tax memorandum

B. Travitz & Co., Inc. (Travitz & Co. or the company), is a cotton merchant engaged in the business of buying and selling cotton throughout the world. Originally formed as a partnership in 1928, Travitz & Co. was incorporated under the laws of the State of Texas in 1966. It has maintained its principal place of business in Houston, Texas, since its incorporation. During 1977, Travitz & Co. was an electing subchapter S corporation for Federal income tax purposes, and its outstanding shares of stock were owned as follows:

      Shareholder                               Number of shares Ben Travitz, Jr .................................  2,250 Thomas G. Travitz ..............................   2,250 Paula M. Kandel ................................   2,250 Gloria Travitz .................................     375 Ben Travitz, Jr., Thomas G. Travitz, Paula M. Kandel, and Gloria Travitz will sometimes be referred to as the taxpayers.

As a cotton merchant, Travitz & Co. purchases cotton from farmers, ginners, and other merchants and then resells the cotton to domestic and foreign textile mills and, occasionally, to other merchants. Cotton is planted between March and June and is harvested from late July to January. The traditional cotton crop year, or season, runs from August 1 to July 31, but cotton merchants buy and sell cotton throughout the year.

There are two basic methods of purchasing cotton: the "spot purchase" and the "forward purchase." In a spot purchase, the cotton is available for immediate delivery to the buyer. In a forward purchase, the seller contracts to deliver the cotton to the buyer at a specified future date.

Both spot purchases and forward purchases can be made at either "fixed" or "on call" prices. In a fixed price contract, the price per pound of cotton is established or "fixed" on the day the agreement is entered into by buyer and seller. In an on-call contract, the price remains open or "on call" until the seller exercises a call right granted by the contract. The purchase price is ultimately determined by a formula tied to the market price of cotton: the contract price is a specified number of "points" above or below the futures price for the base quality cotton traded on the New York Cotton Exchange for a particular month for future delivery. Such price is then adjusted to reflect any difference in quality between base quality cotton and the cotton actually delivered under the contract. Cotton is traded on the futures market for the months of March, May, July, October, and December. The seller may exercise the call right at any time between the execution of the contract and the day preceding the first "notice day" of the designated call month. The first notice day generally falls on about the fifth day preceding the first day of the call month. For example, on December 8, 1977, Travitz & Co. entered into an on-call purchase contract which provided for a contract price of "850 points off July 1978, futures price at time of seller's fixation." Under the contract, the seller had until about June 25, 1978, to call and fix the price, and he would receive a price per pound of 8.5 cents less than the July futures price on the day he exercised the call. If the seller failed to exercise the call, the price would be determined by reference to the futures settlement price at the close of the last day before the first notice day of a July 1978 futures contract. In a large purchase, Travitz & Co. might permit the seller to call the price in increments of 100 bales per call, with the result that the price of the entire contract would not be fixed until the seller made several calls or the first notice day arrived. Cotton bought on call and delivered to the cotton merchant may be resold by the merchant long before the original seller fixes the price and receives payment in final settlement of the contract.

In most on-call cotton purchases, the price is a specified number of points off (below) the futures market price. All of the Travitz & Co. on-call purchase contracts at issue here provided for a price off the price of July 1978 futures. The exact price terms of on-call cotton purchase contracts are influenced by a competitive marketplace. Travitz & Co. bases the price terms of its on-call purchase contracts on the difference between the spot price and the futures price existing at the time it enters into the contract. The "spot price" of cotton is the price at which cotton can be purchased for cash in the open market for immediate delivery. The difference on any given day between the spot price of cotton and the futures price for cotton traded on the New York Cotton Exchange for a particular month is called the "basis." For example, if on December 1, 1977, the spot price of cotton was 45

cents per pound and the market price for July 1978 futures was 50 cents per pound, the basis would have been 5 cents (500 points). The basis fluctuates over time but not to the [pg. 489]same extent as the futures price, which may fluctuate by as much as 2 cents per pound in a single day. By looking to the basis existing at the time it enters into an on-call contract, Travitz & Co. determines the price terms of the contract; in our example, the price formula would be 500 points off July 1978 futures.

