UNPUBLISHED
UNITED STATES COURT OF APPEALS
FOR THE FOURTH CIRCUIT
No. 05-1667
In re: HEILIG MEYERS COMPANY, d/b/a RoomStore
Furniture, ValueHouse, RentSmart, John M.
Smyth’s Homemakers, West End Furniture
Company, The HUB, The RoomStore Furniture,
Baton Rouge Furniture Outlet, Bedding Experts,
Incorporated, Ganz Furniture, Guardian
Protection Products I, Heath Furniture,
McMahan Furniture, Renfrows Furniture, Rhodes
Furniture, Brown’s Furniture,
Debtor.
---------------------------------------------
HEILIG MEYERS COMPANY; HEILIG-MEYERS FURNITURE
COMPANY; HEILIG-MEYERS FURNITURE WEST,
INCORPORATED; HMY STAR, INCORPORATED; HMY
ROOMSTORE, INCORPORATED; MACSAVER FINANCIAL
SERVICES, INCORPORATED,
Plaintiffs - Appellants,
versus
INTERNAL REVENUE SERVICE,
Defendant - Appellee,
and
OFFICIAL COMMITTEE OF UNSECURED CREDITORS,
Creditor,
and
US TRUSTEE, Richmond,
Trustee.
Appeal from the United States District Court for the Eastern
District of Virginia, at Richmond. Henry E. Hudson, District
Judge. (04-858-3-HEH; 00-34533-DOT; 03-3295-DOT)
Argued: January 31, 2007 Decided: May 9, 2007
Before WILKINSON, NIEMEYER, and SHEDD, Circuit Judges.
Affirmed by unpublished opinion. Judge Wilkinson wrote the
majority opinion, in which Judge Shedd joined. Judge Niemeyer
wrote a dissenting opinion.
ARGUED: Michael Brown Quigley, WHITE & CASE, Washington, D.C., for
Appellants. Joan Iris Oppenheimer, UNITED STATES DEPARTMENT OF
JUSTICE, Tax Division, Washington, D.C., for Appellee. ON BRIEF:
Brian S. Gleicher, Brian P. Arthur, WHITE & CASE, Washington, D.C.,
for Appellants. Chuck Rosenberg, United States Attorney, Eileen J.
O’Connor, Assistant Attorney General, Bruce R. Ellisen, UNITED
STATES DEPARTMENT OF JUSTICE, Tax Division, Washington, D.C., for
Appellee.
Unpublished opinions are not binding precedent in this circuit.
2
WILKINSON, Circuit Judge:
Debtors Heilig-Meyers Company et al. filed an adversary
proceeding in bankruptcy court challenging a proof of claim filed
by the Internal Revenue Service (“the Service”) for a deficiency
arising from Debtors’ undervaluation of their installment accounts
receivable under the mark-to-market accounting method set forth at
26 U.S.C. § 475(b) (2000). Debtors contended that their loss
calculation and concomitant deduction were reasonable and should be
sustained. The bankruptcy court upheld the Service’s determination
on the ground that Debtors’ valuation method failed to reflect
income clearly, as required by 26 U.S.C. § 446(b) (2000). The
district court affirmed. Debtors now appeal, claiming that the
§ 446(b) clear reflection of income requirement does not apply to
the valuation of their accounts receivable, and, in the
alternative, that if § 446(b) does apply, the bankruptcy court
erred in accepting the Service’s determination. Because the
assessment of fair market value is the core of the mark-to-market
method, § 446(b) was correctly applied to Debtors’ valuation.
Because the bankruptcy court properly found that Debtors failed to
meet their burden of proof, it did not err in upholding the
Service’s determination. We thus affirm.
3
I.
This appeal involves a tax issue arising in the course of
Chapter 11 bankruptcy proceedings for Debtors Heilig-Meyers
Company, Heilig-Meyers Furniture Company, Heilig-Meyers Furniture
West, Inc., HMY Star, Inc., HMY RoomStore, Inc., and MacSaver
Financial Services, Inc. (collectively “Debtors”). Appellant is
Heilig-Meyers Liquidation Trust, successor in interest to Debtors.
Debtors were primarily engaged in the retail sale of home
furnishings, with a large portion of their sales being made through
installment credit purchases. The dispute concerns Debtors’
valuation of their installment accounts receivable under the mark-
to-market method of accounting pursuant to Internal Revenue Code
§ 475, 26 U.S.C. § 475, for the tax year ended February 28, 1997.
Section 475 imposes the mark-to-market method of accounting
on non-inventory securities held by securities dealers. 26 U.S.C.
§ 475(a). Under the mark-to-market method, any security that is
held by a securities dealer at the end of the year and is not
inventory must be “marked to market,” i.e., treated as though it
had been sold for its fair market value on the last business day of
the taxpayer’s taxable year. Id. § 475(a)(2)(A). The taxpayer
recognizes a gain or loss equal to the difference between the fair
market value so calculated and the security’s basis. Id. If the
taxpayer recognizes a loss on the security -- that is, if the
security’s fair market value on the last day of the taxable year is
4
lower than its basis -- then the taxpayer receives a tax deduction
in the amount of the loss.
