Hospital Corporation of America and Subsidiaries v. Commissioner

107 T.C. No. 8

UNITED STATES TAX COURT

HOSPITAL CORPORATION OF AMERICA AND SUBSIDIARIES, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 10663-91, 13074-91 Filed September 17, 1996.
28588-91, 6351-92.

Ps own, operate, and manage hospitals and related
businesses. For taxable year ended 1987 and following
years, certain Ps elected to use the nonaccrual-
experience method provided pursuant to sec. 448(d)(5),
I.R.C. On audit, R determined that those Ps could not
use the nonaccrual-experience method to compute taxable
income for either 1987 or 1988 because Ps sold medical
supplies and because they could not determine the
portion of their income attributable solely to the
performance of services, or, alternatively, that if Ps
are entitled to use the nonaccrual-experience method,
they must use the formula set forth in amended sec.
1.448-2T(e), Temporary Income Tax Regs., 53 Fed. Reg.
12513 (Apr. 15, 1988), as applied to the portion of the
hospitals' income that R determined is attributable to
the performance of services. Ps claim that all of the
hospitals' income is attributable to the performance of
services and, therefore, they may use the nonaccrual-
experience method for all of their income, the amended
temporary regulations are invalid, and Ps may use the
formula originally set forth in sec. 1.448-2T(e),
 - 2 -

Temporary Income Tax Regs., 52 Fed. Reg. 22775 (June
16, 1987).
Held: Amended sec. 1.448-2T(e), Temporary Income
Tax Regs., 53 Fed. Reg. 12513 (Apr. 15, 1988), is a
permissible construction of sec. 448(d)(5), I.R.C.,
and, therefore, the amount to be excluded from income
for 1987 and 1988 pursuant to sec. 448(d)(5), I.R.C.,
must be calculated as required by the amended temporary
regulations.
Held, further: Medical supplies are a necessary
and vital part of furnishing medical services to Ps'
patients and, therefore, income attributable to medical
supplies constitutes income earned from the performance
of services for purposes of sec. 448(d)(5), I.R.C.

N. Jerold Cohen, Randolph W. Thrower, J.D. Fleming, Jr.,

Walter H. Wingfield, Stephen F. Gertzman, Reginald J. Clark,

Amanda B. Scott, Walter T. Henderson, Jr., William H. Bradley,

and John W. Bonds, Jr., for petitioners in docket No. 10663-91.

N. Jerold Cohen, Randolph W. Thrower, J.D. Fleming, Jr.,

Walter H. Wingfield, Stephen F. Gertzman, Reginald J. Clark,

Amanda B. Scott, Walter T. Henderson, Jr., William H. Bradley,

John W. Bonds, Jr., and Daniel R. McKeithen, for petitioners in

docket No. 13074-91.

N. Jerold Cohen, Walter H. Wingfield, Stephen F. Gertzman,

Amanda B. Scott, Reginald J. Clark, Randolph W. Thrower, Walter

T. Henderson, Jr., and John W. Bonds, Jr., for petitioners in

docket No. 28588-91.

N. Jerold Cohen, Reginald J. Clark, Randolph W. Thrower,

Walter T. Henderson, Jr., and John W. Bonds, Jr., for petitioners

in docket No. 6351-92.
 - 3 -

Robert J. Shilliday, Jr., Vallie C. Brooks, and William B.

McCarthy, for respondent.

WELLS, Judge: These cases were consolidated for purposes of

trial, briefing, and opinion and will hereinafter be referred to

as the instant case.1 Respondent determined deficiencies in

petitioners' consolidated corporate Federal income tax as shown

below.

TYE Deficiency

1978 $2,187,079.00
1980 388,006.58
1981 94,605,958.92
1982 29,691,505.11
1983 43,738,703.50
1984 53,831,713.90
1985 85,613,533.00
1986 69,331,412.00

1
The instant case involves several issues, some of which have
been settled. The issues remaining to be decided involve matters
that may be classified into four reasonably distinct categories,
which the parties have denominated the tax accounting issues, the
MACRS depreciation issue, the HealthTrust issue, and the captive
insurance or Parthenon Insurance Co. issues. Issues involved in
the first three categories were presented at a special trial
session, and the captive insurance issues were severed for trial
purposes and were presented at a subsequent special trial
session. Separate briefs of the parties were filed for each of
the distinct categories of issues. In a Memorandum Opinion
issued Mar. 7, 1996, Hospital Corp. of America v. Commissioner,
T.C. Memo. 1996-105, and an Opinion issued Sept. 12, 1996,
Hospital Corp. of America v. Commissioner, 107 T.C. (1996),
we addressed two of the tax accounting issues. The instant
opinion addresses the last of the tax accounting issues and
specifically involves taxable years ended 1987 and 1988, which
were not involved in T.C. Memo. 1996-105 (but 1987 was involved
in Hospital Corp. of America v. Commissioner, 107 T.C.
(1996)). Other issues will be addressed in one or more separate
opinions subsequently to be released.
 - 4 -

1987 294,571,908.00
1988 25,317,840.00

Respondent also determined that the provision for increased

interest pursuant to section 6621(c) applied. Unless otherwise

indicated, all section references are to the Internal Revenue

Code in effect for the years in issue, and all Rule references

are to the Tax Court Rules of Practice and Procedure.

The issue to be decided in the instant opinion is what

amount, if any, petitioners may exclude from income for taxable

years ended 1987 and 1988 pursuant to the nonaccrual-experience

method.

FINDINGS OF FACT

Some of the facts have been stipulated for trial pursuant to

Rule 91. We incorporate those stipulated facts herein by

reference and find them as facts herein.

During the years in issue, petitioners were members of an

affiliated group of corporations whose common parent was Hospital

Corporation of America (HCA).2 HCA maintained its principal

offices in Nashville, Tennessee, on the date the petitions were

filed. For each of the years involved in the instant case, HCA

and its domestic subsidiaries filed a consolidated Federal

corporate income tax return (consolidated return) on Form 1120

2
On Feb. 10, 1994, HCA was merged with and into Galen
Healthcare, Inc., a subsidiary of Columbia Healthcare Corp. of
Louisville, Kentucky, and the subsidiary changed its name to HCA-
Hospital Corp. of America. On that same date, the parent changed
its name to Columbia/HCA Healthcare Corp.
 - 5 -

with the Director of the Internal Revenue Service Center at

Memphis, Tennessee.

Petitioners' primary business is the ownership, operation,

and management of hospitals. A detailed description of

petitioners' hospital operations is set forth in Hospital Corp.

of America v. Commissioner, T.C. Memo. 1996-105, most of which

will not be reiterated here. Our findings of fact contained in

that Memorandum Opinion are incorporated herein.

For taxable years ended before January 1, 1987, some

petitioner hospitals used the Black Motor formula3 to determine

the portion of their yearend accounts receivable that was

unlikely to be collected. Those hospitals established reserves

for bad debts (bad debt reserves) and, based on the Black Motor

determinations, for years ended prior to 1987 they deducted

additions to the bad debt reserves as ordinary business expenses

in accordance with section 166(c).4 In audits of petitioners'

3
The Black Motor formula is based on a method for computing
additions to a reserve for bad debts that was described initially
in Black Motor Co. v. Commissioner, 41 B.T.A. 300 (1940), affd.
on another issue 125 F.2d 977 (6th Cir. 1942).
4
Sec. 166(c), which was repealed by sec. 805(a) of the Tax
Reform Act of 1986 (TRA), Pub. L. 99-514, 100 Stat. 2361,
provided that an accrual method taxpayer generally could deduct a
reasonable addition to a reserve for bad debts in lieu of the
specific charge-off of wholly or partially worthless debts
provided by sec. 166(a). Congress repealed sec. 166(c) because
it believed that allowing deductions for losses that
statistically occur in the future was inconsistent with the
treatment of other deductions under the all events test inasmuch
as allowance of the deduction before the losses occurred
(continued...)
 - 6 -

Federal income tax returns for years ended prior to 1987,

respondent did not contend that the Black Motor formula employed

by those petitioners incorrectly reflected the hospitals' bad

debt experience. In some instances, respondent's agents required

petitioners not using the Black Motor formula to employ that

formula to compute their bad debt reserves. In accordance with

the repeal of section 166(c), effective for the year ended 1987,

petitioners could use only the specific charge-off method to

deduct bad debts. Tax Reform Act of 1986, Pub. L. 99-514, sec.

805, 100 Stat. 2361-2362.

With the consolidated return for taxable year ended 1987,

petitioners timely filed an application on Form 3115, Application

for Change In Accounting Method, to elect the so-called

nonaccrual-experience method5 for taxable year ended 1987.