Under an on-call purchase contract, the cotton merchant may or may not agree to make a provisional payment, or advance, to the seller upon delivery of the cotton, with the balance (if any) to be paid when the seller fixes the price. Delivery is made by transferring a negotiable warehouse receipt for each bale of cotton sold. The transfer of the warehouse receipts also effects the transfer of legal title to the cotton. The amount of the provisional payment is determined in different ways depending on where the cotton is purchased: in some areas of the country, farmers demand a provisional payment bearing some relation to the amount that they would receive if they pledged their cotton in return for an agricultural loan from the Federal Government; in other areas, farmers request a provisional payment determined under a formula tied to the futures market. If the seller receives a provisional payment, he is paid any balance due him when he fixes the price.

The on-call purchase contract has been used since the 1930s. It arose in response to the introduction of a Federal Government price-support program for cotton farmers under which the Secretary of Agriculture establishes loan values for cotton based on the grade, staple, and micronaire of the cotton. The base quality cotton for the Government loan program is the same as the base quality cotton traded on the New York Cotton Exchange. The Government loan program affords the farmer the opportunity to pledge his cotton to the Government in return for the receipt of the Government loan value for such cotton, thereby creating a floor or minimum price for the cotton. For the next 10 months (in some cases, 18 months), the farmer has the right to redeem his cotton from the Government by paying back the loan value received, plus the accrued carrying charges for interest, storage, and insurance. If he redeems the cotton, the farmer is free to sell it on the open market at the then-prevailing market price. If he fails to redeem the cotton, the farmer has, in effect, sold his cotton to [pg. 490]the Government at a price equaling its loan value. Thus, participation in the Government loan program guarantees the farmer a minimum price while allowing him to wait 10 or 18 months for a rise in the market value of his cotton which would enable him to get a higher price. In the past, during periods in which the spot price of cotton has approximated the loan value of such cotton, farmers tended to participate in the Government loan program in hopes of a rise in the market. As farmers pledged their cotton under the loan program, it became difficult for cotton merchants and textile mills to buy cotton. Therefore, to secure themselves a supply of inventory, they instituted the on-call purchase contract. The on-call purchase contract is more advantageous to farmers than the Government loan program because it permits farmers to secure the full benefit of a market rise without having to pay any carrying charges.

As a general rule, farmers sell their cotton under on-call contracts when the spot, or market, price of cotton is close to its Government loan value. Conversely, when the spot price of cotton is high, well above its loan value, farmers tend to want to "lock in" the high price through a fixed price contract. From the end of World War II up to about 1970, and particularly during the 1960s, the Government maintained cotton loan values (and thus cotton prices) at a very high level. Large cotton surpluses developed as farmers began, in effect, to grow cotton for the loan. The spot price of cotton stayed at the loan level, and the cotton export market dried up. On-call purchases were infrequent because it was unlikely that the futures price of cotton would rise above the loan level. In the early 1970s, the Federal Government began an extensive program to dispose of its surplus, to cut back on cotton acreage, and to move toward a free market system. As the surpluses disappeared, the cotton markets moved away from the support prices, and with the increasing risk of market fluctuations, the futures market became more active and the number of on-call purchases and sales became significant. In 1977 and at the time of trial, use of the on-call purchase contract was a common, accepted, and industry-wide practice.

Cotton merchants, including Travitz & Co., may engage in hedging transactions with respect to their fixed price purchases and fixed price sales. Fixed price contracts may hedged by entering into an offsetting transaction in the cotton futures market. Thus, if a cotton merchant purchases 100 bales of cotton at a fixed price, the merchant would sell

one contract (which consists of 100 bales) on the cotton exchange for future delivery. Cotton merchants do not hedge unfixed, on-call purchases.

