Rameau A. and Phyllis A. Johnson v. Commissioner

108 T.C. No. 22

UNITED STATES TAX COURT

RAMEAU A. AND PHYLLIS A. JOHNSON, ET AL.,1 Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 16038-93, 16039-93, Filed June 16, 1997.
17007-93, 14430-94.

Ds sold multiyear vehicle service contracts
(VSC's) in connection with the sale of motor vehicles
under a common program administered by A, an unrelated
party. Under the terms of the program, Ds retained a
portion of the contract price as their profit and
remitted the remainder to A: (1) For deposit of a
specified amount in escrow to fund their obligations
under the VSC, and (2) for payment of A's fees and a
premium for excess loss insurance provided by an
unrelated insurance company. Ds currently included in
gross income only the portion of the contract price
that they retained as profit. Ds reported amounts held
in escrow only when released to them.

1
Cases of the following petitioners are consolidated
herewith: Thomas R. and Karon S. Herring, docket No. 16039-93;
DFM Investment Co., docket No. 17007-93; and David F. and
Barbara J. Mungenast, docket No. 14430-94.
 - 2 -

Held:

1.(a) At the time Ds sold a VSC they acquired a
fixed right to receive, and must currently include in
gross income, the portion of the contract price
deposited in escrow. The reasoning of Commissioner v.
Hansen, 360 U.S. 446 (1959), controls.

(b) This amount did not constitute a purchaser
deposit. Commissioner v. Indianapolis Power & Light
Co., 493 U.S. 203 (1990), distinguished.

(c) Nor did this amount constitute a trust fund
for the benefit of the purchaser. Angelus Funeral Home
v. Commissioner, 47 T.C. 391 (1967), affd. on other
grounds 407 F.2d 210 (9th Cir. 1969), and Miele v.
Commissioner, 72 T.C. 284 (1979), distinguished.

2. Pursuant to secs. 671 and 677, I.R.C., Ds are
treated as owners of the escrow accounts and must
currently include investment income of the accounts in
gross income. Effect of sec. 468B(g), I.R.C.,
explained.

3. Premiums are capital expenditures that must be
recovered through amortization. Fees are deductible in
accordance with a formula that reasonably measures A’s
performance of services over the life of the VSC’s. Ds
may not either currently deduct these payments to
offset income they are required to recognize with
respect to the corresponding portions of the contract
price or defer recognition of income until the
offsetting deductions are allowable.

4. An adjustment under sec. 481, I.R.C., is
sustained.

Kenneth G. Kolmin, Francis J. Emmons, and Aaron E. Hoffman,

for petitioners.

Karen J. Goheen and Elsie Hall, for respondent.
 - 3 -

BEGHE, Judge: Respondent determined deficiencies in

petitioners' Federal income tax, additions to tax and penalties

as follows:2

Rameau A. Johnson and Phyllis A. Johnson (the Johnsons),

docket No. 16038-93.

Penalty
Year Deficiency Sec. 6662(a)
1991 $4,097 $819

Thomas R. Herring and Karon S. Herring (the Herrings),

docket No. 16039-93.

Penalty
Year Deficiency Sec. 6662(a)
1991 $2,093 $419

DFM Investment Co., d.b.a. St. Louis Honda, docket No.

17007-93.

Addition to Tax Penalty
Year Ended Deficiency Sec. 6653(a) Sec. 6662(a)

Mar. 31, 1989 $2,285 $114 - 0 -
Mar. 31, 1990 110,378 - 0 - $22,076
Mar. 31, 1992 34,686 - 0 - 6,937

David F. Mungenast and Barbara J. Mungenast (the Mungenasts)

docket No. 14430-94.

Addition to Tax Penalty
Year Deficiency Sec. 6651(a)(1) Sec. 6662(a)
1990 $355,623 $27,492 $71,125
1991 84,431 5,316 16,886

2
Unless otherwise indicated, section references are to the
Internal Revenue Code in effect for the years at issue. All Rule
references are to the Tax Court Rules of Practice and Procedure.
 - 4 -

These cases were consolidated for trial, briefing, and

opinion by reason of the presence of common issues regarding the

methods used by certain motor vehicle dealerships to report

income and expense on the sale of multiyear vehicle service

contracts (VSC's). In docket Nos. 16038-93, 16039-93, and 17007-

93 all the adjustments are attributable to these common issues.

In docket No. 14430-94 only the adjustments related to the tax

treatment of VSC's have been consolidated; the remaining

adjustments were settled by the parties separately. Prior to

trial, respondent revised the adjustments on the basis of more

complete information, as a result of which the deficiencies now

asserted are lower than those set forth in the notices of

deficiency. Respondent has also conceded the addition to tax

under section 6653(a) in docket No. 17007-93 and penalties under

section 6662(a) in all dockets to the extent attributable to the

consolidated issues. The issues that remain for decision are:

1. Whether accrual basis motor vehicle dealerships may

exclude from gross income for the year of the sale of a VSC that

portion of the contract price that they were required to deposit

in escrow to secure their obligations under the contract;

2. whether the dealerships may exclude from gross income

the investment income earned by the funds held in escrow; and

3. whether the dealerships may exclude or deduct from

gross income for the year of the sale of a VSC those portions of
 - 5 -

the contract price that they remitted to third parties as

prepayments of service fees for administration of the VSC program

and an insurance premium for indemnification of their losses

under the program. If respondent prevails on these issues, we

must further decide whether the income of one of the dealerships

is subject to an additional adjustment pursuant to section 481.

