BRC Operating Company LLC v. Commissioner
T.C. Memo. 2021-59

On May 12, 2021, the Tax Court issued a Memorandum Opinion in the case of BRC Operating Company LLC v. Commissioner (T.C. Memo. 2021-59). The primary issue presented in BRC Operating Company LLC v. Commissioner was whether and when a cost of goods sold (COGS) offset may be recognized for tax purposes.

Background to BRC Operating Company LLC v. Commissioner

During tax years 2008 and 2009 the petitioner paid approximately $180 million to acquire hundreds of thousands of acres of minerals and lease interests in West Virginia, Pennsylvania, Ohio, and Kentucky (leases). The petitioner reported, as costs of goods sold, estimated drilling costs for natural gas exploration and mining. The amounts in issue claimed as costs of goods sold are $100 million for tax year 2008 and $60 million for tax year 2009.

It should be noted that the petitioner did not drill, receive drilling services from third parties, or receive drilling property during the tax years in issue. Similarly, it reported no gross receipts or sales during these years attributable to the sale of natural gas.

The IRS disallowed the claimed costs of goods sold in their entirety, determining that the petitioner had not established that it satisfied the “all events” test and the economic performance requirement in IRC § 461(h)(1).

The Petitioner’s Argument

The core issue is whether the economic performance requirement in IRC § 461(h)(1) applies to the petitioner’s estimated drilling costs reported as costs of goods sold. The IRS argues yes, citing the regulations. See, e.g., Treas. Reg. § 1.61-3(a) (observing that “an amount cannot be taken into account in the computation of cost of goods sold any earlier than the taxable year in which economic performance occurs with respect to the amount”).

The petitioners argue that the economic performance requirement does not apply because the regulations “extending” it to amounts included in cost of goods sold went too far. Petitioners argue that, as an offset against gross receipts to arrive at gross income, cost of goods sold is an “item of gross income” the timing of which is governed by IRC § 451 and the corresponding regulations, and therefore the economic performance requirement in IRC § 461 does not apply.

Costs of Goods Sold (COGS)

Cost of goods sold includes the “costs of acquiring inventory, through either purchase or production.” Patients Mut. Assistance Collective Corp. v. Commissioner, 151 T.C. 176, 205 (2018), aff’d, ––– F.3d ––––, 2021 WL 1570288 (9th Cir. Apr. 22, 2021); see also Reading v. Commissioner, 70 T.C. 730, 733 (1978), aff’d, 614 F.2d 159 (8th Cir. 1980); Treas. Reg. § 1.61-3(a); Treas. Reg. § 1.162-1(a). The cost of goods sold offset against gross receipts ensures that there is not a tax on the return of capital. See Commissioner v. Weisman, 197 F.2d 221, 224 (1st Cir. 1952) (“The return of capital is guaranteed by the ‘cost of goods’ offset against gross receipts and thus is avoided the charge that it is a tax on capital and not on income.”). Thus, the “cost of goods sold concept embraces expenditures necessary to acquire, construct or extract a physical product which is to be sold; the seller can have no gain until he recovers the economic investment that he has made directly in the actual item sold.” Reading, 70 T.C. at 733. The regulations similarly reflect this principle. Treas. Reg. § 1.61-3.

Cost of goods sold is calculated as the sum of the cost of beginning inventory and purchases (and other acquisition or production costs) during the tax year less the cost of ending inventory. Huffman v. Commissioner, 126 T.C. 322, 324 (2006), aff’d, 518 F.3d 357 (6th Cir. 2008); see also Alterman v. Commissioner, T.C. Memo. 2018-83 (holding taxpayer’s method of computing cost of goods sold improper when taxpayer considered only purchase and production costs and not beginning and ending inventory); see also Treas. Reg. § 1.162-1(a); Treas. Reg. § 1.446-1(a)(4)(i); Treas. Reg. § 1.471-1. The taxpayer must retain records sufficient to substantiate the reported cost of goods sold. See IRC § 6001; Newman v. Commissioner, T.C. Memo. 2000-345.  The Tax Court has disallowed cost of goods sold when a taxpayer fails to present evidence of net sales or beginning or ending inventory. See Petzoldt v. Commissioner, 92 T.C. 661, 698 (1989) (sustaining disallowance of cost of goods sold offset when the taxpayer did not provide records to determine net sales or inventory); Chico v. Commissioner, T.C. Memo. 2019-123, *25 (sustaining disallowance of cost of goods sold offset because the taxpayers presented invoices for materials but no information regarding beginning and ending inventory).

Cost of goods sold generally is determined under IRC § 471 and the accompanying regulations. See Treas. Reg. § 1.471-3; Treas. Reg. § 1.471-11. Producers must include in cost of goods sold both the direct and indirect costs of creating their inventory. See Treas. Reg. § 1.471-3(c); Treas. Reg. § 1.471-11. IRC § 471 and its regulations also direct taxpayers to IRC § 263A for additional rules. Under IRC § 263A, a taxpayer is not allowed to deduct currently the direct or indirect costs of personal property produced by the taxpayer. See IRC § 263A(a)(1), (b)(1). Instead, these costs must be capitalized or included in inventory costs. See IRC § 263A(a)(1).

Generally, cost of goods sold is not allowable unless, and until, the taxpayer actually sells or disposes of goods. See Patients Mut., 151 T.C. at 205 (holding that when accounting for COGS as opposed to deductions, taxpayers have to capitalize an item’s cost in the year of acquisition or production and either amortize it or wait until the year the item’s sold to make the corresponding adjustment to gross income); see also Jones v. Commissioner, 25 T.C. 1100, 1102-1104 (1956) (holding that the taxpayer could not recover cost of goods sold until the goods were sold or otherwise disposed of), rev’d on other grounds, 259 F.2d 300 (5th Cir. 1958). This principle is illustrated by Bernard v. Commissioner, T.C. Memo. 1998-20 and Weaver v. Commissioner, T.C. Memo. 2004-108.

Bottom Line, It’s in the Name

Even where otherwise appropriate, cost of goods sold generally is not allowable with respect to goods that have not been sold or otherwise disposed of during the taxable year. Jones v. Commissioner, 25 T.C. 1100, 1103-1104 (1956), revd. on other grounds 259 F.2d 300 (5th Cir. 1958); Bernard, T.C. Memo. 1998-20.  The term “cost of goods sold” contains the words “goods sold.” Thus, the sale of goods is generally a prerequisite to recognizing cost of goods sold. And these cases illustrate the basic flaw in petitioners’ position: the petitioner had no gross receipts from the sale of goods to offset. Cost of goods sold does not exist in a vacuum, as a stand-alone deduction in the Code, but serves as an offset against gross receipts. See Sullenger v. Commissioner, 11 T.C. 1076, 1077 (1948) (“Section 23 [now section 162] makes no provision for the cost of goods sold, but the Commissioner has always recognized, as indeed he must to stay within the Constitution, that the cost of goods sold must be deducted from gross receipts in order to arrive at gross income. No more than gross income can be subjected to income tax upon any theory.”); Treas. Reg. § 1.61-3.

(T.C. Memo. 2021-59) BRC Operating Company, LLC v. Commissioner

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