Travitz & Co. has always reported its income on a calendar year basis for Federal income tax purposes. It uses a fiscal year ending July 31 for financial reporting purposes. Technically, Travitz & Co. employs a hybrid method of accounting: the day-to-day operations of the company are recorded on a cash basis, but at yearend, adjusting entries are made to all material accounts (such as accounts receivable, accounts payable, and purchases) to effectively place the company on an accrual basis for income tax purposes.

Travitz & Co. uses inventories and computes its cost of goods sold by adding the year's cotton purchases to opening inventory—thereby indicating the total cost of goods available for sale—and then subtracting ending inventory. The ending inventory consists of sold and unsold cotton to which the company has title at yearend. The company values its ending inventory at "market": inventory under a sales order (i.e., sold but not yet delivered) is valued at the contract sale price less certain (unspecified) charges; unsold inventory is valued at its current market value, determined by reference to several factors, including daily spot price quotations published by the Department of Agriculture and the price of futures contracts traded on the New York Cotton Exchange. The market value so determined may be higher or lower than the actual cost of the cotton inventory. A year's ending inventory figure is used as the opening inventory figure in the following year.

Cotton purchases are accounted for at cost under an accrual method: during the course of the year, the purchases account is debited by the amounts paid under fixed price contracts, advanced as provisional payments under delivered, on-call contracts, and paid in final settlement of delivered, on-call contracts that have been fixed by the end of the year; at yearend, in the event of a rising market, Travitz & Co. accrues an additional amount to the purchases account (by debiting purchases and crediting accounts payable) to account for the additional money potentially due to sellers under delivered, on-call purchase contracts that have not yet been fixed. Cotton merchants sometimes refer to this accrual calculation as bringing the unfixed, delivered, on-call purchases "to market," but in fact, the purchase obligations are not accrued at the yearend market (or spot) value of the purchased cotton. Rather, the amount of the accrual is determined in accordance with the price terms of each unfixed, delivered, on-call purchase contract, in light of the market price on December 31 of futures of the designated call months: generally, Travitz & Co. calculates the amount that it owes under the contracts (without regard to amounts previously advanced as provisional payments) as if the sellers had elected to call and fix the prices on December 31, and then accrues the difference between such amount and the provisional payments. 7 Although the accrual technically does not peg the cost of unfixed, delivered, on-call purchases at the yearend market value of cotton, we may hereinafter refer to the accrual as bringing such purchases "to market" for brevity's sake and because the purchase cost as accrued is tied to the yearend market price of futures.

Travitz & Co. reverses the year-end accruals for unfixed, delivered, on-call purchases shortly after the start of the following year by debiting accounts payable and crediting the purchases account. Reversing the accrual entries prevents the duplication in the following year of the previously accrued cost of such purchases. When each seller actually fixes the price of his cotton, Travitz & Co. pays the difference between the called price and the amount provisionally advanced, and it debits the purchases account and credits the cash account for the additional amount paid.

Travitz & Co. has always valued its inventory at market. Likewise, the company has always accrued a liability to its purchases account at yearend for the unpaid balance (if any) due under unfixed, delivered, on-call purchase contracts. These adjustments are made for financial accounting purposes as well as for tax accounting purposes. However, due to the fact that the cotton season ends on July 31 of each year, Travitz & Co.'s inventory is much lower at the close of its fiscal year on July 31. Furthermore, the company rarely has any unfixed, delivered, on-call purchases at the close of its fiscal year because it typically ends the season with on-call purchases based on July futures; in only a few, isolated instances has cotton been delivered and sold to Travitz & Co. on-call in one season based on October futures, which falls in the next season. Consequently, no adjustment is usually necessary in the preparation of the company's financial statements to accrue amounts potentially owing on unfixed, delivered, on-call purchases. None of the company's

delivered, on-call purchases remained unfixed on July 31, 1978.