4
(...continued)
permitted a deduction that was larger than the present value of
the losses. See H. Rept. 99-426, at 577 (1985), 1986-3 C.B.
(Vol. 2) 1, 577; S. Rept. 99-313, at 155 (1986), 1986-3 C.B.
(Vol. 3) 1, 155. Pursuant to TRA sec. 805(a), 100 Stat. 2362,
the positive sec. 481(a) adjustment relating to the repeal of the
reserve method of accounting for bad debts was to be accounted
for ratably over a 4-year spread period commencing with the year
ended 1987.

5
The nonaccrual-experience method provides that an accrual-
method taxpayer generally does not have to accrue as gross income
at the time the taxpayer normally would be required to recognize
income with respect to an account receivable (i.e., at the time
all events had occurred to fix the right to receive the income
and the amount could be determined with reasonable accuracy)
accounts receivable relating to services performed by the
taxpayer that, based on experience, the taxpayer will not
(continued...)
 - 7 -

Petitioners elected to use the periodic system6 of the

nonaccrual-experience method to estimate on a hospital-by-

hospital basis the portion of their income they would not collect

(sometimes hereinafter referred to as the Uncollectible Amount),

except that petitioners computed the Uncollectible Amount by

using the formula (Original Formula)7 set forth in section 1.448-

2T(e)(2)(i), Temporary Income Tax Regs., 52 Fed. Reg. 22775 (June

16, 1987) (Original Temporary Regulations), rather than the

formula (Amended Formula) set forth in amended section 1.448-

2T(e)(2), Temporary Income Tax Regs., 53 Fed. Reg. 12513-12514

(Apr. 15, 1988) (Amended Temporary Regulations). Hereinafter, we

sometimes will refer to the method petitioners used to compute

the Uncollectible Amount for years ended 1987 and 1988 as the

modified periodic system.

For taxable years ended 1987 and 1988, petitioners reduced

(or increased) income of each hospital by the sum of (1) net

5
(...continued)
collect. Sec. 448(d)(5). See infra pp. 17-21 for a detailed
description of the nonaccrual-experience method. Pursuant to
sec. 1.448-2T(h)(1), Temporary Income Tax Regs., 52 Fed. Reg.
22776 (June 16, 1987), consent to a change to the nonaccrual-
experience method is granted automatically if the taxpayer is
qualified to use that method.
6
The periodic system of the nonaccrual-experience method,
described in Notice 88-51, 1988-1 C.B. 535, is similar to a
reserve system. See infra pp. 20-21 for a detailed description
of the periodic system.
7
The parties agree that the Original Formula is identical to
the Black Motor formula.
 - 8 -

writeoffs of bad debts (i.e., total bad debts written off during

the year less any recoveries) and (2) the annual increase or

decrease in the aggregate Uncollectible Amount (i.e., the

aggregate amount that petitioners estimated would not be

collected on accounts receivable outstanding at yearend) computed

on the basis of the modified periodic system. Respondent agrees

that petitioners' reductions for net writeoffs of bad debts were

proper but does not agree with petitioners' computation of the

aggregate Uncollectible Amount.

For each petitioner qualified to use the nonaccrual-

experience method, petitioners computed the amount of the

negative section 481(a) adjustment relating to the change to that

method to be equal to the Uncollectible Amount as of December 31,

1986, as calculated under the modified periodic system.8 In the

case of those petitioners that had employed an overall accrual

method of accounting for taxable years ended prior to January 1,

1987, each petitioner's negative section 481(a) adjustment

relating to the change to the nonaccrual-experience method for

taxable years ended 1987 and 1988 equaled the amount of the net

positive section 481(a) adjustment relating to the repeal of the

reserve method of accounting for those years.

8
In other words, petitioners calculated the portion of
accounts receivable that would not be collected by multiplying
yearend accounts receivable by the ratio of writeoffs for bad
debts (adjusted for recoveries) for the current year and the 5
preceding years over the sum of the yearend accounts receivable
balances for the same 6-year period.
 - 9 -

In the case of those petitioners that had employed the

hybrid method of accounting for taxable years ended prior to

January 1, 1987, to the extent that the Uncollectible Amount was

attributable to the use of the cash method for taxable years

ended prior to January 1, 1987, each qualified petitioner reduced

taxable income for each of the years ended 1987 and 1988 by one-

tenth of the portion of accounts receivable estimated to be

uncollectible as of December 31, 1986, using the modified

periodic system. To the extent that the Uncollectible Amount was

attributable to the use of an accrual method for taxable years

ended prior to January 1, 1987, the Uncollectible Amount was

equal to the net positive section 481(a) adjustment relating to

the repeal of the reserve method of accounting for bad debts. As

calculated by petitioners, for taxable years ended 1987 and 1988

the negative section 481(a) adjustment relating to the election

of the nonaccrual-experience method was equal to the positive

section 481(a) adjustment relating to the repeal of the reserve

method of accounting for bad debts.

On audit, respondent disallowed all reductions in

petitioners' taxable income attributable to the use of the

nonaccrual-experience method, other than net writeoffs of bad

debts for each year, on the grounds that petitioners had failed

to provide documentation needed to compute the portion of

petitioners' income earned from the performance of services and

that they had not used the proper formula in applying the
 - 10 -

nonaccrual-experience method. Respondent's adjustments had the

effect of disallowing petitioners' negative section 481(a)

adjustment attributable to the election of the nonaccrual-

experience method, but leaving unchanged the positive section

481(a) adjustment attributable to the repeal of the reserve

method of accounting for bad debts. Accordingly, respondent's

adjustments increased petitioners' income for each of the years

ended 1987 and 1988 by one-fourth of the positive section 481(a)

adjustment attributable to the repeal of the reserve method of

accounting for bad debts.

As calculated pursuant to the Black Motor formula, for

taxable years ended 1987 and 1988, without taking into account

the impact of the resolution of other issues raised in the notice

of deficiency, the percentage of petitioners' yearend accounts

receivable not accrued in income under the nonaccrual-experience

method are 19.94 percent and 20.62 percent, respectively.

On their consolidated return for the taxable year ended 1987

as originally filed, HCA, as parent of the affiliated group,

added $20 million to their consolidated income, and thereby

reduced by that amount the aggregate Uncollectible Amount as

determined under the modified periodic system. Petitioners added

the $20 million to their consolidated income to account for

possible future corrections or adjustments to their nonaccrual-

experience method computations following the issuance of final

regulations or on audit. In an amended consolidated return for
 - 11 -

the taxable year ended 1987 (amended return) filed September 9,

1991, HCA claimed that it was entitled to reduce consolidated

income, and thereby increase the aggregate Uncollectible Amount,

by $20 million. On audit, respondent allowed the claimed $20

million reduction in consolidated income by offsetting the

nonaccrual-experience method adjustment by that amount.

In the amended return, HCA also claimed that petitioners

were entitled to a refund of tax based on a computational

adjustment in the application of the nonaccrual-experience method

for certain petitioners whose stock was sold, or whose assets

were transferred to a subsidiary whose stock was sold, to

HealthTrust, Inc.--The Hospital Corporation (HealthTrust) in

September 1987. On petitioners' original return, the Original

Formula was applied to those petitioners by using the accounts

receivable as of the date of sale and by using the net writeoffs

of bad debts from January 1, 1987, through the date of sale. In

the amended return, the computation was made by annualizing the

net writeoffs of bad debts for the period from January 1, 1987,

through the date of the sale, thus increasing the Uncollectible

Amount for the taxable year 1987 by $7,366,123.

Petitioners do not charge or otherwise require interest to

be paid on their accounts receivable, they do not charge or

otherwise impose any penalties for failing to pay an account

receivable timely, and no portion of their accounts receivable

was owed on account of activities with respect to either (1)
 - 12 -

lending money or (2) acquiring receivables or other rights to

receive payment from other persons.

Petitioner's hospitals make frequent use of various medical

and surgical supply items and pharmaceuticals (hereinafter

sometimes collectively referred to as medical supplies) in

providing medical care to patients. Many of the medical supplies

are used directly on a patient by a physician in the performance

of a medical procedure, and others are used by nurses,

attendants, and other medical personnel in the treatment of the

patient. The quantities of items used, administered, or consumed

and the timing of such use, administration, or consumption are

determined by the physician or hospital staff, on some occasions

after consultation with the patient.

