Before drilling down into Judge Pugh’s prose, I’d like to bestow a new Taishoff award, called the Chutzpahdika Punim, upon the trusty attorneys for BRC Operating Company LLC, Bluescape Resource Company LLC, Tax Matters Partner, and Bluescape Resources Company LLC, Bluescape Resources Investors LLC, Tax Matters Partner, twinned for trial and disposition in 2021 T. C. Memo. 59, filed 5/12/21. The reason for the award will become clear, even without the need for translation.

The Bluescapes passed through to their investors $160 million in mineral lease acquisition costs over two (count ’em, two) tax years. But The Bluescapes failed to heed the well-known admonition “Drill, Baby, drill!” Not only did they not drill anything but two test wells, which they stiped were irrelevant, they earned no income whatsoever. But they characterized the passed-throughs as costs of goods sold.

The Bluescapes try to dodge IRS’ motion for summary J disallowing this novel approach by claiming that it’s not section 461 economic performance (The Bluescapes are accrual basis), but Section 451 timing of receipt of gross income. Remember, the Sixteenth Amendment permits taxation of gross income, not gross receipts, lest Congress try to tax return of capital. That’s why COGS.

But before we get to timing, Judge Pugh has a basic question.

“Can Bluescape recognize costs of goods sold before it has any gross receipts from the sale of goods? In other words do we even reach the question of whether costs of goods sold are subject to the economic performance requirement when there are no gross receipts to offset yet?” 2021 T. C. Memo. 59, at p. 7.

IRS says ya gotta have goods sold to offset income therefrom with cost of the goods ya sold.

“Petitioners, framing respondent’s position as a ‘clear reflection of income’ argument, argue that ‘matching’ of cost of goods sold and gross receipts is not required. Thus, petitioners argue, they can recognize cost of goods sold as soon as they assume the obligations to drill the wells, giving rise to a loss that flows through to their partners.” 2021 T. C. Memo. 59, at p. 8.

Judge Pugh goes back to 1918 for the history of COGS. And the cases The Bluescapes cite only shows up the illogic of their position. Taxpayers won those cases by expensing against income items disallowed by IRS as COGS. But they had to have income against which to deduct or offset.

“…petitioners take the position that Bluescape’s estimated drilling costs are not deductible expenses but costs included in cost of good [sic] sold–that is, that the expenses are part of the cost of acquiring the natural gas. This position is how they claim to avoid the economic performance requirement. But it is also what requires them to wait until there are gross receipts against which to offset cost of goods sold.” 2021 T. C. Memo. 59, at pp.16-17.

Despite all The Bluescapes’ trusty attorneys’ gyrations, there is only one essential undisputed material fact.

“In sum, we conclude that to recover cost of goods sold a taxpayer generally must have some gross receipts from the sale of goods to offset. Because Bluescape had no gross receipts from the sale of natural gas for the years in issue, the estimated drilling costs reported as ‘cost of goods sold’ are not allowable as a cost of goods sold offset to gross receipts.” 2021 T. C. Memo. 59, at pp. 20-21.

“Inventive” isn’t the word.