legal expenses in obtaining an additional deduction for contributions (G. C. M. 263), 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), a contribution to a fund to purchase land for a naval ordnance plant (1 B. T. A. 124), legal fees paid to break a will (1 B. T. A. 372) or in connection with disbarment proceedings (I. T. 2168), repairs to rented property to put it in shape for a residence (1 B. T. A. 400), a penalty paid for the violation of the Federal hours of service law (S. R. 1448).

Expenses of corporations have included membership fees in chambers of commerce (O. D. 421 and 496), payments to such organizations for property protection (A. R. R. 1052), 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), Christmas gifts to the buyers of trade customers (A. R. R. 3131). A payment to a chamber of commerce to make good an operating deficit was deductible, being in the same category as dues (I. T. 1964).

XIX

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 the 1918 and 1921 and Sec. 205 of the 1924 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. 23-24). 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.

Strictly speaking, inventories are neither income or expense. But a reduction in the valuation of the closing inventory is reflected in a corresponding reduction in net income; and because the closing inventory is so often thought of in this connection, the whole topic is conveniently discussed at this point.

TAKING THE INVENTORY

General precautions in taking inventories have been laid down by the Department (Art. 1611):

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 ac

counts 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 ordered 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. 1612).

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 well-known rule of "cost or market, whichever is lower," was recognized. As a matter of fact, however, many taxpayers had previously rendered returns on this 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, giving 30 days' notice (Art. 1612).

Merchandise on hand will be assumed to be that most recently purchased and should be priced accordingly; or, book inventories will be accepted, provided 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 used in the inventory will be required and the records of the taxpayer should be complete in this respect (Art. 1612).

COST

Treasury Department rulings covering the computation of both cost and market have been much the same in the

last four years. Relative to cost the Department has stated (Art. 1613):

1. 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); Art. 1592; 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. "Cash" discounts, granted whether or not prompt payment is made, must be deducted (1 B. T. A. 124; S. M. 5281).

3. Transportation and handling 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.

6. Allowances of depreciation or depletion based on March 1, 1913, value may properly be included (for tax purposes, at least) in the "cost" of inventories (3 B. T. A. 1282).

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. 1614):

1. Specific transactions entered into in good faith, in the quantity ordinarily purchased by the taxpayer.

2. Payments made in cancelation of purchase commitments; by subtracting such payments from the contract price, a "forced market" valuation is indicated.

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.

Arbitrary reductions to market price are improper; and the Board of Tax Appeals has properly ruled out cases involving percentage reductions of the entire inventory (2 B. T. A. 90, 266, 369; 3 B. T. A. 52; 4 B. T. A. 246).