It was unclear under § 475 as originally enacted whether the
statute’s definition of “securities” encompassed debt instruments
that constituted customer paper and thus obligated sellers of
nonfinancial goods and services to use the mark-to-market method
for those items. See Omnibus Budget Reconciliation Act of 1993,
Pub. L. 103-66, 107 Stat. 312, 481; 26 U.S.C. § 475(c)(2)(C). The
Department of Treasury promulgated regulations, in effect during
the tax period in dispute here, which provided that if sellers of
nonfinancial goods and services would not qualify as securities
dealers under § 475 but for their nonfinancial customer paper, they
did not constitute securities dealers and thus were not required
under § 475 to use the mark-to-market method. See 26 C.F.R.
§ 1.475(c)-1(b)(1) (1997). If, however, the taxpayer so chose, it
could elect § 475 treatment. See id. § 1.475(c)-1(b)(3), (4).
Thus, for instance, retailers that made loans to customers, such as
Debtors in the present case, could elect to treat their accounts
receivable in accordance with § 475, using mark-to-market
accounting to calculate their gain or loss on such accounts.
Congress subsequently eliminated such election by amending § 475 to
provide that nonfinancial customer paper did not constitute a
“security” for purposes of the statute. See Pub. L. 105-206, Title
VII, § 7003(a), 112 Stat. 685, 832 (1998) (codified at 26 U.S.C.
5
§ 475(c)(4)). Thus retailers such as Heilig-Meyers may no longer
elect § 475 treatment for their accounts receivable.
For Debtors’ taxable year ended February 28, 1997, Debtors
elected § 475 treatment for their accounts receivable. Debtors
filed an Application for Change in Accounting Method, IRS Form
3115, which the Service approved. Debtors retained Ernst & Young,
LLP, to determine the year-end fair market value of their accounts
receivable for purposes of § 475’s mark-to-market determination.
Ernst & Young partner Barbara Rayner (“Rayner”) prepared a
valuation study of the accounts receivable.
Rayner determined the assets’ fair market value using a
discounted-cash-flow approach, which calculates an accurate present
value by discounting the future cash flow from the asset to present
value at an appropriate discount rate. The method requires a
determination of the asset’s projected cash flow over its life and
the selection of an appropriate risk-adjusted discount rate for
reducing the future income to its net present value.
In estimating the future cash flow of the accounts receivable,
Rayner reduced their face value by (1) the cost of servicing the
accounts, estimated at 3% of their face value; (2) anticipated
defaults by some customers; and (3) projected income taxes on the
receivables’ income stream. In discounting the future income to
present value, Rayner selected a discount rate using a weighted
average cost of capital (“WACC”) methodology, which measures a
6
company’s cost of debt and equity financing weighted by the
percentage of debt and percentage of equity in a company’s capital
structure. Rayner based her WACC analysis in part on an estimate
of the weighted average required investment return with respect to
the stock of seven consumer credit card companies. On this basis,
Rayner arrived at a WACC of 11%. From that rate she derived three
different discount rates for three different categories of Debtors’
accounts receivable: a rate of 8% for current receivables, 15% for
receivables that were 61 to 120 days delinquent, and 22% for
receivables that were 121 to 180 days delinquent. Applying these
discount rates, she arrived at a fair market value for the accounts
receivable of $1,027,312,671. As the undisputed book value of the
accounts receivable was $1,073,234,932, Debtors recognized a loss,
and thus a tax deduction, in the amount of $45,922,261. The § 475
deduction contributed to a net operating loss for the tax year
ended February 27, 1998, the entirety of which Debtors carried back
to the tax year ended February 28, 1994.
The Service later undertook an audit of Debtors’ federal
income tax returns for the tax years ended February 28, 1994
through February 28, 2001. The Service concluded that, in the
return for the year ended February 28, 1997, Debtors inaccurately
determined the fair market value of their installment accounts
receivable pursuant to § 475. The Service identified a number of
problems with Debtors’ methodology. In the determination of future
7
cash flow, the Service questioned Debtors’ estimation of servicing
costs and rejected as improper the reduction of the assets’ value
by Debtors’ anticipated income tax liability on those assets. In
the discounting of future income to present value, the Service
found Debtors’ discount rates excessive and unfounded. It found
that the rates allowed too much for risks flowing from potential
customer defaults, both in that the rates themselves overestimated
the likelihood of such defaults and in that Debtors had already
reduced the face value of the receivables for anticipated defaults
when estimating future cash flow. The Service found a risk-free
discount rate to be more appropriate and, applying a rate of 6.5%,
which was the rate of eighteen-month Treasury securities issued in
February 1997, computed the fair market value of the accounts
receivable as $1,048,940,674, which resulted in a loss and
deduction of $24,294,258 rather than $45,922,261. The Service thus
disallowed $21,628,003 of Debtors’ § 475 deduction.
After Debtors filed for bankruptcy protection, the Service
filed an amended proof of claim seeking to recover, among other
amounts,1 $3,923,904 for underpayment of tax arising from Debtors’
inaccurate § 475 determination and $882,080 in statutory pre-
petition interest, for a total of $4,805,984. Debtors commenced
this adversary proceeding in the bankruptcy court, objecting to the
Service’s proof of claim.
1
Other amounts sought by the Service involved claims not
related to this dispute.