Medical supplies may be applied to, implanted in, or

otherwise administered to, furnished to, or used in connection

with the treatment of patients. Examples of these medical

supplies include casts, crutches, canes, walkers, bandages,

sutures, splints, skin staples, various implants such as joint

replacements, pacemakers, and heart valves, orthopedic devices,

and physical and occupational therapy items. These items often

leave the hospital with the patient, although some items such as

sutures, splints, skin staples, and implants can be removed from

the patient only by a physician or other trained medical

personnel.
 - 13 -

Medicines and prescription drugs frequently are administered

to a patient during the course of treatment for the patient's

condition. Intravenous solutions or blood and blood derivatives

also may be administered to a patient. Medical supplies,

moreover, may be used in performing surgical and other procedures

on patients, including such items as scalpels and other surgical

instruments, sponges, surgical drapes, surgical gowns, towels,

syringes, alcohol preparations, drainage and irrigating tubes,

and tourniquets.

Additionally, many ancillary hospital departments use

medical supplies in the course of performing their particular

specialties relating to patient hospital care. For example, x-

ray film, chemicals, dyes, and nuclear materials are used in the

course of performing radiological diagnostic procedures. Gases

are administered to patients during surgery under the strict

supervision of an anesthesiologist. Oxygen is administered to

patients by the respiratory therapy department. Dyes are

injected in patients with possible coronary artery disease during

the diagnostic procedure known as cardiac catheterization.

Psychiatric facilities sometimes use other medical supplies and

equipment in certain treatments, such as insulin therapy,

electroshock therapy, and hydrotherapy.

The hospitals employ sophisticated medical records systems

to identify which medical supplies are used on or for each

patient. The hospitals determine patient charge amounts for
 - 14 -

listing on billing statements for many individual procedures

involving a medical supply based on a schedule of algorithms that

typically are a multiple of the cost of the supply item used or a

multiple of the average wholesale price of the pharmacy item

used.

At discharge, patients are furnished a summary bill that

shows separate charge categories such as patient room charges,

pharmacy, medical/surgical supplies, and laboratory. Upon

request, the patient will receive a more detailed bill that

itemizes each separate charge within the broad categories. The

items listed on summary bills vary from patient to patient based

on the exact medical care received by the patient. For example,

the bill often identifies charges as being for the use of patient

rooms and for various special areas, such as the operating room,

recovery room, delivery room, nursery, emergency room, or

intensive care unit. The bill also may identify charges for

ancillary procedures such as radiology, anesthesia, nuclear

medicine, various laboratory procedures, inhalation therapy, and

physical therapy. Some specific charges on the detailed bill are

identified by the name and/or code of a particular medication,

supply item, or IV solution used in providing medical services to

the patient.

Public or private insurance programs directly or indirectly

pay 70 and 80 percent of the hospitals’ bills to patients. Those

insurance programs calculate payments to the hospitals on a flat
 - 15 -

amount based on a particular procedure or on some other

negotiated per-case or per diem basis. Thus, in most cases, the

hospitals' itemized bills do not bear any particular relationship

to the amounts that the hospitals actually will be paid for the

services provided. See Hospital Corp. of America v.

Commissioner, T.C. Memo. 1996-105, for a detailed description of

the hospitals' billing practices and the insurers' payment

policies.

OPINION

An accrual method taxpayer generally must include a taxable

amount in income when all events have occurred that fix the right

to receive the income and the amount can be determined with

reasonable accuracy. Sec. 1.451-1(a), Income Tax Regs. Section

448(d)(5),9 however, provides that an accrual-method taxpayer is

not required to accrue income earned by the taxpayer with respect

to the performance of services which, based on experience, it

will not collect (i.e., the Uncollectible Amount) and for which

no interest is charged or no penalty is applied for overdue

9
Sec. 448(d)(5) provides as follows:

(5) Special rule for services.--In the case of
any person using an accrual method of accounting with
respect to amounts to be received for the performance
of services by such person, such person shall not be
required to accrue any portion of such amounts which
(on the basis of experience) will not be collected.
This paragraph shall not apply to any amount if
interest is required to be paid on such amount or there
is any penalty for failure to timely pay such amount.
 - 16 -

receivables. The nonaccrual-experience method is treated as a

method of accounting. Sec. 1.448-2T(b), Temporary Income Tax

Regs., 52 Fed. Reg. 22774-22775 (June 16, 1987).

The Positions of the Parties

Petitioners contend that the Amended Temporary Regulations

are invalid because they are inconsistent with the plain meaning

of section 448(d)(5). Petitioners maintain that Congress

expressly authorized use of the Black Motor formula to compute

the Uncollectible Amount. Additionally, petitioners contend that

their accounts receivable are derived entirely from the

performance of services and, as a result, the Uncollectible

Amount should be determined with respect to all of their accounts

receivable. Petitioners further assert that, for those

petitioners which had short taxable years for 1987 because their

stock was sold, the Black Motor formula must be applied in

conjunction with the periodic system by annualizing the writeoffs

of bad debts to avoid a distortion for that year.

Respondent contends, on the other hand, that the Amended

Formula is taken directly from the legislative history of section

448 and is consistent with the statute's plain language, origin,

and purposes. Respondent maintains that the Amended Regulations

are a valid interpretation of congressional intent and properly

compute the Uncollectible Amount. Additionally, respondent

contends that the hospitals sell substantial amounts of medical

supplies to their patients in addition to performing services.
 - 17 -

Respondent maintains that petitioners' records do not properly

allocate accounts receivable between income earned from the sale

of services and income earned from the sale of inventory;

therefore, petitioners cannot use the nonaccrual-experience

method because they cannot establish the portion of their income

that is derived solely from the performance of services.

The question is one of first impression.

The Nonaccrual-Experience Method Formula

The temporary regulations apply the nonaccrual-experience

method formula to each separate trade or business of a taxpayer.

Sec. 1.448-2T(e)(1), Temporary Income Tax Regs.,10 52 Fed. Reg.

10
Sec. 1.448-2T(e), Temporary Income Tax Regs., as amended,
provides in pertinent part as follows:

(e) Use of experience to estimate uncollectible
amounts--(1) In general. In determining the portion of
any amount due which, on the basis of experience, will
not be collected, the formula prescribed by paragraph
(e)(2) of this section shall be used by the taxpayer
with respect to each separate trade or business of the
taxpayer. No other method or formula may be used by a
taxpayer in determining the uncollectible amounts under
this section.

(2) Six-year moving average--(i) General rule.
For any taxable year the uncollectible amount of a
receivable is the amount of that receivable which bears
the same ratio to the account receivable outstanding at
the close of the taxable year as (A) the total bad
debts (with respect to accounts receivable) sustained
throughout the period consisting of the taxable year
and the five preceding taxable years (or, with the
approval of the Commissioner, a shorter period),
adjusted for recoveries of bad debts during such
period, bears to (B) the sum of the accounts receivable
earned throughout the entire six (or fewer) taxable
(continued...)
 - 18 -

22775 (June 16, 1987). No other method or formula may be used to

10
(...continued)
year period (i.e., the total amount of sales resulting
in accounts receivable) throughout the period.
Accounts receivable described in paragraphs (c) [any
amounts due for which interest or penalties are
charged] and (d) [any amounts not earned by the
taxpayer for services performed by the taxpayer] of
this section are not taken into account in computing
the ratio.

(ii) Period of less than six years. A period
shorter than six years generally will be appropriate
only if there is a change in the type of a substantial
portion of the outstanding accounts receivable such
that the risk of loss is substantially increased. * * *

* * * * * * *

(3) Mechanics of nonaccrual-experience method.
The nonaccrual-experience method shall be applied with
respect to each account receivable of the taxpayer
which is eligible for such method. With respect to a
particular account receivable, the taxpayer will
determine, in the manner prescribed in paragraph (e) of
this section, the amount of such account receivable
that is not expected to be collected. Such
determination shall be made only once with respect to
each account receivable, regardless of the term of such
receivable. The estimated uncollectible amount shall
not be recognized as gross income. Thus, the amount
recognized as gross income shall be the amount that
would otherwise be recognized as gross income with
respect to the account receivable, less the amount
which is not expected to be collected. Upon the
collection of the account receivable, additional gross
income shall be recognized with respect to the
collection of any amount not initially expected to be
collected. Similarly, no bad debt deduction under
section 166 for a wholly or partially worthless account
receivable shall be allowed for any amount not
previously taken into income under the nonaccrual-
experience method. [Sec. 1.448-2T(e), Temporary Income
Tax Regs., 52 Fed. Reg. 22774-22775 (June 16, 1987), as
amended by T.D. 8194, 1988-1 C.B. 186.]
 - 19 -

calculate the Uncollectible Amount pursuant to the temporary

regulations. Id.

