## Facts

- Photo-Sonics, Inc., a manufacturer, valued inventory using a “prime cost” method that included only direct labor and materials.
- The prime-cost method excluded all factory overhead (fixed and variable) from inventory valuation and expensed it currently.
- The IRS determined the method did not clearly reflect income and assessed an income tax deficiency.
- The Tax Court upheld the Commissioner’s determination, and Photo-Sonics petitioned for review in the Ninth Circuit.
- Factory overhead was material, including “shop and tool expense” of $8,215.34 (1958), $40,397.22 (1959), and $103,896.18 (1960).
- The business was expanding, so some goods produced in one year were sold in later years; expensing all overhead immediately shifted costs away from the year of sale.
- The taxpayer’s accounting testimony acknowledged that excluding material factory overhead could mislead users of financial statements.

## Issues

1. Whether an inventory method that capitalizes only direct labor and materials, while excluding all factory overhead, clearly reflects income under I.R.C. §§ 446 and 471.
2. Whether Treasury regulations require allocation of factory overhead to inventory such that the Commissioner may reject prime-cost inventory accounting and adjust taxable income.

## Decision

- The Ninth Circuit affirmed the Tax Court and sustained the deficiency.
- The court held that excluding all factory overhead from inventory is not an acceptable accounting practice for tax purposes.
- The court concluded that the method failed the statutory requirement of clearly reflecting income, particularly given the materiality of omitted overhead and the distortion in matching costs with sales revenues.
- The court noted it was not deciding whether direct costing (including variable overhead) or absorption costing (including fixed and variable overhead) is preferable in general; the defect was the complete omission of overhead.

## Legal Principles

- Under I.R.C. §§ 446 and 471, the governing standard for inventory accounting is whether the method clearly reflects income, including proper matching of costs and revenues.
- Treasury regulations (including Treas. Reg. § 1.471-3(c)) require manufacturers to allocate factory overhead to inventory; overhead attributable to unsold goods generally may not be fully deducted in the year incurred.
- The Commissioner has authority to reject a taxpayer’s inventory method and require adjustments when the method materially distorts income.
- Materiality of omitted costs and the taxpayer’s business context (e.g., growth with interperiod inventory carryover) are relevant to whether the method clearly reflects income.

## Conclusion

The court held that a prime-cost inventory method excluding all factory overhead does not clearly reflect income and may be rejected by the Commissioner, who may require overhead capitalization into inventory to prevent distortion of taxable income.


Photo-Sonics, Inc. v. Commissioner, 357 F.2d 656 (9th Cir. 1966)