practice, that fact does not change the nature of the expenditures or require that they shall be considered as subtractions in computing gross income in applying section 711(b)(1) and section 433(b)(9) and (10) of the Code. Thus, State real estate, personal property, income, or franchise taxes, Federal and State social security or unemployment compensation taxes are not subtractions in computing gross income, though they have been claimed and allowed as a part of the cost of goods sold ( The Montreal Mining Company v. Commissioner , 2 T.C. 688). The fact however that a taxpayer has included an item in cost of goods sold, though not decisive, is of evidentiary value, as showing that the taxpayer considered the item to be normal rather than abnormal ( Tovrea Land and Cattle Company v. Commissioner , 10 T.C. 90).

In the case of articles of inventory which are the subject of one or more losses within the meaning of the term `deductions under section 23(f) for losses,' as used in section 711(b)(1)(E) and section 433(b)(9)(C) of the Code, the cost of the articles shall be computed pursuant to the provisions of this Revenue Ruling respecting the computation of cost of goods sold. If the adopted basis of valuing inventories is `cost or market, whichever is lower,' the basis for computing the casualty loss shall not exceed the lower value at the time of the casualty. If for the taxable years beginning after December 31, 1940, and prior to January 1, 1948, the provisions of section 22(d)(6)(A) of the Code are applicable, the basis for computing the casualty loss shall be adjusted to reflect the increase or decrease of net income, under clauses (i) and (ii) thereof, attributable to the casualty loss. In view of the provisions of section 433(b)(10)(D) of the Code, if the provisions of section 22(d)(6)(F) of the Code are applicable, the basis for computing the casualty loss for any taxable year ending after June 30, 1950, and prior to January 1, 1954, shall also be adjusted for reflect the attributable increase or decrease of net income under clause (i) thereof. However, for the purposes of section 711(b)(1)(E) and section 433(b)(9)(C) of the Code, the loss attributable to the casualty shall not include any part due to circumstances other than the casualty, as, for example, price fluctuations occurring prior to the casualty.

Expenditures allowable as ordinary and necessary business expenses, including expenditures occasioned by the casualty, cannot be treated as `deductions under section 23(f) for losses' within the meaning of section 711(b)(1)(E) and section 433(b)(9)(C) of the Code. There is no authority to change an expense under section 23(a)(1)(A) of the Code into a loss under section 23(f), in order to consider and disallow it under the provisions of section 711(b)(1)(E) or section 433(b)(9)(C) of the Code ( Consolidated Motor Lines, Inc. v. Commissioner , 6 T.C. 1066). This rule is applicable regardless of whether the expenditures have been claimed and allowed as deductions under section 23(a)(1)(A) of the Code or, pursuant to an acceptable accounting practice, have been included in cost of goods sold and claimed and allowed as subtractions in computing gross income ( Veeder-Root, Inc. v. Commissioner , 11 T.C. 602).