their control and ownership, may be deducted (I. T. 1258, 1332). Doubtful capital charges, considered expenses by the Department, have included expenses of defending title and right to a patent (A. R. R. 98), expenses of restoring orange trees damaged by frost (O. D. 554), a bonus and attorney's fees paid to secure immediate or early possession of property (A. R. R. 178), such bonus to be spread from payment to the date delivery of the property otherwise would have been made (O. D. 664), the cost of setting up or revising a system of accounting (A. R. R. 992), repairs and depreciation in the case of a person in the business of buying and selling houses (I. T. 1342). Business expenses of individuals have consisted of crop insurance premiums (O. D. 215), fees paid to secure employment (O. D. 579) but not expenses of seeking employment (I. T. 1327), the expense of an automobile used in business (A. R. R. 266 and O. D. 1122), expenses of a trip to Washington in connection with an additional income tax assessment (O. D. 849), an initiation fee, in addition to the cost of a seat in the stock exchange (I. T. 1271), office and clerical expenses where most of the income comes from stocks and bonds (O. D. 877), and entertaining expense on behalf of a partnership if capable of substantiation (A. R. R. 3131). Gifts of corporations have not included membership fees in chambers of commerce (O. D. 421 and 496), nor payments to such organizations for property protection (A. R. R. 1052), nor expenses of a baseball team in a territory in which the corporation does business, including the cost of newspaper reports on the games (O. D. 1030), nor Christmas gifts to the buyers of trade customers (A. R. R. 3131). XVII THE VALUATION OF INVENTORIES Taking the inventory. Pricing. Cost basis. Market-raw materials and goods bought for resale. Market-goods in process. Rules applicable to certain businesses. INVENTORIES must be set up when in the opinion of the Commissioner they are necessary (Sec. 203 of both the 1918 and 1921 Revenue Acts). Inventories are required in a manufacturing or trading business at the beginning and end of the fiscal or calendar year, though the "receipts" method of accounting for income is otherwise followed (Art. 23-4). Estimated or book inventories presumably will be satisfactory substitutes where no physical inventories have been taken. Inventories other than physical inventories should, of course, stand the test of good accounting practice, the principal features of which have been incorporated into the regulations as outlined below. (a) Taking the Inventory. General precautions in taking inventories have been laid down by the Department (Art. 1581): 1. The inventory should include materials on hand purchased for resale, for consumption, and for productive use, as well as finished and partly finished goods. 2. Goods sold and unshipped and included in accounts receivable or cash should be excluded from the inventory. 3. Consigned goods unsold should be included in the inventory of the consignor only. 4. Title should be vested in the taxpayer, goods or dered for future delivery, even though the purchase price has been agreed upon, being excluded. 5. Goods in transit may be included with merchandise on hand, due care being taken to see that in both (4) and (5) the proper liability has been set up. 6. Inventory sheets must be preserved as part of the accounting record of the taxpayer (Art. 1582). (b) Pricing. Under the 1916 law the Department ruled that inventories must be valued at cost. It was not until December 19, 1917, (T. D. 2609) that the present wellknown rule of "cost or market, whichever is lower" was recognized. As a matter of fact, however, many taxpayers had previously rendered returns on the last basis and no objection was raised by the Department. Regulations issued under the 1918 act permitted (a) cost or (b) cost or market, whichever was the lower (Art. 1582, Regulations 45). If the latter method was used, it was to be applied consistently to the entire inventory. Where the basis was changed, permission from the Commissioner was required. At the end of 1920, most businesses found themselves with a rapidly declining inventory and many desired, perhaps for the first time in several years, to take advantage of market prices which were below cost. Cost or market, whichever was the lower, had, in effect, been followed previously because cost had been below market. Consequently at the end of 1920 a ruling was issued which permitted all taxpayers to elect the cost or market basis without submitting a request therefor (T. D. 3108). Changes now to any other method must first be approved by the Commissioner (Art. 1582). Merchandise on hand will be assumed to be that most recently purchased and should be priced accordingly; or, book inventories will be accepted providing they are in accordance with good accounting procedure: namely, are priced in and out at cost and are verified at reasonable intervals by a physical count. In any case proof of the prices taken will be required and the records of the taxpayer should be complete in this respect (Art. 1582). (c) Cost. Treasury Department rulings covering the computation of both cost and market will doubtless continue in force. Relative to cost the Department has stated (Art. 1583): I. In the case of merchandise on hand at the beginning of the year and still on hand cost is the inventory value previously taken (Sec. 202 (a) (1) and I. T. 1561). 2. Trade discounts should be deducted; cash discounts may or may not be deducted, but the taxpayer must be consistent in his practice. 3. Transportation and other charges incurred in acquiring the goods should be added. 4. Cost of raw materials, direct labor, and indirect expenses are the elements of cost in the case of finished and partly finished goods. A portion of management expenses may be included in indirect expenses but no selling expense, interest, or profit. 5. Costs may be approximated in cases where the usual rules fail to apply but should be in agreement with the standard practices common to the particular industry concerned. (d) Market-Raw Materials and Goods Bought for Resale. "Market price" is defined by the Department as the "current bid price prevailing at the date of the inventory for the particular merchandise in the volume in which usually purchased by the taxpayer." This rule applies primarily to raw materials and goods bought for resale. Other methods of determining market where no quotations are available are (Art. 1584): 1. Specific transactions entered into in good faith, in the quantity ordinarily purchased by the taxpayer. 2. Payments made in cancellation of purchase commitments. 3. Actual selling price-to be tested by examining sales before and after the date of the inventory-less an allowance for selling expense. Because of unstable conditions at the end of 1918, an inventory loss of that year could be proved in 1919 and the taxes for 1918 redetermined (Art. 261, Regulations 45, under authority of Sec. 214(a) (12) of the Revenue Act of 1918). At present, shrinkage of inventory values below those existing at the date of the inventory can be deducted only in the year in which the shrinkage occurs. In Regulations 45, (e) Market-Goods in Process. three bases were outlined for ascertaining the market price of goods in process, the lowest of the three to be used: 1. Replacement cost at the date of the inventory. 2. Proportionate part of the actual finished cost 3. Proportionate part of the sales price of the finished product It can be easily seen that this rule was clumsy and difficult of application (Art. 1584, Regulations 45). The rule has been omitted from Regulations 62, and in its place is the following, applicable to both goods in process and finished stock: the market price (as defined in the first sentence of (d), above), may be ascertained in the case of the basic elements of cost which are, of course, raw materials, direct labor, and burden or overhead. The assumption follows that the replacement cost of each of these three elements should be ascertained and applied, if lower than cost. Specific exemption from the possibility of valuing below cost is made in the case of work-in-process and finished goods which are to be delivered at a price fixed by contract (Art. 1584). (f) Rules Applicable to Certain Businesses. Rules gov |