We hold that the dealerships' method of accounting for VSC's

was not a proper application of the accrual method, and, except

in regard to the treatment of the dealerships’ administrative fee

expenses, we sustain respondent's revised adjustments in full.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

The stipulations of fact and attached exhibits are incorporated

by this reference. At the times they filed their petitions, the

Johnsons, the Herrings, and the Mungenasts were residents of, and

DFM Investment Co. maintained its principal place of business in,

the State of Missouri. The relationships between petitioners and

the dealerships whose method of accounting for VSC's is the

subject of controversy in these cases (collectively, the

Dealerships) are set forth below:

Corporate Doing Tax Status During Petitioners
Name Business As Taxable Yr.(s) At Issue Owning Shares

DFM Investment Co. St. Louis Honda Subchapter C corp. David Mungenast
(at least 82%)
DRK Investment Co. St. Louis Acura Subchapter S corp. David Mungenast
(100%)
Capco Sales, Inc. St. Louis Lexus Subchapter S corp. David Mungenast
(100%)
 - 6 -

MAD Investment Co. Alton Toyota/Dodge (not in evidence) David Mungenast
(prior to 1991) (not in evidence)
DAR, Inc. Alton Toyota/Dodge Subchapter S corp. David Mungenast
(beginning 1991) (50%), Rameau
Johnson (33%),
Thomas Herring (17%)

During the years at issue, the four Dealerships offered

VSC's under a common program in conjunction with the sale of new

and used motor vehicles. Before October 1991 the program was

administered by Mechanical Breakdown, Inc. (MBP), a corporation

unrelated to petitioners. From October 1991 through March 1992,

the program was administered by Automotive Professionals, Inc.

(API), also unrelated to petitioners, but the structure and

operation of the program remained, in all material respects,

substantially unchanged.3 A standard form of VSC recites that it

is a contract between the issuing dealer and the motor vehicle

purchaser (referred to in some contracts as the "contract

holder"). Under the terms of the VSC, the dealer agrees, for a

fixed price, to

make repairs or replace any of the below listed parts
or components of the Contract Holder's Vehicle covered
hereunder or cause such repairs or replacement to be
made by an authorized repair facility at no cost for
parts or labor to the Contract Holder (but subject to
applicable deductible, if any) whenever covered
components or parts in the Contract Holder's said
Vehicle experience a Mechanical Breakdown.

3
MBP continued to administer contracts sold before October
1991. All contracts sold thereafter were administered by API.
Where a distinction is appropriate, we will refer to “the program
administered by MBP” and “the program administered by API.”
 - 7 -

The parties agree that the full purchase price of the VSC was due

and collected at the time of sale.4

The VSC purchaser can select the term of coverage he desires

from a range of options, each defined by reference to a specified

time or mileage limitation, whichever is reached first.

Approximately three-quarters of the contracts sold by the

Dealerships during the years at issue provided coverage for at

least 5 years or 60,000 miles. However, the aggregate limit of a

dealer's liability is fixed in some of the contracts as the value

of the vehicle at the time of purchase and in the rest of the

contracts as the lesser of the value of the vehicle at the time

of purchase or $10,000.

The VSC provides that

A specific amount of the Contract purchase price shall
be held in escrow in accordance with and as specified
in Automotive Professionals, Inc.'s Administrator
Agreement, a copy of which is available from the
Dealer. Said amount shall be paid directly to the
escrow account established by the Administrator and

4
Purchasers had the option to finance the contract by
adding the purchase price to the installments payable for the
vehicle. Although the details of the financing arrangements are
not disclosed by the record, presumably the Dealership would
immediately assign the purchaser's installment obligation to a
finance company for cash, in accordance with the conventional
practice for financed sales of motor vehicles. See Commissioner
v. Hansen, 360 U.S. 446 (1959); Resale Mobile Homes, Inc. v.
Commissioner, 91 T.C. 1085 (1988), affd. 965 F.2d 818 (10th Cir.
1992). Neither party suggests that the tax treatment of VSC's
should be affected by the use of financing. The parties'
stipulations and arguments on brief assume that the full contract
price was due and paid in cash at the time of the sale. For
convenience of analysis, we do so also.
 - 8 -

Brokerage Professionals, Inc., the Escrow Trustees.
* * * All amounts placed in escrow, together with
accrued investment income, shall constitute a Primary
Loss Reserve Fund (the "Reserves") for payment of
claims covered by the Contract. Dealer further agrees
to provide an insurance policy with the Travelers
Indemnity Company to cover claims in excess of the
Reserves and continue to maintain said policy in force
during the term of this Contract.

The purchaser is directed to return the vehicle to the

dealer in the event of a mechanical breakdown. Repairs performed

by another repair facility are not covered by the contract unless

the purchaser secures the Administrator's prior authorization.

When the Administrator authorizes covered repairs by another

repair facility, the Administrator arranges for payment of the

claim from the Primary Loss Reserve Fund (PLRF) on the dealer's

behalf.

The purchaser is entitled to cancel the VSC at any time upon

payment of a nominal service charge. The purchaser’s

cancellation rights are spelled out in the contract as follows:

1. This contract may be cancelled and the entire
Contract purchase price will be refunded by the Dealer
to the Contract Holder/lienholder if notice of
cancellation is given during the first sixty (60) days
provided a claim has not been filed hereunder.