The Separate Receivable System of the Nonaccrual-Experience
Method

The so-called separate receivable system provided in the

temporary regulations applies the nonaccrual-experience method to

each account receivable which is eligible for that method. Sec.

1.448-2T(e)(3), Temporary Income Tax Regs., 52 Fed. Reg. 22775

(June 16, 1987). For any eligible receivable, the taxpayer

includes in gross income only the amount of that receivable that

is recognized as gross income minus the Uncollectible Amount.

The Uncollectible Amount of any receivable is the amount of the

receivable outstanding at the close of the taxable year

multiplied by a percentage. The Amended Formula provides for the

determination of the percentage by dividing (a) total bad debts

(adjusted for recoveries) sustained during the current and 5

preceding taxable years (or a shorter period with the approval of

the Commissioner) by (b) the sum of the accounts receivable

earned throughout that same 6-year (or shorter) period.

Accordingly, the Amended Formula provides for the determination

of the denominator of the fraction on the basis of total sales

resulting in accounts receivable throughout the applicable

period. Sec. 1.448-2T(e)(2)(i), Temporary Income Tax Regs., 53

Fed. Reg. 12513-12514 (Apr. 15, 1988). A taxpayer which has been

in existence for less than 6 years is to use its experience for
 - 20 -

the current year and the actual number of preceding taxable

years. The taxpayer may use a predecessor's experience from

preceding taxable years. Sec. 1.448-2T(e)(2)(iii), Temporary

Income Tax Regs., 52 Fed. Reg. 22775 (June 16, 1987).

The separate receivable system provides for the

determination of the Uncollectible Amount only once for each

account receivable, regardless of the term of that receivable.

Sec. 1.448-2T(e)(3), Temporary Income Tax Regs., supra. As each

receivable is collected, income is reported only to the extent

not previously accrued. If a receivable is not collected, the

bad debt deduction is limited to the amount previously reported

as income. Id.

The Periodic System of the Nonaccrual-Experience Method

Alternatively, a taxpayer may elect the so-called periodic

system for applying the nonaccrual-experience method. Notice 88-

51, 1988-1 C.B. 535; see H. Rept. 99-426, at 608 (1985), 1986-3

C.B. (Vol. 2) 1, 608. The periodic system requires a taxpayer to

establish an account which represents the aggregate amount of

accounts receivable in a trade or business eligible for the

nonaccrual-experience method that the taxpayer estimates will not

be collected, based on the 6-year moving average formula set

forth in section 1.448-2T(e)(2)(i), Temporary Income Tax Regs.,

supra, and Notice 88-51, 1988-1 C.B. at 536. At yearend, the

taxpayer adjusts the account to reflect the aggregate amount that

the taxpayer estimates will not be collected on the accounts
 - 21 -

receivable outstanding at that time. Income is increased to

reflect any decrease in the reserve balance or decreased to

reflect any increase in that balance. Notice 88-51, 1988-1 C.B.

at 536. Accordingly, the periodic system of the nonaccrual-

experience method of accounting is somewhat similar to a reserve

method. Id.

The periodic system requires the taxpayer to charge wholly

or partially worthless accounts receivable directly to bad debt

expense, ignoring the Uncollectible Amounts pertaining to those

accounts receivable. Similarly, the taxpayer must disregard the

Uncollectible Amounts of accounts receivable when it accounts for

the collection of those receivables. Id. The 6-year moving

average formula is used to estimate the total amount of all

eligible accounts receivable outstanding at yearend that the

taxpayer estimates it will not collect, including accounts

receivable outstanding at the end of prior taxable years. Id.

Is Section 448(d)(5) Ambiguous?

Petitioners contend that the Amended Regulations are invalid

because they are an unreasonable interpretation of an unambiguous

statutory provision. In response, respondent contends that the

statute is ambiguous in that it does not specify how "experience"

is to be determined. Respondent contends further that the

Amended Regulations are a valid interpretation of the statute.

In construing section 448(d)(5) our task is to give effect

to the intent of Congress. We begin with the statutory language,
 - 22 -

which is the most persuasive evidence of the statutory purpose.

United States v. American Trucking Associations, Inc., 310 U.S.

534, 542-543 (1940); Helvering v. Stockholms Enskilda Bank, 293

U.S. 84, 93-94 (1934); General Signal Corp. & Subs. v.

Commissioner, 103 T.C. 216, 240 (1994), supplemented by 104 T.C.

248 (1995). Ordinarily, the plain meaning of statutory language

is conclusive. United States v. Ron Pair Enters., Inc., 489 U.S.

235, 241-242 (1989).

Where a statute is silent or ambiguous, we look to

legislative history in an effort to ascertain congressional

intent. Burlington No. R.R. v. Oklahoma Tax Commn., 481 U.S.

454, 461 (1987); United States v. American Trucking Associations,

Inc., supra at 543-544; Peterson Marital Trust v. Commissioner,

102 T.C. 790, 799 (1994), affd. 78 F.3d 795 (2d Cir. 1996); U.S.

Padding Corp. v. Commissioner, 88 T.C. 177, 184 (1987), affd. 865

F.2d 750 (6th Cir. 1989). Even where the statutory language

appears to be clear, we are not precluded from consulting

legislative history. United States v. American Trucking

Associations, Inc., supra at 543-544. Nevertheless, our

authority to construe a statute is limited where the agency

charged with administering that statute has promulgated

regulations thereunder.

The limitation on our authority is found in the so-called

Chevron rule as stated in the following passage:
 - 23 -

When a court reviews an agency's construction of
the statute which it administers, it is confronted with
two questions. First, always, is the question whether
Congress has directly spoken to the precise question at
issue. If the intent of Congress is clear, that is the
end of the matter; for the court, as well as the
agency, must give effect to the unambiguously expressed
intent of Congress. If, however, the court determines
Congress has not directly addressed the precise
question at issue, the court does not simply impose its
own construction on the statute, as would be necessary
in the absence of an administrative interpretation.
Rather, if the statute is silent or ambiguous with
respect to the specific issue, the question for the
court is whether the agency's answer is based on a
permissible construction of the statute. [Chevron
U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467
U.S. 837, 842-843 (1984); fn. refs. omitted.]

See also NationsBank v. Variable Annuity Life Ins. Co., 513 U.S.

___, 115 S. Ct. 810, 813 (1995); Pension Benefit Guar. Corp. v.

LTV Corp., 496 U.S. 633, 647-648 (1990). The Supreme Court

further has stated that a reviewing court

need not conclude that the agency construction was the only
one it permissibly could have adopted to uphold the
construction, or even the reading the court would have
reached if the question initially had arisen in a judicial
proceeding. [Chevron U.S.A., Inc. v. Natural Res. Def.
Council, Inc., supra at 843 n.11; citations omitted.]

Accordingly, "If the administrator's reading fills a gap or

defines a term in a way that is reasonable in light of the

legislature's revealed design, we give the administrator's

judgment 'controlling weight.'" NationsBank v. Variable Annuity

Life Ins. Co., 513 U.S. at , 115 S. Ct. at 813-814. Despite

the fact that the Chevron rule "has had a checkered career in the

tax arena", Central Pa. Sav. Association v. Commissioner, 104

T.C. 384, 391-392 (1995), the Court of Appeals for the Sixth
 - 24 -

Circuit, to which an appeal of the instant case would lie absent

stipulation of the parties to the contrary, has stated that where

"Congress has not directly spoken to the precise question at

issue, the [Chevron] rule * * * should be applied". Peoples Fed.

Sav. & Loan Association v. Commissioner, 948 F.2d 289, 299 (6th

Cir. 1991), revg. T.C. Memo. 1990-129. "If there are gaps left

by silence or ambiguity of the statutes in question, agencies may

fill the gaps with necessary rules, providing they are

reasonable, and courts should not interfere with this process."

Id. at 300.

Petitioners maintain that the phrase "on the basis of

experience" is not defined in the statute and that Congress did

not delegate to the Commissioner the authority to define the

phrase. Petitioners assert further that no definition is

necessary because the phrase is not ambiguous and must be

interpreted in accordance with its plain, everyday meaning. We

conclude, however, that the phrase is ambiguous.

The words in a revenue act generally should be interpreted

in their ordinary, everyday sense. Commissioner v. Soliman, 506

U.S. 168, 174 (1993). Webster's II New Riverside University

Dictionary (1984) defines "experience" as "An event or series of

events participated in" or "The totality of such events in the

past of an individual or group." We do not find in that

definition a clear mechanism for determining how a taxpayer's bad

debt experience will be utilized to calculate the uncollectible
 - 25 -

portion of a receivable. The statute on its face, furthermore,

provides no formula for calculating that amount. Petitioners,

however, in essence argue that, when the Code employs the word

"experience" in conjunction with bad debts, the word has a

predetermined meaning which prescribes the formula that must be

used to calculate the uncollectible portion of an amount owed a

taxpayer.

