In Chatham Tax Case, IRS Targets Memo Goods

SAN FRANCISCO - Sending out goods "on memo" is an integral part of a gem dealer'sbusiness, and most take for granted the ability to send a retailer three stonesand have him accept one.

But the Internal Revenue Service has put memo under a microscope and has issueda decision that says goods on memo are actually sales. If the decision stands upto appeal, companies may have to pay income tax on merchandise they send out onmemo.

In January 1996, the IRS audited Chatham Created Gems, based here, focusingoriginally on a separate debt issue. But when they came upon the issue ofmemorandum, the agency decided that Chatham should pay income tax on its memogoods.

Chatham President Tom Chatham appealed that decision to the IRS Appeals Office,which has yet to rule on the matter.

The problem stems from the fact that while memo is a standard practicethroughout the gem industry, no legal contract of this kind appears to exist, atleast in the world of tax law.

Instead, the IRS has tried to define memo as an instance of one of the contracttypes that do exist. It says that a memo is a sale or return contract - meaningthe buyer purchases large quantities of merchandise from the seller on thecondition that any goods the buyer is unable to sell after a certain amount oftime will be returned.

Chatham and other gem dealers insist this is not the case. In his positionpapers submitted to the IRS, Chatham quotes the Internal Revenue Code, section451, which says: "Under an accrual method of accounting, income is includible ingross income when all the events have occurred which fix the right to receivesuch income and the amount thereof can be determined with reasonable accuracy."

The question at hand is when memo goods become a sale, or has passed the "allevents test." The IRS, though it would not comment on the case, seems to believethat the sale is closed when the goods are shipped to the buyer.

But Chatham Inc. maintains that the "all events test" is only satisfied afterthe customer accepts the goods and an invoice is issued.

Chatham says the company follows industry custom in handling its accounts inthis manner. And according to Treasury Regulation 1.446-1-1, one of the legalfactors to be taken into account in this decision is how companies in the gemindustry traditionally account for memo goods.

The other kind of contract that the IRS recognizes is a consignment contract,which has led to some confusion among the gemstone community.

Many dealers believe that "consignment" and "memorandum" are synonymous. Forexample, gemstone dealer Maurice Shire, of Maurice Shire Inc., New York, said heroutinely refers to his memos as "consignment memorandums."

But technically, the two contracts differ in the following ways: in terms oflength of time (memos should turn around in less than 30 days, consignments maylast for months); amount of goods (consignments tend to be much larger thanmemos); third-party involvement (consignments usually involve selling to a thirdparty, memos usually do not); and type of contract (a consignment contract is aspecific form, while memorandum forms are developed individually by eachcompany).

When asked why he doesn't simply call memos consignments to appease the IRS,Chatham said the assumption is that actual consignment contracts would have tobe submitted - copies of memo forms would not suffice.

Chatham argues that memos are neither sale and return contracts nor consignmentcontracts, but a third type of contract endorsed by the gem community, where thebuyer and dealer agree that title for the goods doesn't pass until acceptance.

Most memos include such a statement.

And so the argument rages on.

"The IRS is picking on a gray area, and they have their arguments and test casesand we have ours," Chatham said. "The IRS can be extremely fickle in how theydetermine what they think is right."

Chatham said he believes the IRS is using the memo issue as a negotiatingstrategy. "I have a feeling they are just taking a typical hardball negotiatingstance," he maintained. "When you get into these corporate audits, they pick onthese soft areas, knowing that you're going to have to give something up. Theyfind little areas that can make differences in hundreds of thousands ofdollars."

If the IRS wins its case, it indeed could cost Chatham such amounts in backtaxes and fees. And if this case sets a precedent, it could mean difficultiesfor the entire gem industry. If the IRS were to begin taxing goods on memo atthe end of this year, most companies' taxes would increase drastically.

Yet neither Chatham nor the gem industry seems unduly worried. While Chathamdecries the amount the legal case has cost him and the huge amount of paperworkinvolved, he believes the company and the IRS will reach some kind ofsettlement.

The gem industry, meanwhile, continues to use memo without concerning itselfwith the IRS.

"It would take reform legislation to deal with this issue," said Owen Bordelon,president of the American Gem Trade Association. "We've discussed this andwritten letters, but it would take a concerted effort among various industries.So far, it seems that only the guys that have gotten burned worry about it."

Retailers benefit from using memo, Bordelon said. Customers want so manydifferent items that retailers cannot stock so much in their store, heexplained. They routinely make special requests of dealers in such instances,and at Christmas they may want stones just to beef up their cases.

The memo issue typically has come up in bankruptcy cases, when memo goods may bejudged part of the retailer's inventory.

"This is the first case that I've heard of regarding the IRS," Bordelon said.According to Bordelon and Chatham, The Uniform Commercial Code (UCC) thatapplies to bankruptcy rulings, says a dealer must file a security agreement onthe city, county and state levels - in all 50 states - describing the goods beingtransferred every time something is sent out on memo.

"Gems are too mobile for that kind of process to be effective," Bordelon said.

"I could file a UCC filing here in New York, but that will only cover me as longas the stone stays there. It's cumbersome and unwieldy."

So until otherwise mandated, the gem industry intends to continue using memo.

"There's really nothing you can do," Chatham said. "I've tried to think of waysto protect us from this, but I can't."

But Chatham offers a word to the wise: "Keep all your December memos or anypaperwork that goes from year to year. It doesn't solve the problem, but it cansave you a pain in the neck.