8
The bankruptcy court heard argument and testimony on December
18, 2003 and January 16, 2004. The Service called Theodore
Barnhill, Jr., a finance professor at George Washington University,
to testify to the problems with Debtors’ methodology. Barnhill
conducted his own valuation of Debtors’ accounts receivable as of
February 28, 1997, using the discounted-cash-flow method. Barnhill
employed a range of discount rates from 6.2% to 7.3%, applying the
lower rate to accounts maturing earlier and the higher rates to
accounts maturing later. Based on this method, Barnhill calculated
Debtors’ § 475 deduction at $30,974,000, more than the IRS’s
calculation of $24,294,258 and less than Debtors’ calculation of
$45,922,261. Barnhill offered several criticisms of Debtors’
method, including Rayner’s estimation of cash flows on a pre-tax
basis, her inappropriate use of a WACC methodology to arrive at
discount rates, and her lack of quantitative justification for her
choice of the three discount rates for three categories of
receivables.
Debtors attacked Barnhill’s method as inferior to Rayner’s.
They acknowledged that they no longer had accounting records for
the accounts receivable and thus could not provide any substantive
support for the assumptions upon which Rayner’s valuation was
based. Rayner acknowledged that her valuation report did not
explain her choice of seven consumer credit card companies for the
WACC determination or her selection of discount rates of 8%, 15%,
9
and 22%. She offered as an explanation for these choices her
judgment as a valuation expert.
In their initial post-trial brief, Debtors contended that
their valuation method need only be “reasonable” to satisfy I.R.C.
§ 475. For support, Debtors cited Bank One Corp. v. Commissioner,
120 T.C. 174 (2003), which also involved the mark-to-market method
of accounting. In its post-trial reply brief, the Service
responded that the Tax Court in Bank One held that valuation of
property under § 475 is a method of accounting that must clearly
reflect income in accordance with § 446(b). The Service contended
that Debtors therefore had to prove that the Service’s
determination was unlawful or arbitrary.
In its opinion, the bankruptcy court held that Debtors’
valuation method was subject to § 446(b). The court noted that in
Bank One, the Tax Court held that the taxpayer’s burden was to
prove that the Commissioner’s determination was clearly unlawful or
plainly arbitrary, by establishing that its own method clearly
reflected income. In re Heilig-Meyers Co., 316 B.R. 866, 870
(Bankr. E.D. Va. 2004). The court found that Debtors failed to
meet this burden due to three flaws in its valuation. First,
Rayner’s estimate of servicing costs at 3% of the face value of the
accounts receivable was contradicted by Debtors’ contemporaneous
assertion on an SEC Form 10-K that they could not accurately
calculate figures necessary to such an estimation. Id. at 871-72.
10
Second, Rayner’s WACC analysis was questionable because she was
unable to justify her selection of the seven particular credit card
companies on which she based her analysis. Id. at 872. Third,
Rayner did not adequately justify or provide independent
verification for the three discount rates she chose. Id. The
court found that while Debtors had raised questions about the
valuation study of Service expert Barnhill, the fact remained that
Debtors bore the burden of showing their accounting method clearly
reflected income. Id. at 873. The court allowed the Government’s
claim in the amount of $4,815,907.51, which included the
recalculation of the § 475 deduction in the amount determined by
the Service. Id.
In the district court, Debtors argued that the bankruptcy
court erred in applying the § 446(b) clear reflection of income
requirement and should instead have considered Debtors’ valuations
under a reasonableness standard. Debtors also argued that, even if
§ 446(b) applied, the bankruptcy court had to make findings that
the Service’s valuation clearly reflected income before it could
uphold the Service’s determination. The district court affirmed
the bankruptcy court. It upheld the application of § 446(b)
because “[t]he income tax regulations clearly provide that ‘[t]he
term ‘method of accounting’ includes not only the overall method of
accounting of the taxpayer but also the accounting treatment of any
item.’” In re Heilig-Meyers Co., No. 00-34533, 2005 WL 1303351, at
11
*3 (E.D. Va. 2005) (quoting 26 C.F.R. § 1.446-1(a)(1)). The
district court further held that Debtors bore the burden of showing
that the Service’s determination of deficiency was clearly unlawful
and that they had failed to do so. Id. at *4. Debtors appeal.
This Court reviews the judgment of a district court sitting in
review of a bankruptcy court de novo, using the same standards of
review used in the district court. Thus we review the bankruptcy
court’s factual findings for clear error and questions of law de
novo. In re Litton, 330 F.3d 636, 642 (4th Cir. 2003).
II.
Debtors’ principal contention is that § 446(b) does not apply
to the determination of the fair market value of their accounts
receivable because such a determination does not constitute a
method of accounting governed by § 446(b). We hold that the
bankruptcy court properly applied § 446(b).
Section 446 sets forth, and indeed bears the title of, a
“[g]eneral rule for methods of accounting.” 26 U.S.C. § 446.
Section 446(a) provides, “Taxable income shall be computed under
the method of accounting on the basis of which the taxpayer
regularly computes his income in keeping his books.” Id. § 446(a).
Section 446(b), meanwhile, sets forth an important exception: “[I]f
the method used does not clearly reflect income, the computation of
taxable income shall be made under such method as, in the opinion
12
of the Secretary, does clearly reflect income.” Id. § 446(b).
Treasury Regulations further provide that “no method of accounting
is acceptable unless, in the opinion of the Commissioner, it
clearly reflects income.” 26 C.F.R. § 1.446-1(a)(2).
Section 446 constitutes a recognition that the aims of
financial accounting and tax accounting, while sometimes congruent,
often diverge. See Thor Power Tool Co. v Comm’r, 439 U.S. 522, 542
(1979) (noting the “vastly different objectives that financial and
tax accounting have”). While financial accounting aims “to provide
useful information to management, shareholders, creditors, and
others properly interested,” tax accounting serves to facilitate
the “equitable collection of revenue” and to “protect the public
fisc.” Id. For this reason, an accounting method that may be
entirely satisfactory for book purposes may be unsatisfactory for
reporting taxable income. The design of § 446 is clear: whatever
accounting method is used by the taxpayer to calculate income, that
method must render a clear reflection of income consistent with the
goals of the Internal Revenue Service, as determined by the
Service.