In that regard, petitioners contend that Congress explicitly

recognized that the term "experience" as it relates to bad debt

experience is synonymous with the Black Motor formula. We have

found no cases, and petitioners have cited none, where the term

"experience" was found to have the technical meaning advanced by

petitioners. Moreover, section 448 does not define the word in

that manner. In support of their contention petitioners cite

section 585(b)(2),11 which describes "the experience method" that

11
Sec. 585, as amended by sec. 11801(c)(12) of the Omnibus
Budget Reconciliation Act of 1990, Pub. L. 101-508, 104 Stat.
1388-527, provides in pertinent part as follows:

SEC. 585. RESERVES FOR LOSSES ON LOANS OF BANKS.

(a) Reserve for Bad Debts.--

(1) In general.--Except as provided in subsection
(c), a bank shall be allowed a deduction for a
reasonable addition to a reserve for bad debts. Such
deduction shall be in lieu of any deduction under
section 166(a).

* * * * * * *

(b) Addition to Reserves for Bad Debts.--
(continued...)
 - 26 -

11
(...continued)
(1) General rule.--For purposes of subsection
(a), the reasonable addition to the reserve for bad
debts of any financial institution to which this
section applies shall be an amount determined by the
taxpayer which shall not exceed the addition to the
reserve for losses on loans determined under the
experience method as provided in paragraph (2).

(2) Experience method.--The amount determined
under this paragraph for a taxable year shall be the
amount necessary to increase the balance of the reserve
for losses on loans (at the close of the taxable year)
to the greater of--

(A) the amount which bears the same ratio to
loans outstanding at the close of the taxable year
as (i) the total bad debts sustained during the
taxable year and the 5 preceding taxable years
(or, with the approval of the Secretary, a shorter
period), adjusted for recoveries of bad debts
during such period, bears to (ii) the sum of the
loans outstanding at the close of such 6 or fewer
taxable years, or

(B) the lower of--

(i) the balance of the reserve at the
close of the base year, or

(ii) if the amount of loans outstanding
at the close of the taxable year is less than
the amount of loans outstanding at the close
of the base year, the amount which bears the
same ratio to loans outstanding at the close
of the taxable year as the balance of the
reserve at the close of the base year bears
to the amount of loans outstanding at the
close of the base year.

For purposes of this paragraph the base year shall be
the last taxable year before the most recent adoption
of the experience method, except that for taxable years
beginning after 1987 the base year shall be the last
taxable year beginning before 1988.

(continued...)
 - 27 -

qualified banks use to determine the maximum amount they may add

to their reserves for bad debts. Petitioners assert, and

respondent does not dispute, that the experience method described

in section 585(b)(2) and section 1.585-2(c)(1), Income Tax Regs.,

is identical to the Black Motor formula.

Petitioners seemingly would have us conclude from the

foregoing that the word "experience" in section 448(d)(5) has the

same meaning as the term "experience method" in section 585. We,

however, do not agree that Congress' use of the word "experience"

in section 448(d)(5) necessarily shows congressional intent that

the Uncollectible Amount be calculated under the Black Motor

formula. Indeed, we think that it is more probable that, if

Congress had intended the same formula to apply in section

448(d)(5) and in section 585, then it would have specified that

the Uncollectible Amount be based on "the experience method" or

on "the Black Motor formula". The use of the word "experience"

in section 448(d)(5) and the words "experience method" in section

585 may reasonably be viewed as an indication of two different

meanings. Cf. Norfolk S. Corp. v. Commissioner, 104 T.C. 13, 38-

41 (1995).

In sum, we do not find that the statutory language manifests

congressional intent as to what method is to be employed to

calculate the Uncollectible Amount, and we conclude that section

11
(...continued)
 - 28 -

448(d)(5) is ambiguous as to the meaning of "experience". We

next look to the statute's legislative history in an attempt to

ascertain congressional intent.

Does the Legislative History Clearly Reveal Congressional
Intent as to the Formula To Apply?

Petitioners maintain that the legislative history of section

448(d)(5) does not clearly reveal Congress' intent as to the

proper formula to apply. A description of the nonaccrual-

experience method formula is contained only in the report of the

Committee on Way and Means.12 Because that report contains

conflicting language, we do not think it clearly describes the

formula. H. Rept. 99-426, at 608 (1985), 1986-3 C.B. (Vol. 2) 1,

608, states in pertinent part as follows:

Amount of accrual

The committee bill provides that an accrual basis
taxpayer need not accrue as income any portion of
amounts billed for the performance of services which,
on the basis of experience, it will not collect. * * *

The amount of billings that, on the basis of
experience, will not be collected is equal to the total
amount billed, multiplied by a fraction whose numerator
is the total amount of such receivables which were
billed and determined not to be collectible within the
most recent five years taxable years [sic] of the

12
A provision comparable to sec. 448(d)(5) was not present in
the Senate amendment, and the conference report does not describe
the nonaccrual-experience method formula. See H. Conf. Rept. 99-
841 (Vol. 2), at II-285 to II-289 (1986), 1986-3 C.B. (Vol. 4) 1,
285-289.
 - 29 -

taxpayer, and whose denominator is the total of such
amounts billed within the same five year period. If
the taxpayer has not been in existence for the prior
five taxable years, the portion of such five year
period which the taxpayer has been in existence is to
be used.

For example, assume that an accrual-basis taxpayer
has $100,000 of receivables that have been created
during the most recent five taxable years. Of the
$100,000 of accounts receivable, $1,000 have been
determined to be uncollectible. The amount, based on
experience, which is not expected to be collected is
equal to 1 percent ($1,000 divided by $100,000) of any
receivable arising from the provision of services that
are outstanding at close of the taxable year. [Emphasis
added; fn. ref. omitted.]

As the foregoing emphasized language reveals, one paragraph

of the committee report specifies that the Uncollectible Amount

is calculated by multiplying the total amount billed during the

taxable year by the ratio of the sum of the amount of those

billings determined uncollectible within the most recent 5

taxable years to the sum of the billings within that same 5-year

period. In the example in the following paragraph, however, the

formula is expressed somewhat differently; to wit, in the

example, the Uncollectible Amount is calculated by multiplying

the receivables outstanding at the close of the taxable year by

the ratio of the amount of those billings determined

uncollectible within the most recent 5 taxable years to the sum

of the billings within that same 5-year period. In our view, the

committee report merely suggests that Congress intended eligible

taxpayers to employ a method to determine statistically the
 - 30 -

Uncollectible Amount that was similar, but not identical, to the

Black Motor formula. Consequently, we do not find the

legislative history to clearly reveal Congress' intent as to the

method of calculating the Uncollectible Amount. In the absence

of a clear indication of congressional intent on the precise

question in issue, our next task is to decide whether the

temporary regulations13 promulgated under section 448(d)(5) are a

permissible construction of the statute.

Are the Amended Regulations a Permissible Construction of
the Statute?

To be valid, section 1.448-2T(e)(2)(i), Temporary Income Tax

Regs., 53 Fed. Reg. 12513-12514 (Apr. 15, 1988), need not be the

only, or even the best, construction of section 448(d)(5).

Rather, the Amended Regulations need only be a reasonable

interpretation of congressional intent. Chevron U.S.A., Inc. v.

Natural Res. Def. Council, Inc., 467 U.S. at 843; Peoples Fed.

Sav. & Loan Association v. Commissioner, 948 F.2d at 299-300.

"The choice among reasonable interpretations is for the

Commissioner, not the courts." National Muffler Dealers

Association v. United States, 440 U.S. 472, 488 (1979); see also

13
Temporary regulations are entitled to the same weight as
final regulations. Peterson Marital Trust v. Commissioner, 102
T.C. 790, 797 (1994), affd. 78 F.3d 795 (2d Cir. 1996); see also
Truck & Equip. Corp. v. Commissioner, 98 T.C. 141, 149 (1992);
Nissho Iwai Am. Corp. v. Commissioner, 89 T.C. 765, 776 (1987);
Zinniel v. Commissioner, 89 T.C. 357, 369 (1987).
 - 31 -

United States v. Correll, 389 U.S. 299, 306-307 (1967); Udall v.

Tallman, 380 U.S. 1, 16-17 (1965).