2. If a claim was authorized during the first sixty
(60) days or if a cancellation is requested after the
first sixty (60) days, the pro-rata unearned Contract
purchase price will be refunded by the Dealer to the
Contract Holder/lienholder based on the greater of the
days in force or the miles driven related to the terms
of this Contract.
 - 9 -

The purchaser's rights against other entities participating

in the program that are not parties to the contract is expressly

limited:

The Administrator does not assume and specifically
disclaims any lability to the Purchaser. The liability
of the Administrator is to the issuing Dealer only in
accordance with their separate agreement. If the
dealer fails to pay an authorized covered claim within
sixty (60) days after proof of loss has been filed or,
in the event of cancellation, the dealer fails to
refund the unearned portion of the consideration paid,
the purchaser is entitled to make a claim directly
against the Travelers Indemnity Company * * * through
its managing agent.

Each Dealership also entered into an Administrator

Agreement. The other parties to the agreement were MBP or API,

the Travelers Indemnity Co. (Travelers), and Travelers' managing

agent during the years at issue, Brokerage Professionals, Inc.

(BPI), referred to in the agreement as Administrator, Insurer,

and Managing Agent, respectively. The Administrator Agreement

provides for the establishment of "one or more trust funds or

custodial accounts with financial institutions and/or money

market funds in the name of the Administrator and Managing Agent

as Escrow Trustees (the `Escrow Account(s)’)." Under the program

administered by API, a separate account was established in the

name of the Trustees for each Dealership at a bank called the

Massachusetts Co. Under the program administered by MBP, the

Trustees, in the exercise of their discretion, maintained all

reserves deposited by the Dealerships in a single account at the
 - 10 -

Mercantile Bank of St. Louis. In order to implement the

provisions of the Administrator Agreement for release and

forfeiture of reserves, it would nevertheless have been necessary

to account for the reserves attributable to each Dealership

separately. The Administrator Agreement states:

All reserves in the Escrow Account(s) shall be held
for the primary benefit of Contract holders to secure
Dealer's performance under the Contracts and to pay for
valid claims arising under the Contracts. Dealer shall
have no beneficial or other property interest in the
Reserves or investment income in the Escrow Account(s);
nor can Dealer assign, pledge or transfer such
Reserves.

The disposition of the purchase price collected from the

contract holder was subject to detailed procedures set forth in

the Administrator Agreement. The Dealership retained a portion

as its profit. Of the remainder, specified amounts were payable

to the PLRF as reserves, to Travelers as a premium for excess

loss insurance over the full term of the contract (Premium), to

MBP or API as a fee for administrative services (Fees), and to

each of BPI and the company that marketed the VSC program on the

Administrator's behalf as a commission (Commissions). The

Administrator Agreement provides that "Dealer agrees to accept

and hold such monies as a fiduciary in trust and shall be

responsible for the proper and timely remittance of the same to

the Administrator, Managing Agent or Escrow Accounts(s)." The

PLRF deposits, Premiums, Fees, and Commissions payable with

respect to all VSC's sold during a given month were required to
 - 11 -

be remitted by check to the Administrator no later than the 15th

day of the following month, together with a remittance report

summarizing VSC sales during the month. After verification and

processing of the information contained in the remittance

reports, the Dealerships' payments were distributed

appropriately.

The Administrator Agreement provided for the refund of these

payments in the event that the VSC was canceled in accordance

with its terms. The "unearned" portions of: (1) Reserves

attributable to the canceled contract (exclusive of any

investment income), (2) the Fees, (3) the Premium, and (4) the

Commissions were refunded to the dealer, who then would forward

the combined amounts of these refunds, plus the "unearned"

portion of its profit on the sale to the purchaser.

The Dealerships' access to the reserves held in escrow was

strictly controlled. Under the Administrator Agreement, release

of reserves to a dealer required the approval of both Escrow

Trustees and was limited to the following circumstances:

1. When the dealer had performed repairs for a contract

holder, it was entitled to compensation at standard rates for

parts and labor.

2. When a VSC sold by the dealer was canceled in accordance

with its terms, the dealer was entitled to the return of the

amount it owed to the contract holder.
 - 12 -

3. When a VSC sold by the dealer expired, the dealer was

entitled to the release of unconsumed reserves attributable to

that contract, subject to certain limitations. First, under the

program administered by MBP, corpus and investment income of the

PLRF were separately accounted for, and the dealer was not

entitled to release of the investment income portion of the

unconsumed reserves. This limitation was relaxed under the

program administered by API; corpus and income were available for

release to the dealer on the same terms. Second, a dealer

forfeited its right to unconsumed reserves attributable to a

contract if it committed certain specified acts of default:

Failure to achieve a minimum sales quota in the year the contract

was sold, breach of the Administrator Agreement, bankruptcy,

termination of participation in the program without achieving a

minimum balance in its PLRF account, dissolution without a

successor in interest, and the like. Third, no unconsumed

reserves were released unless, in the judgment of the Escrow

Trustees and Travelers, the dealer's account balance would remain

at an actuarially safe level for satisfaction of the dealer's

obligations under all unexpired contracts. It was Travelers'

policy to approve release of unconsumed reserves only to the

extent that the particular dealer's loss to earned reserve ratio

did not exceed 70 percent.
 - 13 -

The Administrator Agreement provided for release of reserves

to other parties under the following circumstances:

1. When a claim for covered repairs was submitted by an

authorized repair facility other than the dealer that sold the

VSC, the Administrator withdrew funds for payment.

2. Under the program administered by MBP, investment income

not used to pay claims or refunds was payable to the

Administrator upon expiration of the contract to which it was

attributable, provided that the dealer's account would remain at

an actuarially safe level.

3. Upon expiration of all the contracts of a dealer and

payment of all claims, any unconsumed reserves that the dealer

had forfeited for one reason or another became the property of

the Administrator.