As part of § 446’s general rule, § 446(b)’s clear reflection
of income requirement applies to all methods of tax accounting. As
the Treasury Regulations make clear, “The term ‘method of
accounting’ includes not only the overall method of accounting of
the taxpayer but also the accounting treatment of any item.” 26
13
C.F.R § 1.446-1(a)(1); see Thor, 439 U.S. at 531 n.10. Thus the
clear reflection of income requirement applies both to the
taxpayer’s overall accounting method, e.g., cash method or accrual
method, and also to the “accounting treatment of any item,” such as
inventory accounting for items of inventory, or mark-to-market
accounting under § 475. 26 C.F.R § 1.446-1(a)(1); see 26 U.S.C.
§§ 471-74 (inventory accounting); id. § 475.
This case concerns what it means to say that the accounting
treatment of an item -- specifically, the marking to market of
Debtors’ accounts receivable under § 475 -- is subject to
§ 446(b)’s clear reflection of income requirement. It is
undisputed that § 446 allows the Service to determine whether a
given accounting method -- either an overall method or the method
for a specific item -- is an appropriate method for accurately
representing taxable income. If the type of accounting method used
by the taxpayer does not result in a clear reflection of income,
the Service may compel the taxpayer to employ another method. See
id. § 446(b).
Debtors recognize this power of the Service, but they contend
that it constitutes the entire scope of § 446(b). Once the
question of what accounting method to use is settled, Debtors
argue, the taxpayer’s particular employment of that method is not
governed by § 446(b). Thus they argue that § 446(b) has no
relevance in this case, where it is undisputed that Debtors sought
14
and received the Service’s approval to use § 475’s mark-to-market
method on their accounts receivable. Rather, Debtors claim, this
conflict pertains merely to valuation, and thus the § 446(b) clear
reflection of income requirement has no bearing. The Service, in
invoking § 446(b), is improperly framing a valuation dispute as a
clash over accounting methods.
Debtors’ contention is not supportable. The Supreme Court’s
elucidation of § 446(b) establishes that it is not limited to the
threshold question of which type of accounting method the taxpayer
should use. See Thor, 439 U.S. at 532. Where, as here, the
accounting method at issue essentially consists of a determination
of market value, § 446(b) applies to that determination. The
conclusions of the Tax Court and one of our sister circuits in the
specific § 475 context further confirm that Debtors’ reading of
§ 446(b) is foreclosed in this instance.
In Thor Power Tool Co. v Comm’r, 439 U.S. at 526-27, the
Service took issue with tool manufacturer Thor Power Tool Co.’s
determination of losses stemming from certain items of inventory --
namely, 44,000 pieces of excess merchandise, most of them spare
parts and accessories. To value these items, Thor employed the
“lower of cost or market” (LCM) method of inventory accounting.
See id. at 533. Under this method, the taxpayer values inventory
at either cost or market value, whichever is lower. See id. at
535. Thor put the market value of the items of excess merchandise
15
at approximately their scrap value and thus recognized a loss on
those items, which contributed to a net operating loss for the
year. See id. at 524. Meanwhile, however, Thor continued to offer
the “excess” items for sale at their original prices. See id. The
Commissioner disallowed the offset on the ground that Thor’s
valuation of the inventory did not constitute a clear reflection of
income as required by §§ 446(b) and 471.2 Id. at 524, 530. The
Court agreed, concluding that “the Commissioner acted within his
discretion in deciding that Thor’s write-down of ‘excess’ inventory
failed to reflect income clearly.” Id. at 537-38.
Thor is significant because there was no contention that Thor
should have been using a different type of accounting method. The
government did not take issue with the fact that “[a]t all times
relevant, Thor has used . . . the ‘lower of cost or market’ method
of valuing inventories.” Id. at 525. Nevertheless, this did not
answer the question of whether Thor’s “particular method” was
clearly reflective of income. Id. at 532. The Court agreed with
the Commissioner that the taxpayer’s particular valuation method
had failed to “reduce[] its inventory to ‘market’ in accord with
2
Section 471 provides that “inventories shall be taken . . .
on such basis as the Secretary may prescribe as conforming as
nearly as may be to the best accounting practice in the trade or
business and as most clearly reflecting income.” 26 U.S.C. §
471(a). The Supreme Court in Thor made clear that the existence of
§ 471 is not an indication that § 446(b) does not apply to
inventory accounting. Rather, “[i]nventory accounting is governed
by §§ 446 and 471 of the Code.” 439 U.S. at 531. Thus the Court
reinforced what is clear from the face of § 446 -- that it governs
all methods of tax accounting.
16
its ‘lower of cost or market’ method of accounting.” Id. at 530;
see id. at 532. Thus, the clear reflection of income standard
applied not just to the selection of the LCM method over other
accounting methods, but to Thor’s determination of market value in
the course of employing the LCM method.