The Original Formula as promulgated in section 1.448-

2T(e)(2)(i), Temporary Income Tax Regs., 52 Fed. Reg. 22775 (June

16, 1987), used the Black Motor formula to determine the

Uncollectible Amount.14 The Original Formula provides that the

Uncollectible Amount would be calculated as follows:
Total bad debts with respect to accounts
Uncollectible Accounts receivable sustained during the current
amount of a = receivable x tax year and 5 preceding tax years less
receivable outstanding recoveries of bad debts during that period
at yearend sum of the accounts receivable at
yearend for the same 6-year period

14
As originally promulgated, sec. 1.448-2T(e)(2)(i), Temporary
Income Tax Regs., read as follows:

(2) Six-year moving average--(i) General rule.
For any taxable year the uncollectible amount of a
receivable is the amount which bears the same ratio to
the accounts receivable outstanding at the close of the
taxable year as (A) the total bad debts with respect to
accounts receivable sustained during the period
consisting of the taxable year and the five preceding
taxable years (or with the approval of the
Commissioner, a shorter period), adjusted for
recoveries of bad debts during such period, bears to
(B) the sum of the accounts receivable at the close of
such six (or fewer) taxable years. Accounts receivable
described in paragraphs (c) [amounts due for which
interest is required to be paid, or for which there is
any penalty for failure to timely pay any amounts due]
and (d) [accounts receivables related to amounts not
earned by the taxpayer through the performance of
services by the taxpayer] of this section are not taken
into account in computing the ratio. [Sec. 1.448-
2T(e)(2)(i), Temporary Income Tax Regs., 52 Fed. Reg.
22775 (June 16, 1987)].
 - 32 -

In contrast, the Amended Formula promulgated in section 1.448-

2T(e)(2)(i), Temporary Income Tax Regs., supra, provides for the

Uncollectible Amount to be calculated as follows:
Total bad debts with respect to accounts
Uncollectible Accounts receivable sustained during the current
amount of a = receivable x tax year and 5 preceding tax years less
receivable outstanding recoveries of bad debts during that period
at yearend sum of accounts receivable earned (i.e.,
total sales) for the same 6-year period

The substantive difference between the Original Formula and the

Amended Formula is the substitution in the denominator of the

multiplier of (1) the sum of accounts receivable earned (i.e.,

total sales resulting in accounts receivable) throughout the 6-

year moving average period for (2) the sum of the yearend

accounts receivable for each year during that 6-year period.

One theme recurring throughout petitioners' challenge to the

validity of the Amended Regulations is that the Amended Formula

is defective because it does not use the Black Motor formula to

calculate the Uncollectible Amount. Neither the statute nor its

legislative history, however, contains anything which leads us to

conclude that Congress intended such a result.

We are not persuaded by petitioners' argument that, inasmuch

as the Original Formula is premised on the Black Motor formula,

the Secretary must have initially read the legislative history in

the same manner as suggested by petitioners. Under the

circumstances of the instant case where the Secretary acted

quickly--within 10 months of promulgation of the Original

Temporary Regulations--to amend temporary regulations that he
 - 33 -

concluded erroneously interpreted the statute, he was entitled to

alter his interpretation of the statute on further reflection.

Rust v. Sullivan, 500 U.S. 173, 186 (1991); Chevron U.S.A., Inc.

v. Natural Res. Def. Council, Inc., supra at 862; Peoples Fed.

Sav. & Loan Association v. Commissioner, supra at 302.

The Secretary's rationale for the amendment to the

nonaccrual-experience formula is revealed in the preamble to the

Secretary's Decision announcing the modification:

Under the nonaccrual-experience method of accounting,
the portion of a receivable that is considered uncollectible
and not required to be accrued is the product of the
receivable and a fraction representing the taxpayer's bad
debt experience. The numerator of the fraction is the
taxpayer's bad debts for the taxpayer's current and five
preceding taxable years, and the denominator of the fraction
is the taxpayer's accounts receivable for the same six-year
period. The Internal Revenue Service has received questions
from taxpayers as to whether the denominator of the fraction
is determined on the basis of (i) total accounts receivable
earned throughout the six-year period (i.e., the total
amount of sales resulting in accounts receivable throughout
the period) or (ii) yearend balances of the accounts
receivable over the six-year period. These regulations
provide that the denominator is based on total accounts
receivable earned throughout the period ending at the close
of the six-year period. This interpretation is consistent
with the legislative history of the Act which provides that
"[t]he amount of billings that, on the basis of experience,
will not be collected is equal to the total amount billed,
multiplied by a fraction whose numerator is the total amount
of such receivables which were billed and determined not to
be collectible within the most recent five taxable years of
the taxpayer, and whose denominator is the total of such
amounts billed within the same five year period." H.R. Rep.
No. 99-426, 99th Cong., 1st Sess. 606 (1985). [T.D. 8194,
1988-1 C.B. 186.15]

15
Additionally, as stated above, petitioners agree that the
relevant legislative history is ambiguous.
 - 34 -

As shown by the foregoing statement, the Secretary

reconsidered the Original Temporary Regulations and the

legislative history as a result of questions from taxpayers as to

the proper formula to use to calculate the Uncollectible Amount

which arose following release of the Original Temporary

Regulations. A review of H. Rept. 99-426, at 608 (1985), 1986-3

C.B. (Vol. 2) 1, 608, reveals that the multiplier delineated in

the Amended Formula is consistent with the multiplier described

in the committee report. Accordingly, we conclude that the

Secretary's formulation of the multiplier in the Amended Formula

is reasonable. Whether the Secretary's framing of the

multiplicand is reasonable, however, requires further analysis.

In both the Original Formula and the Amended Formula, the

multiplicand is described as the accounts receivable outstanding

at yearend. As we explained, however, see supra pp. 28-29, the

description of the multiplicand in the committee report is

inconsistent. There, the multiplicand is defined both as the

total amount billed and as the receivables outstanding at the

close of the taxable year.

Petitioners contend that the Amended Formula compares two

sets of incomparable data. They maintain that a comparison of

past bad debts for the current year and 5 preceding years to past

total charge transactions, which includes charge transactions

that are collected in the same year billed as well as amounts not

yet collected, can only predict bad debts in total current charge
 - 35 -

transactions, not in yearend receivables. According to

petitioners, measuring the historical relationship between annual

bad debt writeoffs (net of recoveries) and total annual charges

may be appropriate for estimating the portion of annual charges

that are not likely to be collected but not for purposes of

estimating the portion of yearend accounts receivable that

probably will not be collected. Petitioners contend that the

Amended Formula produces incorrect results and is contrary to the

language and purpose of section 448(d)(5) because it requires the

hospitals to accrue as income amounts which, based on experience,

they will not collect.16

Petitioners assert that the Black Motor formula reasonably

reflects their bad debt experience and should be applied in the

instant case. Petitioners maintain that the Black Motor formula

was intended to provide an estimate of future uncollectibility

based on the taxpayer's actual recent collection experience.

16
According to petitioners, their tax department calculated
that petitioners' actual bad debt experience with respect to
accounts receivable outstanding at the end of 1990 shows that
approximately 21.4 percent of those accounts receivable was
uncollectible during 1991 and 1992. Moreover, with respect to
accounts receivable outstanding as of specified dates in 1987,
approximately 19 percent of those receivables was uncollectible
within a period of 1 year, and approximately 22 percent to 24
percent would become uncollectible within 2 years. In contrast,
petitioners contend, the Amended Formula produces exclusion
ratios of between 3.4 percent and 5.3 percent of revenue for
taxable year ended 1987 and between 2.6 percent and 4.0 percent
of revenue for taxable year ended 1988, depending upon whether
gross billings, billings net of contractual adjustments, or
billings exclusive of Medicare and Medicaid billings are used to
approximate annual charge transactions.
 - 36 -

They assert that the Black Motor formula was merely a tool for

determining a taxpayer's bad debt experience and was not

mandatory for all circumstances. Petitioners contend that, to

correctly apply the Black Motor formula, the regulations should

allow modifications or departures for particular facts and

circumstances. The foregoing arguments indicate that petitioners

use the term "Black Motor formula" to mean the reserve method of

accounting for bad debts that was in effect prior to repeal of

section 166(c) as well as the mathematical formula specified in

the case from which the method derives it name. See Black Motor

Co. v. Commissioner, 41 B.T.A. 300, 302 (1940), affd. on another

issue 125 F.2d 977 (6th Cir. 1942).