4. Travelers was entitled to reimbursement from a dealer's

account in the event that it was required to pay a claim or

refund by reason of the dealer's delinquency or default.
 - 14 -

Pursuant to the Administrator Agreement, the Dealerships

were subject to audit by the Administrator, BPI, and Travelers to

verify that their requests for disbursements from the PLRF

accounts complied with these terms. An audit of Alton

Toyota/Dodge in January 1992 called certain claims for repairs

into question and resulted in restitution of payments to the

PLRF. The parties agree that otherwise all payments of reserves

to the Dealerships during the years at issue were made strictly

in accordance with the terms of the Administrator Agreement.

The Administrator Agreement imposed upon the Escrow Trustees

a duty to report the status of the PLRF accounts to the other

parties to the agreement on a monthly basis. Inasmuch as the VSC

purchasers were not parties to the agreement, the Trustees were

not required to report to them.

A separate Escrow Agreement was entered into between the

Escrow Trustees and either Mercantile Bank of St. Louis or

Massachusetts Co., acting as the escrow depository. The Escrow

Agreement provides that the bank will establish Primary Loss

Reserve Fund escrow accounts "for the Dealer Group", and that

"each dealer depositor will be insured pursuant to the

regulations and rules adopted from time to time by F.D.I.C."

Under Automobile Dealers Service Contract Excess Insurance

policies issued by Travelers, each of the Dealerships was

entitled to indemnification for covered losses exceeding the
 - 15 -

aggregate amount of reserves deposited by the Dealership in the

PLRF plus the accumulated investment income. The excess loss

insurance policies were renewed on an annual basis throughout the

period at issue.

In 1987, the Dealerships began offering VSC's under the

program outlined above. Until a few years before, dealerships in

which petitioner David Mungenast held an interest had sold

similar vehicle service contracts under a program administered by

a company called North American Dealer Services, Inc. (NADS). It

appears that under that program amounts paid by the dealerships

to NADS to insure their losses had been subject to NADS'

unfettered control. NADS had gone bankrupt, causing the

Dealerships to sustain heavy losses honoring their contractual

obligations without indemnification. The program administered by

MBP and API was designed to offer dealerships greater security

than the NADS program. In marketing the program to the

Dealerships, salesmen for MBP stressed the security provided by

the escrow arrangement and by Travelers' reputation as a major

insurance company. In his decision to adopt the MBP program for

the Dealerships, David Mungenast attached considerable

significance to these characteristics.

The Dealerships evidently believed that Travelers'

participation in the program would be important to their

customers. Promotional literature for the program that the
 - 16 -

Dealerships distributed to their customers emphasized that

"Insurance for this plan is provided by one of the six largest

property and casualty insurance companies in the United States",

and the manager of Alton Toyota/Dodge during the years at issue

kept a red Travelers umbrella in his office to use as part of his

sales presentation. On the other hand, neither the manager of

Alton Toyota/Dodge nor the salesmen of the Dealerships generally

called attention to the PLRF arrangement in their presentations

to customers and did not show them the Administrator Agreement

that governed the PLRF arrangement. No contract holder has ever

requested API to furnish information regarding the status of a

PLRF account.

All of the Dealerships maintained their books and records

under the accrual method of accounting. On their Federal income

tax returns for each of the years at issue, the Dealerships

reported as income from the sale of VSC's only that portion of

the contract price that they retained as profit. The PLRF

accounts were not reflected on the Dealerships' returns for these

years, and the income earned by investment of these reserves was

not currently included in their gross income. The Dealerships

included reserves in income only when, and to the extent, paid to

them from the PLRF accounts.

For calendar year 1992 and subsequent years, the Escrow

Trustees have filed Forms 1041, U.S. Fiduciary Income Tax Return,
 - 17 -

with respect to each of the PLRF accounts. These returns treat

the investment income as if the PLRF accounts were complex

trusts. The Escrow Trustees were of the opinion that this

treatment was required by final regulations under section 468B

issued in December 1992.

Respondent determined that the Dealerships' method of

accounting for the VSC’s did not clearly reflect income because

it resulted in omission of items of income and premature

deduction of some items of expense. Respondent computed

adjustments to their income for each of the years at issue in a

manner designed to result in inclusion of the full purchase price

of contracts sold during the year and deferral of deductions for

related expenses until later years. Respondent further required

the Dealerships to include in income their respective shares of

the investment income of the PLRF accounts as it accrued.

Finally, respondent included in the income of certain Dealerships

an additional amount pursuant to section 481. Only the section

481 adjustment asserted against DFM Investment Co. is at issue in

these proceedings.
 - 18 -

OPINION

1. Portion of Contract Price Deposited in the PLRF

a. Respondent's Theory

Section 451(a) provides that the amount of any item of

income shall be included in gross income for the taxable year

in which received by the taxpayer, unless, under the method of

accounting used in computing taxable income, the amount is

properly accounted for as of a different period. Under the

accrual method of accounting, income is includable for the

taxable year when all the events have occurred that fix the right

to receive the income and the amount of the income can be

determined with reasonable accuracy. Secs. 1.446-1(c)(1)(ii),

1.451-1(a), Income Tax Regs. Generally, all the events that

fix the right to receive income have occurred when it is: (1)

Actually or constructively received; (2) due; or (3) earned by

performance, whichever comes first. Schlude v. Commissioner, 372

U.S. 128 (1963); Union Mut. Life Ins. Co. v. United States, 570

F.2d 382, 385 (1st Cir. 1978); Automobile Club of New York, Inc.

v. Commissioner, 32 T.C. 906, 911-913 (1959), affd. 304 F.2d 781

(2d Cir. 1962).