The circumstances of Thor are strikingly similar to those of
the present case. In Thor, the Service asserted that the
taxpayer’s determination of the market value of certain assets for
the purposes of a permitted tax accounting method failed to reflect
income clearly. Id. at 537-38. In this case, the Service asserts
that the taxpayer’s determination of the fair market value of
certain assets for the purposes of a permitted tax accounting
method failed to reflect income clearly. The only apparent
distinction is that in Thor the Treasury Regulations on proper LCM
methodology were more specific than those that pertained to
Debtors’ mark-to-market methodology.3 The Court concluded that
Thor’s valuation procedures were “inconsistent with this regulatory
scheme.” Id. at 535. But this circumstance is immaterial to
Thor’s application to the present case. The Court noted Thor’s
lack of regulatory compliance simply as an indication that the
Commissioner was within his discretion in finding Thor’s
3
Specifically, in Thor, Treasury Regulations defined “market
value” to mean the current bid price for the merchandise in the
volume usually purchased by the taxpayer and further identified two
limited circumstances in which the taxpayer could value inventory
at below market value so defined. See id. at 534-35 (citing 26
C.F.R. § 1.471-2(c), -4 (1964)).
17
determinations not clearly reflective of income. See id. at 533,
537. The fact remains that the Court subjected Thor’s market value
determination to the clear reflection of income standard of
§ 446(b).
The Tax Court and the Seventh Circuit recently reached the
same conclusion about the precise issue in dispute here: the
determination of the fair market value of assets under the mark-to-
market method of § 475. See Bank One Corp. v. Comm’r, 120 T.C. 174
(2003), aff’d in part, vacated in part sub nom. JPMorgan Chase &
Co. v. Comm’r, 458 F.3d 564 (7th Cir. 2006). JPMorgan Chase
involved transactions known as interest swaps, which were subject
to § 475’s mark-to-market method. See 458 F.3d at 568. The
Commissioner rejected the taxpayer’s determination of the swaps’
fair market value as not clearly reflective of income as required
by § 446(b). At the Tax Court level, the taxpayer asserted, as
Debtors do here, that the dispute was “a ‘valuation case,’ as
opposed to a method of accounting case, and that [taxpayer’s]
valuations must be sustained because its underlying methodology was
reasonable.” 120 T.C. at 281. The Tax Court rejected this
contention and held that “the reporting of income under section
475, inclusive of the valuation requirement subsumed therein, is a
method of accounting.” Id. at 282 (emphasis added). The Seventh
Circuit agreed, stating in no uncertain terms that “[t]he method of
determining ‘fair market value’ under section 475 falls within the
18
definition of ‘method’” for § 446(b)’s requirement that the
taxpayer’s “method of accounting” must clearly reflect income. 458
F.3d at 570. Thus the Tax Court and the Seventh Circuit rejected
Debtors’ contention that § 446(b) places no limitations on how the
taxpayer implements the mark-to-market method. Instead, the
determination of an asset’s fair market value for § 475 must
clearly reflect income. Id.
In light of this case law, it is difficult to read §§ 446(b)
and 475 otherwise than to subject determinations of fair market
value under § 475 to § 446(b)’s clear reflection of income
requirement. Debtors’ position to the contrary is inconsistent
with the Court’s approach in Thor and directly contradicts the
reasoned conclusion of the Tax Court and the Seventh Circuit in
JPMorgan Chase. Nor does our conclusion portend, as Debtors claim,
that the Service will attempt to bring every valuation dispute
within the compass of § 446(b). Here, as in Thor, the accounting
method at issue essentially consisted of the determination of the
market value of the asset. The LCM method involved in Thor
required the valuation of inventory at the lower of market or cost,
and thus necessarily entailed the determination of market value.
The mark-to-market method of § 475 requires nothing other than that
the taxpayer peg the asset’s value to its fair market value on the
last business day of the taxable year. In such instances, for the
taxpayer to fail to assess market value appropriately is in essence
19
for it to have failed to execute the accounting method. In
contrast, a valuation that does not constitute the core of an
accounting method will not implicate § 446(b). See, e.g., Estate
of Godley v. Comm’r, 286 F.3d 210 (4th Cir. 2002) (valuation of
asset for estate tax); Krapf v. United States, 977 F.2d 1454 (Fed.
Cir. 1992) (valuation of asset donated to charity). Our conclusion
today merely gives effect to the unexceptionable proposition that
a taxpayer may not, by invoking the name of an accounting method
that purports to reflect income, employ a methodology that does
not. See Thor, 439 U.S. at 532. To hold otherwise would be to
allow taxpayers to subvert the entire aim of § 446 merely by
confining the devil to the details. See id. at 536 (“If a taxpayer
could write down its inventories on the basis of management’s
subjective estimates . . . the taxpayer would be able, as the Tax
Court observed, to ‘determine how much tax it wanted to pay for a
given year.’”)(citation omitted).
Thus we affirm that Debtors’ determination of the fair market
value of its accounts receivable under § 475 is subject to
§ 446(b)’s clear reflection of income requirement.4
4
Debtors also argue that, as a procedural matter, the
bankruptcy court should not have considered the § 446(b) argument
because the Service did not refer to that provision until its
post-trial reply brief. While early notice of the Commissioner’s
legal theory is certainly preferable to late, “the Commissioner
does not necessarily forfeit his right to rely on a theory by
failing to raise it at the preferred times.” Ware v. Comm’r, 906
F.2d 62, 65 (2d Cir. 1990). The question is whether the timing of
the argument specifically prejudices the taxpayer. Id.
In this case, Debtors do not identify any manner in which they
20
III.