As we view their position, petitioners essentially would

prefer to substitute for the nonaccrual-experience method

provided by Congress the reserve method of accounting for bad

debts that was in effect prior to repeal of section 166(c)

whereby the addition to the bad debt reserve was based on a

reasonable amount determined by the taxpayer, with the

reasonableness of that addition tested generally under the Black

Motor formula. See Thor Power Tool Co. v. Commissioner, 439 U.S.

522, 546 (1979); Black Motor Co. v. Commissioner, supra. That

result, however, is not consistent with the statute. Nothing in

the statute or the legislative history requires the Uncollectible

Amount to equal the amount that would have been calculated
 - 37 -

pursuant to either the reserve method of accounting or under the

Black Motor formula.

We also do not agree that the result under the Amended

Formula is not determined on the basis of the hospitals'

experience. The formula utilizes the bad debt history and

accounts receivable of the hospitals, not some fictional entity.

Petitioners contend further that section 448(d)(5) does not

authorize the prescription of a single formula to be used by all

taxpayers. They argue that prescribing a single fixed formula is

inconsistent with the notion of making a determination "on the

basis of experience" and represents an inappropriate departure

from the plain, everyday meaning of the language of section

448(d)(5) because it results in income being accrued on a basis

other than the taxpayer's actual experience.

We do not agree with petitioners that the temporary

regulation is invalid because it provides one formula to be

applied by all taxpayers to determine the Uncollectible Amount.

Although the legislative history of section 448(d)(5) is not

without ambiguity as to the specific formula to be utilized, the

description of the nonaccrual-experience method in the House

report suggests a congressional preference for a fixed formula

for calculating the Uncollectible Amount. See H. Rept. 99-426,

at 608 (1985), 1986-3 C.B. (Vol. 2) 1, 608. The ambiguity in the

legislative history does not arise because the report fails to

use a fixed formula but because it describes that fixed formula
 - 38 -

in two different ways. Although the Black Motor formula is a

conceivable method for calculating the Uncollectible Amount, and

perhaps even a better choice, it is not the only possible method,

and it is not even one of the two versions of the formula that is

described in H. Rept. 99-426, supra at 608, 1986-3 C.B. (Vol. 2)

at 608. Under the circumstances, we must defer to the

Secretary's choice of formula if the method he selected is

reasonable. Chevron U.S.A., Inc. v. Natural Res. Def. Council,

Inc., 467 U.S. at 843; Peoples Fed. Sav. & Loan Association v.

Commissioner, 948 F.2d at 299-300; see also National Muffler

Dealers Association v. United States, 440 U.S. at 488; United

States v. Correll, 389 U.S. at 306-307.

Petitioners further argue essentially that the Amended

Formula cannot be valid because the formula does not equal the

hospitals' actual bad debt writeoff experience. We do not

believe that section 448(d)(5) requires an exact matching of the

Uncollectible Amount with a taxpayer's actual bad debt writeoff

experience. A statistical approximation of the Uncollectible

Amount determined under the prescribed formula appears to be all

that was contemplated by Congress. See H. Rept. 99-426, supra at

608, 1986-3 C.B. (Vol. 2) at 608, H. Conf. Rept. 99-841 (Vol. 2),

at II-288 (1986), 1986-3 C.B. (Vol. 4) 1, 288. As to the

nonaccrual-experience method, the conference report states the

following:
 - 39 -

Effective date

The provision of the conference agreement is effective
for taxable years beginning after December 31, 1986. * * *
Any adjustment required by section 481 as a result of such
change * * * [from the cash method to the accrual method of
accounting] generally shall be taken into account over a
period not to exceed four years. It is the intent of the
conferees that this apply to all changes resulting from the
provision, including any changes necessitated by the rule
that certain accrual taxpayers, including taxpayers
presently on the accrual method of accounting, need not
recognize income on amounts statistically determined not to
be collectible. [H. Conf. Rept. 99-841 (Vol. 2), supra at
II-288, 1986-3 C.B. (Vol. 4) at 288, emphasis added.]

In the Amended Formula, the multiplicand conforms to one of

two multiplicands described in the legislative history. See H.

Rept. 99-426, supra at 608, 1986-3 C.B. (Vol. 2) at 608. The

Amended Formula, furthermore, effectuates the purpose of the

statute. Accordingly, the Secretary's choice of multiplicand is

a permissible construction of section 448(d)(5). Consequently,

under the Chevron rule, we must defer to that construction.

Chevron U.S.A., Inc. v. Natural Res. Def. Council, Inc., supra at

843; Peoples Fed. Sav. & Loan Association v. Commissioner, supra

at 299-300. For the foregoing reasons, we conclude that the

Amended Temporary Regulations are valid.

Is the Periodic System of the Nonaccrual-Experience Method

Valid?

The periodic system of the nonaccrual-experience method is

not described in section 448(d)(5) or in the legislative history.

H. Rept. 99-426, supra at 608, 1986-3 C.B. (Vol. 2) at 608,
 - 40 -

however, specifies that "the Secretary of the Treasury may

provide a periodic system of accounting for billings that, on the

basis of experience, will not be collected where the periodic

system results in the same taxable income as would be the case

were each receivable recorded separately." In Notice 88-51,

1988-1 C.B. 535, the Commissioner published the periodic system

as an alternative to the separate receivable system under section

1.448-2T(e)(3), Temporary Income Tax Regs., 53 Fed. Reg. 12513-

12514 (Apr. 15, 1988).

Petitioners assert that the periodic system provided by the

Commissioner uses an inappropriate formula to estimate the

portion of yearend accounts receivable that a taxpayer will not

collect. Petitioners argue that, to prevent an incorrect result,

a formula applied to yearend accounts receivable balances must be

based on the relationship of writeoffs to yearend accounts

receivable balances, not the relationship of writeoffs to annual

charges. Accordingly, petitioners' challenge to the periodic

system is premised on their contention that the Amended Formula,

on which the periodic system is based, is invalid. We already

have concluded that the Amended Formula is a permissible

construction of section 448(d)(5). Accordingly, we conclude that

the periodic system of the nonaccrual-experience method is

reasonable and, therefore, valid.
 - 41 -

Respondent contends, however, that, inasmuch as petitioners

did not follow the periodic system described in Notice 88-51,

supra, they must use the separate receivable system described in

the Amended Regulations. We do not agree that, under the

circumstances present in the instant case, petitioners should be

denied the use of the periodic system merely because they

challenged the validity of the formulation of the nonaccrual-

experience method formula. Nor do we read Notice 88-51, supra,

as requiring such a result. Based on the foregoing, we conclude

that petitioners may use the periodic system of the nonaccrual-

experience method, but they must calculate the Uncollectible

Amount under the Amended Formula, not under the Original Formula.

Because we conclude that the Black Motor formula is not

mandated under section 448(d)(5), we do not address petitioners'

further argument that they should be allowed to annualize the

actual bad debt writeoff experience of the corporations that were

sold to HealthTrust during 1987 in order to calculate properly

the Uncollectible Amount for 1987 using the Black Motor formula.

To What Income Is the Formula To Be Applied?

Additionally, respondent contends that in substance the

hospitals "sell" medical supplies to their patients. Respondent

maintains that income attributable to such sale of medical

supplies is not eligible for the nonaccrual-experience method.

Respondent asserts further that petitioners' records do not
 - 42 -

adequately delineate accounts receivable arising from the sale of

medical services from accounts receivable arising from the sale

of medical supplies and, therefore, it is not possible to

segregate the hospitals' income between income earned from the

performance of services and income earned from the sale of

medical supplies. As a result, respondent argues, petitioners

may not utilize the nonaccrual-experience method for taxable

years ended 1987 and 1988.

Petitioners counter that the nonaccrual-experience method is

applicable to all of their accounts receivable because all of

their income is derived from the performance of services.

Alternatively, they contend that, even if a portion of their

accounts receivable is derived from the sale of medical supplies,

petitioners nevertheless are entitled to use the nonaccrual-

experience method with respect to that portion of their income

which is derived from the performance of services.

The nonaccrual-experience method is applicable only to

amounts to be received for the performance of services. Sec.

448(d)(5). Neither the Code nor the regulations promulgated

thereunder define what constitutes the performance of services

for purposes of section 448(d)(5). Presumably, the performance

of services would include activities in the fields of health,

law, engineering, architecture, accounting, actuarial science,

performing arts, and consulting. See sec. 448(d)(2) (defining a
 - 43 -

personal service corporation for which section 448(b)(2) grants

an exception to the general prohibition by section 448(a) of the

use of the cash method of accounting by C corporations,

partnerships which have a C corporation as a partner, and tax

shelters).17

Relying on certain State law cases, respondent contends that

the trend is to consider hospital services as part of sale

transactions involving medical supplies. According to

respondent: "This case law endeavors to protect the patient from

defective hospital services, since the patient is unable to

discern or control defective services and because physicians are

depending on the hospital's services in undertaking the patient's

treatment." Respondent thus asserts that any medical services

accompanying a "sale" of medical supplies is part of the "sale"

transaction.