A line of cases beginning with Commissioner v. Hansen, 360

U.S. 446 (1959), expounds the conditions under which a taxpayer's

right to receive income becomes fixed where payment to the

taxpayer is withheld or deposited in a reserve account. The
 - 19 -

taxpayers in Hansen were accrual basis retail dealers who sold

automobiles and house trailers on credit and then assigned the

consumer installment paper to a finance company, guaranteeing the

consumer's payment. The finance company paid the dealer cash

equal to the face amount of the installment paper less a

specified percentage that the finance company credited to a

reserve account and withheld as collateral to secure the dealer's

guaranty and other obligations to the finance company.

Periodically the finance company released to the dealer amounts

in the reserve exceeding a stated percentage of the unpaid

balances on installment paper purchased from the dealer. On

their tax returns the dealers currently included in income only

the amounts paid to them by the finance company. The dealers

contended, first, that they had no right to receive amounts that

they could not currently compel the finance company to pay them;

second, their right to receive reserves did not become fixed so

long as the amount that they would ultimately recover was subject

to their contingent liabilities to the finance company.

Accordingly, the dealers argued, there was no basis for accrual

of the reserves as income for the year in which the reserves were

withheld and credited to the dealer's account.

The Supreme Court rejected the dealers' first argument,

stating that, under the accrual method, it was the time of

acquisition of the fixed right to receive the reserves, not the
 - 20 -

time of their actual receipt, that controlled when the reserves

must be reported as income. Id. at 464. In reply to the

dealers' second argument, the Court observed that only one of two

things could happen to the reserves: Either they would be paid

to the dealer or applied in satisfaction of the dealer's

obligations to the finance company. As the dealer would thus

effectively receive the entire amount of the reserves in all

events, the right to receive the reserves was not conditional but

absolute at the time they were withheld and credited to the

dealer's account, and the dealer accordingly realized income at

that time. Id. at 465-466.

In General Gas Corp. v. Commissioner, 293 F.2d 35 (5th Cir.

1961), affg. 33 T.C. 303 (1959), the taxpayer was a natural gas

distributor that sold the installment paper generated by sales of

tanks and appliances to its customers to a finance company for a

price equal to its face amount, which included finance charges

payable ratably over the full term of the installment contract.

The finance company paid the taxpayer only 90 percent of the

merchandise price, withholding the remaining 10 percent plus the

amount of the finance charges in a dealer reserve account to

secure the taxpayer’s guaranty of payment on the installment

paper. The taxpayer did not currently include the reserves in

its income. Affirming this Court, the Court of Appeals followed

Hansen, reasoning that since the entire amount of the reserves
 - 21 -

would eventually either be paid to the taxpayer or used to

discharge its liabilities, the taxpayer had a fixed right to

receive, and must currently include, amounts credited to its

reserve account. The Court of Appeals rejected the taxpayer's

argument that Hansen was distinguishable because the reserves

represented, in part, finance charges that the taxpayer would

have reported as income ratably over the term of the installment

contract, as earned, if it had retained the customer’s

installment paper. The Court of Appeals was not persuaded that

the finance charges included in the consideration for the sale of

the paper should be accounted for in the same manner as finance

charges earned and received over time by the holder of the paper.

The Court of Appeals reasoned that the taxpayer materially

altered its economic position by selling the paper. Not only did

it reduce its risk exposure; it also benefited by receiving

immediate credit for an amount corresponding to the full amount

of the finance charges and, depending on the balance in its

account, the credits could produce distributable cash long before

the installments would be collectible from the consumer. Id. at

41.

Since General Gas Corp. v. Commissioner, supra, the courts

have repeatedly held that accrual basis retailers must currently

include the portion of the amount realized on the sale of

installment paper attributable to "participation interest", even
 - 22 -

though it is withheld in a reserve account to secure the

retailer's guaranty obligations and is subject to forfeiture to

the extent that the interest otherwise payable to the finance

company under the installment paper is either abated, as a result

of the consumer's prepayment of the balance of his debt, or

becomes uncollectible. Resale Mobile Homes, Inc. v.

Commissioner, 965 F.2d 818 (10th Cir. 1992), affg. 91 T.C. 1085

(1988); Shapiro v. Commissioner, 295 F.2d 306 (9th Cir. 1961),

affg. T.C. Memo. 1959-151; Federated Dept. Stores, Inc. v.

Commissioner, 51 T.C. 500 (1968), affd. on other issues 426 F.2d

417 (6th Cir. 1970); Klimate Master, Inc. v. Commissioner, T.C.

Memo. 1981-292.

The principles enunciated in the dealer reserve cases have

been affirmed in other multiparty transactions in which payments

to the taxpayer are withheld or deposited in reserve as security

for the taxpayer's executory obligations. Thus, in Stendig v.

United States, 843 F.2d 163 (4th Cir. 1988), an accrual basis

taxpayer that constructed and operated a low-income apartment

complex financed by the Virginia Housing Development Authority

(VHDA) was required to secure both its loan from VHDA and its

obligations to maintain and operate the complex by depositing a

portion of the rents collected from tenants into reserve accounts

under VHDA's control. The Court of Appeals held that the rule of

Hansen required the taxpayer to include the rent deposits in
 - 23 -

income when collected. Although the amount of the reserves that

the taxpayer would ultimately recover was not ascertainable at

the time of deposit, in all cases disposition of the reserves

would inure to the taxpayer's benefit, and therefore the right to

receive was fixed. See also Bolling v. Commissioner, 357 F.2d 3

(8th Cir. 1966), affg. in relevant part and revg. and remanding

on other issues T.C. Memo. 1964-143.

Respondent's position is that the cases at hand are

controlled by the Hansen line of cases. Respondent argues that

the Dealerships acquired a fixed right to receive the full

purchase price of the VSC at the time of the sale, even though

they were required by contract immediately to deposit a portion

in an escrow account. We agree.