Debtors contend that, even if the bankruptcy court did not err
in applying § 446(b), it erred in upholding the Service’s
determination. Having found that the application of § 446(b) was
proper, we also affirm the bankruptcy court’s factual findings
under that standard and its conclusion that the Commissioner’s
determination should be upheld.
Section 446(b) provides, “[I]f the method used [by the
taxpayer] does not clearly reflect income, the computation of
taxable income shall be made under such method as, in the opinion
of the Secretary, does clearly reflect income.” Id. § 446(b).
This provision gives the Commissioner “broad powers” to reject a
taxpayer’s accounting method and to substitute his own. See Comm’r
v. Hansen, 360 U.S. 446, 467 (1959).
The Supreme Court made clear in Thor that the Commissioner’s
rejection of the taxpayer’s accounting method would be upheld
unless the taxpayer showed that it was “clearly unlawful” or
“plainly arbitrary.” See Thor, 439 U.S. at 532; Bank One, 120 T.C.
at 288. In accordance with Thor, Debtors’ first burden in this
case was to show that the Service’s rejection of their accounting
were prejudiced, nor do we conclude that they were. Characterizing
the Service as claiming that the valuation was not accurate, versus
that it did not clearly reflect income, does not change the nature
of the dispute or what evidence would be relevant at trial. See,
e.g., Nat’l Ass’n of Life Underwriters, Inc. v. Comm’r, 30 F.3d
1526, 1531 (D.C. Cir. 1994) (suggesting no prejudice where question
is “how to characterize the transactions involved, the raw facts
seeming to be established”).
21
method was clearly unlawful or plainly arbitrary. In essence, this
burden required Debtors to show that their own method clearly
reflected income, for if it did, the Commissioner’s determination
would perforce be unlawful or arbitrary. See, e.g., Thor, 439 U.S.
at 536, 538 (Thor failed to prove Commissioner’s rejection of its
market valuation was unlawful or arbitrary where it “provided no
objective evidence” of its valuation).
The bankruptcy court found that the taxpayer failed to bear
this burden due to three specific flaws in its determinations.
First, Debtors’ estimation of servicing costs at 3% of the face
value of the accounts receivable did not square with Debtors’
earlier assertion in a Securities and Exchange Commission Form 10-k
that they were unable to give an accurate estimate of numbers upon
which the 3% figure depended. Second, the bankruptcy court found
Debtors’ WACC analysis unpersuasive because Debtors’ expert Rayner
was unable to provide any explanation for how she came to base the
WACC analysis on the stock of seven particular consumer credit card
companies out of the dozens of such companies that exist. Finally,
the bankruptcy court found insufficient support for the three
discount rates employed by Debtors, because Rayner offered no
explanation for the choice of rates other than her personal
judgment as a valuation expert.5 Given the effect these actions
5
In addition to these issues noted by the bankruptcy court,
Rayner estimated the future cash flow of the receivables on a post-
tax rather than a pre-tax basis.
22
had of inflating the losses recognized by Debtors under § 475, and
given Debtors’ inability to offer satisfactory explanations for
these actions at trial, the bankruptcy court had ample reason to
uphold the Commissioner’s rejection of Debtors’ determinations.
Debtors contend that, even if Debtors’ calculations were
properly rejected, the bankruptcy court could not uphold the
Commissioner’s determination without make findings as to its clear
reflection of income. In this, Debtors overlook factual findings
made by the court and misconstrue their own burden of proof. Under
§ 446(b), the Service has broad powers not only to reject the
taxpayer’s accounting method but also to substitute one that, “in
the opinion of the Secretary, does clearly reflect income.” 26
U.S.C. § 446(b). These powers are not unbounded: like the
rejection of the taxpayer’s method, the Commissioner’s substitution
of a new method may not be clearly unlawful or plainly arbitrary.
See Dayton Hudson Corp. & Subsidiaries v. Comm’r, 153 F.3d 660, 667
(8th Cir. 1998) (taxpayer succeeded in establishing that “the
Commissioner’s method does not reflect income and is plainly
arbitrary”); Russell v. Comm’r, 45 F.2d 100, 101 (1st Cir. 1930)
(“An arbitrary adoption of a substitute method of computing a tax,
which does not in fact ‘clearly reflect the income’ of the
taxpayers, cannot be sustained.”). This standard squares with the
general principle in federal tax disputes that the Commissioner’s
determination of deficiency will not be overturned unless the
23
taxpayer proves it is “arbitrary and excessive.” Cebollero v.
Comm’r, 967 F.2d 986, 990 (4th Cir. 1992) (quoting Helvering v.
Taylor, 293 U.S. 507, 515 (1935)).
Under this standard, after the bankruptcy court rejected
Debtors’ method as not clearly reflective of income, it was not
then the court’s task to determine de novo whether the
Commissioner’s method clearly reflected income. It was rather
Debtors’ burden to prove that it did not. The Seventh Circuit
recently and persuasively addressed this issue in JPMorgan Chase.
In that case, as noted above, the Seventh Circuit affirmed the Tax
Court’s conclusion that fair market valuation of interest swaps
under § 475 was subject to the § 446(b) clear reflection of income
requirement. 458 F.3d at 570. The Tax Court, however, after
rejecting the taxpayer’s method, went on to analyze the
Commissioner’s method to determine whether it accurately reflected
the fair market value of the swaps. 120 T.C. at 329-30. The Tax
Court found that it did not and instructed the parties to prepare
a new computation following the court’s instructions. Id. at 331.