Petitioners deny that the hospitals engage in the sale of

medical supplies. They argue that the hospitals use medical

supplies in the course of providing medical services, but they

maintain that all of their income is derived from the performance

of services. Petitioners contend that the business of operating

17
For purposes of sec. 448(d)(2), the performance of services
in the field of health means the provision of medical services by
physicians, nurses, dentists, and other similar healthcare
professionals. Sec. 1.448-1T(e)(4)(ii), Temporary Income Tax
Regs., 52 Fed. Reg. 22768 (June 16, 1987). In the instant case,
respondent does not deny that the hospitals perform services in
the field of health.
 - 44 -

hospitals is the quintessential service business. They argue

that this Court recognized that principle in St. Luke's Hosp. v.

Commissioner, 35 T.C. 236 (1960), as did the Supreme Court in

Abbott Labs. v. Portland Retail Druggists Association, Inc., 425

U.S. 1 (1976), and the Commissioner in the regulations.

Petitioners maintain that hospitals do not sell merchandise but

rather acquire medical supplies for use in performing medical

services.

In the instant case there is no dispute that the hospitals

engage in service activities within the meaning of section

448(d)(5). Rather, the issue we must resolve is whether income

attributable to medical supplies used in the course of performing

those activities is ineligible for the nonaccrual-experience

method of accounting merely because some part of the accounts

receivable attributable to those medical supplies does not

constitute income earned from the performance of services.

We find inapposite to the issue involved here the State law

cases relied on by respondent. The focus of those cases is on

whether strict tort liability principles should be applied to

hospitals. Those cases are concerned with public policy

considerations as to who should bear the loss from defective,

though not negligent, services and/or products. See McDaniel v.

Baptist Memorial Hosp., 469 F.2d 230 (6th Cir. 1972); Johnson v.

Sears, Roebuck & Co., 355 F. Supp. 1065 (E.D. Wis. 1973); cf.
 - 45 -

Perlmutter v. Beth David Hosp., 308 N.Y. 100, 123 N.E.2d 792, 796

(1954) ("what the complaint alleges and truly describes is not a

purchase and sale of a given quantity of blood, but a furnishing

of blood to plaintiff for transfusion at a stated sum, as part

of, and incidental to, her medical treatment"). Whether strict

tort liability applies under the laws of a particular State is

not determinative as to the issue at hand, which is whether, for

purposes of section 448(d)(5), medical supplies are so connected

to the performance of medical services that income attributable

to the medical supplies constitutes income earned from the

performance of those services. We agree with petitioners that,

for purposes of section 448(d)(5), medical supplies furnished in

the course of rendering medical services are inseparably

connected to the performance of those services and that income

attributable to medical supplies therefore constitutes income

earned from the performance of services within the meaning of

that section.18

18
Our conclusion that income earned through the performance of
services includes income relating to accounts receivable
attributable to medical supplies used in the course of the
diagnosis, prognosis, and treatment of the hospitals' patients is
applicable in the instant case only for purposes of our
construction of sec. 448(d)(5). We do not decide in this
opinion, as we did not decide in our prior Memorandum Opinion,
Hosp. Corp. of America v. Commissioner, T.C. Memo. 1996-105, the
question of whether the furnishing of medical supplies by
petitioners' hospitals as a part of the rendering of services to
their patients could be considered to be a sale of merchandise
which must be inventoried pursuant to sec. 1.471-1, Income Tax
(continued...)
 - 46 -

Medical supplies play a necessary and vital role in the

diagnosis, prognosis, and treatment of the hospitals' patients.

In many cases, medical services can not be rendered without using

medical supplies. The furnishing of medical supplies by the

hospitals is merely incidental to the main purpose of rendering

health care services that a patient seeks when entering a

hospital. The hospitals do not acquire medical supplies for sale

to patients but rather to render medical services. Moreover,

under current payment arrangements between the hospitals and

public and private insurers, the hospitals' bills to patients

generally bear no particular relationship to the amounts that the

hospitals actually will be paid for the services provided.

Patients, furthermore, do not come to the hospitals to buy

medical supplies; rather, they are there primarily to obtain a

course of treatment. In many cases patients are not even aware

of all of the medical supplies that are used in the course of the

medical treatment. Patients generally are concerned with the

treatment and healing processes and not with the medical supplies

utilized by the hospitals in rendering medical treatment.

18
(...continued)
Regs. Our conclusion here does not change the result in our
prior Memorandum Opinion, given that for the years ended 1981
through 1986 petitioners' hospitals employed a hybrid method of
accounting, not the cash method or an accrual method. Our
holding applies equally to any accounts receivable attributable
to medical supplies that are dispensed to employees or dependents
of employees for their personal use.
 - 47 -

Patients do not choose which or how many medical supplies will be

used by the hospitals' staffs. With a few exceptions, patients

receive no tangible item that they did not have before the

rendition of the medical services because the medical supplies

generally are used and then discarded by the hospitals.

Patients, moreover, generally do not acquire any rights over the

medical supplies used by the hospitals in the normal course of

the hospitals' operations of providing health care services. We

conclude that for purposes of section 448(d)(5) the use of

medical supplies is part of the medical services furnished

patients and that the cost of those supplies is an incidental

cost of the health care services provided by the hospitals. See

Potter v. James, 499 F. Supp. 607, 611 (M.D. Ala. 1980).

We find support for our conclusion in Abbott Labs. v.

Portland Retail Druggists Association, 425 U.S. at 14-15. In

Abbott Labs. a group of commercial pharmacies brought suit under

the Robinson-Patman Price Discrimination Act (Robinson-Patman

Act), ch. 592, 49 Stat. 1526 (1936) (current version at 15 U.S.C.

secs. 13-13(b), 21(a) (1994)),19 against 12 manufacturers of

pharmaceutical products, alleging that the manufacturers sold

their products to hospitals at prices lower than the prices

19
The Robinson-Patman Price Discrimination Act (Robinson-
Patman Act), ch. 592, 49 Stat. 1526 (1936) (current version at 15
U.S.C. secs. 13-13(b), 21(a) (1994)), generally made it illegal
for a seller of merchandise to discriminate in price among
different purchasers of like commodities.
 - 48 -

charged commercial pharmacies for the same type of products. The

manufacturers countered that sales to the hospitals were exempt

from the Robinson-Patman Act under the Nonprofit Institutions

Act, ch. 283, 52 Stat. 446 (1938) (current version at 15 U.S.C.

sec. 13(c) (1994)), which exempts from the application of the

Robinson-Patman Act "purchases of their supplies for their own

use by * * * hospitals and charitable institutions not operated

for profit." Accordingly, the issue in the Abbott Labs. case was

whether the pharmaceutical products were sold to the hospitals

for resale or for the hospitals' "own use". The Supreme Court

specifically recognized that the purchase of drugs for the

treatment of a hospital's patients is a purchase for that

hospital's "own use" because such use is part of and promotes the

hospital's basic function of caring for patients. Abbott Labs.

v. Portland Retail Druggists Association, supra at 10, 14; see

also St. Luke's Hosp. v. Commissioner, 35 T.C. at 238 (taxpayer

hospital is "not a merchandising business and * * * [taxpayer]

has no merchandise inventories which would require the use of an

accrual method in keeping its books or reporting its income. Its

income is derived from providing hospital and professional care

to the sick.").

We conclude from the foregoing that, for purposes of section

448(d)(5), income earned through the performance of services

includes income relating to accounts receivable attributable to
 - 49 -

medical supplies used in the course of the diagnosis, prognosis,

or treatment of the hospitals' patients. Cf. secs. 1.448-

1T(e)(4), 1.448-2T(d), Temporary Income Tax Regs., 52 Fed. Reg.

22768, 22775 (June 16, 1987). Therefore, no allocation of income

between income attributable to the performance of services and

income attributable to medical supplies is necessary in the

instant case for the purpose of applying the nonaccrual-

experience method of accounting.

Accordingly, we hold that petitioners' hospitals may utilize

the nonaccrual-experience method of accounting for taxable years

ended 1987 and 1988. We hold further that the nonaccrual-

experience method is applicable to income relating to accounts

receivable attributable to medical services and accounts

receivable attributable to medical supplies.

To reflect the foregoing,

Appropriate orders

will be issued.