Petitioners take the position that amounts deposited by a

Dealership in the PLRF were not includable in its gross income

unless or until actually released to the Dealership as payment

for covered repairs or, upon expiration of the VSC, as unconsumed

reserves. Petitioners reason as follows: the VSC's are

executory contracts. The issuing Dealership earned the amounts

required to be paid under their terms through performance. At

the time the VSC's were entered into, the issuing Dealership had

not earned and was not entitled to be paid any portion of the

funds required to be held in escrow. The first time the issuing

Dealership had any right to this portion of the contract holder's
 - 24 -

payment was when (or if) it made repairs covered by the terms of

the VSC. If no such repairs were made, the money remained in

escrow until the VSC expired, and even then would not be paid to

the issuing Dealership unless all of the conditions for a release

of unconsumed reserves were met.

There are a number of problems with petitioners’ argument.

First, it confuses the right to receive with both earning through

performance and the right to present payment. Each of these

rights is independently sufficient to require accrual under the

all events test. Schlude v. Commissioner, 372 U.S. 128 (1963);

Automobile Club of New York, Inc. v. Commissioner, 32 T.C. at

911-913. That the Dealerships could not compel the Escrow

Trustees to pay reserves from the escrow accounts does not

control the determination of whether the Dealerships had a fixed

right to receive them. Commissioner v. Hansen, 360 U.S. at 464.

Nor is it dispositive that the Dealerships had not performed any

repair services under the VSC's at the time they collected the

purchase price and deposited it in escrow. Petitioners'

confusion on this point causes them to misread the relevant case

authorities. Thus, they argue that the fact that the cases at

hand concern executory service contracts distinguishes them

materially from the Hansen line of cases:

Hansen and Resale Mobile Homes both involve the sale of
retail installment contracts. In the context of a sale
of property, these cases held that the taxpayers had to
currently recognize the agreed purchase price for the
 - 25 -

installment contracts as income at the time of sale
since the transfer of the property by them to their
respective purchasers established their right to be
paid. Here, in contrast, we are dealing with executory
service contracts which can be terminated at will by
the Contract Holder. At the time the VSC is entered
into, the Dealerships have only a conditional right to
receive a portion of agreed purchase price, and no
right to receive the amount required to be held in
Escrow. This fundamental difference undoes all of
Respondent's argument based on Hansen and Resale Mobile
Homes.

The distinction that petitioners draw between executory

service contracts and completed sales of property misrepresents

the issue in the dealer reserve cases and their holdings. If the

transactions at issue in those cases had simply been closed and

completed sales of property, then no portion of the purchase

price would have been withheld in reserve. The dealer reserves

were established precisely for the purpose of securing executory

obligations of the taxpayer as guarantor of future payments on

the installment paper. The cases held that the taxpayer acquired

a fixed right to receive the reserves notwithstanding the

possibility that, as guarantor of the consumer's performance, the

taxpayer would forfeit some or all of the reserves to the finance

company in the event that the consumer defaulted or paid off the

balance of the loan prematurely, terminating the installment

contract before the scheduled interest was earned.

Another problem with petitioners' argument is that it

assumes that the proper method of reporting income from the sale

of VSC's is the same as the method the Dealerships are entitled
 - 26 -

to use to report income from repairs that they perform on a fee-

for-service basis. In making this assumption they fail to

appreciate that the economic position of the Dealership (as well

as that of the customer) is materially different in the two

situations. When the Dealership sells a motor vehicle without a

VSC, the income it may earn from servicing the vehicle is

contingent in both time and amount; the Dealership would properly

report income in the future as earned by performance of services.

It would be impracticable to accrue this contingent service

income in the year the vehicle is sold, and the conditions for

inclusion in gross income under the all events test would not be

satisfied. By contrast, when the Dealership sells a vehicle

together with a VSC, it assumes the obligation to perform or

finance all covered repairs that may be required over a defined

term in exchange for a fixed price. The sale of the contract

effects a transfer to the Dealership of the risk that the actual

cost of servicing the vehicle over this term will be greater or

less than the fixed price. Thus, the VSC is not a contract for

the sale of specific future services, as petitioners characterize

it, but a service warranty. The purchase price of the contract

likewise corresponds not to the cost of any particular repair

jobs that the Dealership may be called upon to perform in the

future, but to the cost of assuming a defined risk.
 - 27 -

It is undisputed that the full contract price was due and

collected at the time the VSC was sold. The timing of the

purchaser's performance is consistent with the distinctive

economics of the VSC arrangement. The purchaser agrees to part

with his money in advance of any repair services because the

benefit for which he is paying is the transfer of risk effective

upon execution of the contract. The Dealership demands the full

contract price in advance of repair services because it has begun

to perform when it accepts this risk.

The economic consequences to the Dealership of selling a

service warranty under the VSC arrangement are not the same as

the economic consequences of selling repair services on a fee-

for-service basis. The sale converts contingent future payments

into a fixed cash deposit immediately available for satisfaction

of the Dealership's liabilities to all its contract holders. The

deposit is invested and earns income that is accumulated on the

Dealership's behalf. If the actual cost of repairs under the

Dealership's contracts turns out to exceed the deposits plus

accumulated investment income in its account, and the Dealership

has failed to insure itself or to comply with the terms of the

insurance policy, the Dealership will bear the loss. On the

other hand, if the actual cost of repairs turns out to be less

than the reserves, some or all of the unconsumed reserves revert

to the Dealership. The credit that the Dealership receives for
 - 28 -

each contract sold counts toward satisfaction of the minimum

sales quota that must be achieved for the year in order to

qualify for release of unconsumed reserves attributable to any

contracts sold during the same year; it also contributes toward

the minimum account balance required in order to receive

unconsumed reserves attributable to currently expiring contracts.