Travitz & Co.'s method of accounting for its cost of goods sold conforms to generally accepted accounting principles and to longstanding industry-wide practice. Most, if not all, cotton merchants value their yearend inventories at market for financial and tax accounting purposes, and this practice has been explicitly recognized and permitted by the Commissioner since 1926. Likewise, most, if not all, cotton merchants bring their unfixed, delivered, on-call purchases to market if they have any at the end of their fiscal or taxable years. Unlike Travitz & Co., many cotton merchants, either before or since 1977, have adopted identical years for tax and financial reporting purposes and have selected years corresponding more closely to the traditional cotton season—for example, years ending on May 31, June 30, July 31, or August 31. Such merchants rarely have unfixed, delivered, on-call purchases to bring to market at the end of their taxable years. However, such purchases are brought to market on interim financial statements prepared during the course of the year for company use or to secure bank financing.

Cotton merchants sell cotton on-call in addition to buying cotton on-call. An on-call sale operates much like an on-call purchase; all particulars of the transaction are fixed with the exception of the price, which remains "on-call." The price is a negotiated number of points on or off the price of a futures contract for a call month traded on the New York Cotton Exchange. In an on-call sale, unlike an on-call purchase, the buyer (typically a textile mill) has the call, which may be exercised anytime between the execution of the contract and the first notice day of the call month. Some cotton merchants receive a provisional payment and ship the cotton to the buyer before the price has been fixed. Where the price of cotton sold and delivered on-call has not been fixed by yearend, cotton merchants bring the sale "to market" at the close of the year by accruing the amount that would be due it if the buyer had elected to call the price on the last day of the year. Travitz & Co. engages in on-call sales, but does not, as a rule, ship cotton to a buyer before the buyer has fixed the price. Consequently, Travitz & Co. normally has no unfixed, delivered, on-call sales contracts at yearend; in the event that the company does, it brings such sales to market in the same manner as it brings its on-call purchases to market. Apparently, Travitz & Co. and other cotton merchants do not accrue unfixed, on-call sales at yearend where the cotton has not yet been shipped; but, since the merchants have title to such cotton at the end of the year, it is included in ending inventory at its market value.

In 1977, Travitz & Co. purchased 1,199,915 bales of cotton, of which 1,060,990 were purchased in the United States. On December 31, 1977, the price of 37,706 bales bought on-call and delivered to the compay remained unfixed. Such on-call purchases are divisible into two groups: the Texas contracts, totaling 17,021 bales, and the Memphis territory

contracts, totaling 20,685 bales. Each of the Texas and Memphis territory contracts provided for a price of a specified number of points off July 1978 futures, with adjustments for grade, staple, and micronaire, and each of the contracts provided for a provisional payment. Under a Texas contract, the provisional payment equaled the Government loan value of the cotton less a 50 point "invoicing and outturn charge," and constituted a quaranteed minimum price for the cotton. The Texas farmer was therefore guaranteed the cotton's loan value in the event of a subsequent decline in the futures market. Under some of the Memphis territory contracts, the provisional payment was 40 cents per pound regardless of the actual loan value of the delivered cotton, whereas under the remaining contracts, the provisional payment equaled the Government loan value. Except for two contracts, the provisional payment advanced under a Memphis territory contract was not a guaranteed minimum price.

Travitz & Co. filed a Small Business Corporation Income Tax Return for the calendar year 1977 on which it reported gross sales, cost of goods sold, and gross profit from sales as follows:

Gross sales ...................................  $325,894,477 Less: Returns and allowances ..................     2,296,266                                                  ­­­­­­­­­­­­                                                   323,598,211 Less: Cost of goods sold ......................   317,078,994                                                  ­­­­­­­­­­­­ Gross profit from sales .......................     6,519,217

The company reported total income of $6,772,017, and after subtracting deductions totaling $5,356,303, reported taxable income of $1,415,714.