The Seventh Circuit rejected this approach. Recognizing that “the
Supreme Court instructs that the Commissioner’s interpretation may
not be set aside unless clearly unlawful or plainly arbitrary,” it
concluded that “the tax court was required to defer to the
Commissioner’s method of calculating fair market value.” 458 F.3d
at 570 (internal quotation marks omitted).
24
Similarly, in this case, the bankruptcy court properly upheld
the Service’s determination. The bankruptcy court opinion offers
sufficient grounds for its conclusion that the Commissioner’s
determination should be upheld. The only deficiency the court
notes in relation to the Service’s claim regards one aspect of its
expert Barnhill’s valuation study. See In re Heilig-Meyers Co.,
316 B.R. at 872-73. The bankruptcy court then went on explicitly
to uphold the Service’s determination of the § 475 loss and the
amount of tax owed. Id. at 873. Given these findings, it seems
clear that the bankruptcy court did not find the Service’s
determination to be unlawful and arbitrary, nor does the
established record suggest it should have done so. The court must
“afford the Commissioner the deference due under the statutory
scheme,” JPMorgan Chase, 458 F.3d at 570, as “[i]t is not the
province of the court to weigh and determine the relative merits of
systems of accounting,” Brown v. Helvering, 291 U.S. 193, 204-05
(1934). Just as Debtors did not meet their burden of proving that
their own method clearly reflected income, they also failed to
prove that the Commissioner’s did not, and thus the bankruptcy
court did not err in upholding the Service’s claim in full.
25
IV.
A word finally as to the dissent. The dissent makes no
pretense of trying to reconcile its position with the most relevant
case from the Supreme Court. It all but ignores the Thor Power
Tool decision. The Court in Thor took exactly the approach that we
do here, finding that, regardless of the fact that the taxpayer’s
overall accounting method and specific accounting method were
agreed upon, the taxpayer’s particular way of determining market
value was subject to § 446(b)’s clear reflection of income
requirement. See 439 U.S. at 532. At issue in Thor was the
valuation of spare parts in inventory; the taxpayer’s method of
accounting was required in that case to reflect income clearly, and
we can see no reason, nor does appellant suggest any, why the
treatment should vary with respect to the accounts receivable in
this case. We are bound to implement the law as interpreted by the
Supreme Court, and yet the dissent would overrule the Court on this
point summarily.6
Nor does the dissent acknowledge that it would place this
court at loggerheads with both the Tax Court and the Seventh
6
The dissent’s purported distinction of Thor is, as we have
noted, “immaterial to Thor’s application to the present case. The
Court noted Thor’s lack of regulatory compliance simply as an
indication that the Commissioner was within his discretion in
finding Thor’s determinations not clearly reflective of income.
See id. at 533, 537. The fact remains that the Court subjected
Thor’s market value determination to the clear reflection of income
standard of § 446(b).” See supra, at 17-18.
26
Circuit in JPMorgan Chase.7 The approaches of the Supreme Court,
the Tax Court, the Seventh Circuit, and this court today give
effect to a simple proposition -- that the taxpayer may not avail
itself of an accounting method, the entire substance of which
consists of accurately determining market value, only to implement
it in a way that does no such thing. It is for this reason that
“the reporting of income under section 475, inclusive of the
valuation requirement subsumed therein, is a method of accounting.”
Bank One, 120 T.C. at 282. The dissent’s contrary approach accords
little respect to this body of law or to “the discretion rested by
Congress in the Secretary and the Commissioner for the
administration of the tax laws.” United States v. Catto, 384 U.S.
102, 114 (1966). Nor does it afford proper deference to the
factual findings of the bankruptcy court and its explicit adoption
of the Commissioner’s determination in light of the taxpayer’s
continuing burden of proof. In all of these respects, we do not
write on a blank slate.
Thus we conclude that § 446(b) was properly applied to the
valuation of Debtors’ accounts receivable under § 475, and we
7
The dissent suggests that the Seventh Circuit in JPMorgan
Chase placed the burden on the Service to establish that its method
was lawful and not arbitrary. But the Court in JPMorgan Chase
clearly stated, “In applying the arbitrary or unlawful standard,
the tax court should bear in mind that the taxpayer retains the
burden of proof.” 458 F.3d at 571. The dissent also entirely
ignores the fact that the Seventh Circuit only remanded on this
issue because the Tax Court made an error that the bankruptcy court
here did not: it showed too little deference to the Commissioner’s
method. Id. at 571-72.
27
affirm the upholding of the Commissioner’s determination. The
judgment of the district court is hereby
AFFIRMED.
28
NIEMEYER, Circuit Judge, dissenting:
Relying on 26 U.S.C. § 446(b), the majority permits the IRS
simply to characterize the dispute in this case as one involving
the taxpayer’s method of accounting and thereby avoid a trial and
decision by a factfinder on the fair market value of the taxpayer’s
accounts receivable.
During the course of this litigation, the IRS declared that
the taxpayer’s valuation of its accounts receivable was an
accounting method that did not clearly reflect income. Therefore,
the IRS claimed its right under § 446(b) to recompute the
taxpayer’s taxes under a method that does clearly reflect income.
The problem with this approach was that the IRS and the taxpayer
did not dispute a method of accounting, but only the valuation of
the taxpayer’s asset -- its accounts receivable. All of the
taxpayer’s practices properly regarded as methods of accounting
were never in dispute, and the methods the taxpayer used clearly
reflected income (or loss) to the very last detail.