In brief, the many distinctive benefits and risks of the VSC

arrangement for the Dealership are attributable to the form of a

present sale in which it is cast: "It is the sale itself which

makes a difference." General Gas Corp. v. Commissioner, 293 F.2d

at 41. Therefore, it is entirely appropriate to treat the

arrangement as a present sale for Federal income tax purposes,

with consideration received up front in the form of cash and

reserve credits. Cf. id.; Klimate Master, Inc. v. Commissioner,

T.C. Memo. 1981-292 (both discussing significance for tax

treatment of finance charges of distinction between holding

installment paper and selling it).

Like the taxpayers in the Hansen line of cases, petitioners

argue that the inability of the Dealership to predict at the time

it sold a VSC how much of the reserve it would ultimately

recover, either through performance of repairs or upon expiration

of the contract, precludes satisfaction of the necessary

conditions for accrual under the all events test. They attempt

to distinguish Hansen on the ground that in that case the funds
 - 29 -

in the dealer reserve account would in all events either be paid

to the taxpayer or be applied in satisfaction of his obligations,

whereas in the cases at hand the reserves might have been

disposed of in a manner that did not constitute "receipt" by the

Dealership. Specifically, there were two additional possible

scenarios: The reserves might be: (1) Paid to another repair

facility, or (2) refunded to the purchaser upon cancellation of

the contract.

The VSC imposes an obligation upon the issuing Dealership

either to perform covered repairs itself or to pay for covered

repairs by another authorized facility. The use of the reserves

to pay another authorized repair facility would discharge the

Dealership's obligation and thereby constitute "receipt" within

the meaning of Hansen. Commissioner v. Hansen, 360 U.S. at 465-

466; cf. Old Colony Trust Co. v. Commissioner, 279 U.S. 716, 729-

730 (1929). The Dealership would also "receive" the reserves in

the second scenario posited by petitioners. Under the VSC, like

a standard contract of insurance which it closely resembles, upon

notification of the purchaser's election to cancel the contract,

the Dealership immediately becomes personally indebted to the

purchaser for the amount of the unearned portion of the contract

price. See 7 Williston on Contracts, sec. 920, at 618-619, 634

(3d ed. 1963). When the Dealership secures release of reserves
 - 30 -

and uses them to discharge its personal indebtedness, it has

plainly "received" them for purposes of the all events test.

This result is consistent with the case law on the taxation

of dealer reserve accounts. As noted above, it is well

established that a taxpayer that sells a consumer installment

contract for a price that includes interest payable over the term

of the contract acquires a fixed right to receive the amount of

the purchase price attributable to the interest at the time it is

credited to the taxpayer's reserve account, even though the

reserve account will be charged to the extent of any interest

that is abated before it is earned as a result of the consumer's

decision to prepay the balance and terminate the contract

prematurely. Resale Mobile Homes, Inc. v. Commissioner, 965 F.2d

at 823; Shapiro v. Commissioner, 295 F.2d at 307; General Gas

Corp. v. Commissioner, 293 F.2d at 39-41; Federated Dept. Stores,

Inc. v. Commissioner, 51 T.C. at 502-503. We do not perceive any

difference in substance between forfeiture under those conditions

and forfeiture through the cancellation refund provisions of the

VSC. In both situations the forfeiture constitutes an

application of the funds to discharge the taxpayer's obligations,

which unquestionably inures to the taxpayer's benefit; in neither

situation does the existence of the contingent liability prevent

the taxpayer from acquiring a fixed right to receive the amounts
 - 31 -

subject to forfeiture when they are credited to the taxpayer's

reserve account.

So long as a Dealership (including any successor in

interest) remains in existence until all of its VSC's have

expired, all proceeds from the sale of those contracts that it

deposits in the PLRF will, as in Hansen, either be paid to the

Dealership directly or be applied in satisfaction of its various

liabilities under the operative agreements. The problem of

prediction suggested by petitioners does not arise.

b. Petitioners' Deposit Theory

Petitioners advance two alternative theories under which the

reserves would not be reportable as income to the Dealerships in

the year they were collected from the purchaser. One theory

characterizes the reserves as customer deposits. The authority

on which they rely is the "complete dominion" test enunciated by

the Supreme Court in Commissioner v. Indianapolis Power & Light

Co., 493 U.S. 203 (1990). Although petitioners do not spell out

in detail how they think Indianapolis Power & Light applies, the

argument seems to run as follows: inasmuch as the Dealerships

collected the amounts allocable to the PLRF subject to an

obligation to refund them at the purchaser's option, the

Dealerships did not have "some guarantee that * * * [they would]

be allowed to keep the money" as long as they complied with the

terms of the contract. Accordingly, the reserves were not income
 - 32 -

to the Dealerships until applied to future purchases of repairs

or released to the Dealerships without restriction upon

expiration of the contract.

In Indianapolis Power & Light the issue was whether an

accrual method public utility was required to include in gross

income upon receipt the amount of refundable security deposits

that it required from customers with suspect credit. The amount

of the deposit was twice the customer's estimated monthly utility

bill. A customer could obtain a full refund of his deposit by

demonstrating acceptable credit or by making timely payments over

a specified period. The customer could choose to receive the

refund in cash or have it applied against future bills. The

Court held that the customer deposits were not advance payments

for electricity and therefore not taxable upon receipt. "The

key", said the Court, "is whether the taxpayer has some guarantee

that he will be allowed to keep the money." Id. at 210. In the

case of a nonrefundable advance payment, exemplified by the fees

for dancing lessons at issue in Schlude v. Commissioner, 372 U.S.