The company's cost of goods sold, as reported on its 1977 return, was computed as follows:

Beginning inventory ............................  $104,323,282 Plus: Purchases ................................   251,095,008                                                   ­­­­­­­­­­­­                                                    355,418,290 Plus: Freight ..................................     8,149,007       Compress charges and controlling fees ....     6,042,641       Interest and exchange ....................     4,292,541       Insurance on cotton ......................       824,411       Purchase commissions .....................       268,681       Customs and duties .......................        48,579                                                   ­­­­­­­­­­­­                                                    375,044,150 Less: Ending inventory .........................    57,965,156                                                   ­­­­­­­­­­­­ Cost of cotton sold .............................  317,078,994 In computing the value of its ending inventory, Travitz & Co. valued unsold inventory at its market value on December 31, 1977, and sold-but-undelivered inventory at its sales price. The price of cotton and cotton futures was rising at the end of 1977. By December 31, 1977, the price of July 1978 futures for base quality cotton had risen to 55.40 cents per pound. To bring unfixed, delivered, on-call purchases to market on December 31, 1977, Travitz & Co. accrued an additional $1,099,464.58 to its purchases account, consisting of $189,324.58 that would have been due under the Texas contracts and $190,140 that would have been due under the Memphis territory contracts had the sellers under such contracts fixed their prices on December 31. The additional $1,099,464.58 was then included in the purchases figure to increase the company's cost of goods sold by such amount and to reduce its gross profit and taxable income by such amount.

Travitz & Co. employed different methods to calculate the amounts potentially due under the Texas and Memphis territory contracts. In computing the accrual for the Texas contracts, the company first determined that the weighted average of the different buying bases (the number of points off July 1978 futures) provided in the Texas contracts was 853 points, or 8.53 cents, per pound. The company then deducted 8.53 cents from 55.40 cents, the December 31, 1977, price of July 1978 futures, to arrive at a price of 46.87 cents per pound for base quality cotton. The difference between 46.87 cents and the loan value of base quality cotton in Texas, 44.60 cents per pound, was 2.27 cents. By multiplying 2.27 cents by 8,340,290 pounds (the approximate weight of 17,021 bales of Texas cotton ), the company arrived at $189,324.58 as the amount that it would have owed in addition to the previously advanced provisional payments if the Texas contracts had been called on December 31, 1977. To compute the accrual for the Memphis territory contracts, the company separately determined the amount per pound potentially due under each contract by subtracting the provisional payment actually advanced from the price on December 31, 1977, as determined in accordance with the contract. The average amount due was 880 points, or 8.8 cents, per pound. By multiplying 8.8 cents by 10,342,500 pounds (the approximate weight of 20,685 bales of Memphis territory cotton ), the company determined that it would have owed $910,140 more if the sellers had fixed their prices on December 31, 1977.

All of the sellers under the Texas and Memphis territory contracts exercised their call rights and fixed their prices by June 23, 1978; Travitz & Co. paid approximately $1,839,633.70 in 1978 in final settlement of the Texas and Memphis territory contracts.

The taxpayers reported their distributive shares of Travitz & Co.'s reported taxable income on their Federal income tax returns for 1977. In his notices of deficiency, the Commissioner determined that Travitz & Co. could not bring its unfixed, delivered, on-call purchases to market on December 31, 1977, by accruing $1,099,465 to purchases in computing its cost

of goods sold, because, on December 31, 1977, such purchase contracts were open-ended contracts under which Travitz & Co. had only a contingent liability for additional costs. The Commissioner therefore limited purchases to the $249,995,543 actually paid by Travitz & Co. in 1977 and increased the company's taxable income by $1,099,465. There is no evidence that the Commissioner changed the company's method of valuing opening and ending inventories at market.

The taxpayer sent you the following e­mail and asked you to research: 1. ACCOUNTING PERIOD AND METHODS—Methods of accounting—change of accounting

method—IRS power to require change. Can IRS use its discretion by determining that cotton merchant which values ending inventory at market couldn't accrue its estimated liability at year-end for cotton purchased under on-call contracts where cotton had been delivered to taxpayer but price hadn't been fixed? Was “All events test" applicable to ending inventory calculation and did taxpayer's method of valuing inventory clearly reflected income?

2. Is Tax Court is empowered to award costs or attorneys' fees under the Equal Access to Justice Act and are the taxpayers entitled to an award of such costs or fees under sec. 7430, I.R.C. 1954, even though they commenced these cases before the effective date of sec. 7430?