The IRS and the taxpayer agreed on the taxpayer’s overall
method of accounting -- the accrual method. The IRS and the
taxpayer agreed on how, under the accrual method, to value the
taxpayer’s accounts receivable -- the mark-to-market method. The
IRS and the taxpayer agreed on how to calculate income or loss
using the mark-to-market method -- by subtracting the market value
of the accounts receivable from their book value. The IRS and the
29
taxpayer agreed on the method of determining the market value of
the receivables -- by reducing the book value to present value by
applying a discount rate. The IRS and the taxpayer agreed on the
book value of the accounts receivable -- $1,073,234,932. Finally,
the IRS and the taxpayer agreed on how to determine the discount
rate -- by adding a risk premium to the risk-free rate of return.
In short, there was no disagreement over the taxpayer’s method of
accounting.* Moreover, this agreement on accounting methods
resulted in very similar valuations. The IRS and the taxpayer
agreed on a value of the taxpayer’s accounts receivable within 2%.
The narrow disagreement between the IRS and the taxpayer was over
the proper risk premium to add to the risk-free rate of return to
get a discount rate to apply to the book value, ultimately to reach
the market value. That narrow issue is a factual question that
must be resolved by a factfinder.
Under the majority’s view, the taxpayer never receives a trial
on the fact of the appropriate risk premium by which to discount
*
This agreement on the method of accounting makes this case
quite different from Thor Power Tool Co. v. Commissioner, 439 U.S.
522 (1979), on which the majority relies. In Thor Power Tool, the
taxpayer’s “method of inventory accounting” was “plainly
inconsistent with the governing Regulations” and the taxpayer
“‘made no effort to determine the purchase or reproduction cost’ of
its ‘excess’ inventory.” Id. at 532-33, 535 (emphasis added).
This distinction also applies to JPMorgan Chase & Co. v.
Commissioner, 458 F.3d 564, 569 (7th Cir. 2006), where the
taxpayer’s method of accounting similarly violated IRS regulations.
Here, not only was the taxpayer’s method of accounting consistent
with all governing law and regulations, but the IRS explicitly
agreed with the taxpayer’s method in all material respects.
30
the book value of its accounts receivable. Rather, the majority
upholds the IRS’s post-trial declaration that the selection of a
particular risk premium is a method of accounting within the IRS’s
regulatory purview. Under the majority’s view, at no point is the
taxpayer entitled to a finding of fact on the disputed issue by a
neutral adjudicator. Thus, the IRS may always decree that the
taxpayer’s position on valuing accounts receivable fails to clearly
reflect income and therefore is subject to recomputation by the IRS
under 26 U.S.C. § 446(b) without a trial. The IRS’s authority to
regulate the tax accounting system, however, does not reach down to
this level of detail, and it should not. If the IRS and the
taxpayer disagree on the proper discount percentage to apply to the
book value of the taxpayer’s accounts receivable, the taxpayer is
entitled to have a factfinder resolve the disagreement.
What is even more troubling in this case is that even if the
IRS had such a broad authority to deny the taxpayer a fact trial on
its accounts receivable valuation, its exercise of that power was
unreasonable and unfair. The IRS undertook to exercise its “clear
reflection” authority for the first time in a litigation document
prepared after trial. The IRS thus put the taxpayer through an
elaborate and costly trial, undertaken to determine the valuation
of the accounts receivable, only to then preempt the trial’s
results by declaring, during post-trial briefing, that the case was
resolvable by IRS fiat under § 446(b). (As the IRS’s internal
31
procedures now recognize, this practice was unreasonable. See Rev.
Proc. 2002-18 § 7, 2002-1 C.B. 678). Deference to the IRS’s
regulatory authority under 26 U.S.C. § 446(b) should be based on
more than the post-trial briefing decision of a Department of
Justice line attorney. See Bowen v. Georgetown University
Hospital, 488 U.S. 204, 213 (1988) (“Deference to what appears to
be nothing more than an agency’s convenient litigating position
would be entirely inappropriate”).
Even under its own rationale, the majority has chosen the
wrong remedy. In cases where the IRS declares unreasonable a
taxpayer’s method of accounting, the IRS must still demonstrate
that its own method is lawful and not arbitrary. In this case,
the bankruptcy court, despite finding several serious flaws with
the IRS’s valuation, did not decide whether that valuation was
lawful and not arbitrary. The Seventh Circuit, on which the
majority relies so heavily, has required just such a remand. See
JPMorgan Chase, 458 F.3d at 572 (vacating in part and remanding for
evaluation of Commissioner’s chosen valuation method). The
majority improperly assumes that even though the bankruptcy court
has never addressed the issue, it would nonetheless uphold the
IRS’s method. But that is not our decision to make.
My position is not a far-reaching one -- only a demand for
simple procedural fairness. My position does not deny the IRS any
of the authority that it was given under the Internal Revenue Code.
32
I would simply remand this case so that the bankruptcy court can
determine the value of the taxpayer’s accounts receivable. The IRS
should not be able to avoid such factfinding simply by declaring
that the taxpayer’s “method of accounting” is improper,
particularly after agreeing to every aspect of that accounting
method. This case centers solely on the proper percentage by which
to reduce book value to market value, and up until now, the
taxpayer has not had the opportunity to have this issue tried and
resolved. Under the majority’s holding, it never will.
In sum, I would reverse the judgment of the district court and
remand the case to the district court with instructions to remand
the case to the bankruptcy court to make a factual finding on the
proper valuation of the taxpayer’s accounts receivable.
33