128 (1963), and subscription fees in American Auto. Association

v. United States, 367 U.S. 687 (1961),

the seller is assured that, so long as it fulfills its
contractual obligation, the money is its to keep.
Here, in contrast, a customer submitting a deposit made
no commitment to purchase a specified quantity of
electricity, or indeed to purchase any electricity at
all. IPL's right to keep the money depends upon the
customer's purchase of electricity, and upon his later
decision to have the deposit applied to future bills,
 - 33 -

not merely upon the utility's adherence to its
contractual duties. Under these circumstances, IPL's
dominion over the funds is far less complete than is
ordinarily the case in an advance-payment situation.

* * * * * * *

The customer who submits a deposit to the utility * * *
retains the right to insist upon repayment in cash; he
may choose to apply the money to the purchase of
electricity, but he assumes no obligation to do so, and
the utility therefore acquires no unfettered "dominion"
over the money at the time of receipt. [Commissioner
v. Indianapolis Power & Light Co., supra at 210-212;
fn. ref. omitted.]

In subsequent cases this Court has had occasion to apply the

reasoning of Indianapolis Power & Light to analogous situations.

Oak Indus., Inc. v. Commissioner, 96 T.C. 559 (1991), concerned

the tax treatment of a subscription television operator that

collected a security deposit from all subscribers. Upon

termination of service at any time by either party, if no amounts

were due from the subscriber, the television company was required

to refund the entire deposit. A majority of subscribers chose to

apply at least a portion of the deposit to pay monthly service

charges on their final bill. In holding that the deposits were

not taxable income to the television company, we reasoned that

the subscribers controlled whether the deposit would be refunded

or applied against amounts due for services. The subscriber made

no commitment to purchase a specified amount of services from the

television company, or indeed to purchase any services at all.
 - 34 -

Thus, there was no guarantee that the television company could

keep the deposit.

In Buchner v. Commissioner, T.C. Memo. 1990-417, the

taxpayer operated a direct mail advertising service and required

its clients to make deposits into "postage impound accounts" to

cover estimated postage expenses. In the event that a client

failed to reimburse the taxpayer for postage, money would be

withdrawn from the client's account. When a client terminated

its relationship, any balance in the account not so applied was

refunded. We held that the deposits were not income to the

taxpayer under the "complete dominion" test, because so long as

clients paid their monthly bills, no portion of the deposits

would be applied to payments for services and retained by the

taxpayer.5

Petitioners’ attempt to apply the teaching of Indianapolis

Power & Light to the cases at hand is self-contradictory and does

not support their position on the issues in dispute. If the

reserves were nontaxable deposits by reason of the Dealerships'

contingent liability to refund them on demand, then they would

have ceased to be deposits and become taxable income at such time

5
Cf. Kansas City S. Indus., Inc. v. Commissioner, 98 T.C.
242 (1992) (railroad company did not realize income upon
collection of deposits from shippers for estimated costs of
sidetrack construction which railroad company agreed to refund,
to the extent deposits exceeded actual construction costs,
through a rebate formula based on shipping volumes).
 - 35 -

as they became nonrefundable. Under the VSC, the portion of the

contract price to be refunded to the purchaser on cancellation

declines in proportion to the greater of time elapsed or mileage

driven. Yet the Dealerships did not so report the reserves on

their returns and petitioners do not argue that it would have

been appropriate for them to do so.6 The method of accounting

for the reserves that the Dealerships did use is inconsistent

with the characterization of these amounts as deposits. And it

is this method, not the treatment of the reserves as deposits,

that respondent determined did not clearly reflect income. Thus,

when carried to its logical implications, the deposit theory is

not germane to any matter in controversy.

It is worth noting, moreover, that the portion of the VSC

purchase price that the Dealerships reported as their profit on a

sale was also subject to refund on cancellation in accordance

with the same declining balance formula applicable to the

reserves. Yet petitioners do not suggest that the Dealerships

would have been entitled to exclude their profit from gross

income on the ground that it too was merely a customer deposit.

6
Since mileage driven would not have been ascertainable by
the Dealerships, the most likely method of reporting income
consistent with the deposit theory would have been simply to
prorate the amount of the deposit over the maximum period of
coverage provided under the contract in accordance with the
refund schedule. Cf. Highland Farms, Inc. v. Commissioner, 106
T.C. 237 (1996).
 - 36 -

Even if petitioners' deposit theory were consistent with the

accounting method that they are defending, their reliance upon

Indianapolis Power & Light would be misplaced. Not all

refundable payments can be excluded from income. There is a

large body of case law to the contrary. See, e.g., Brown v.

Helvering, 291 U.S. 193 (1934) (insurance commissions repayable

in the event of policy cancellation); United States v. Wiese, 750

F.2d 674, 677 (8th Cir. 1984) (refundable payments received under

installment sales contract prior to delivery of merchandise);

Union Mut. Life Ins. Co. v. United States, 570 F.2d at 386 n.2

(prepaid interest refundable in the event of premature loan

repayment); Ertegun v. Commissioner, 531 F.2d 1156 (2d Cir.

1976), affg. T.C. Memo. 1975-27 (receipts from record sales under

contract entitling purchaser to return for credit refund); S.

Garber, Inc. v. Commissioner, 51 T.C. 733 (1969) (refundable

advance payments for custom-made clothing); Moritz v.

Commissioner, 21 T.C. 622 (1954) (refundable advance payments for

photographs); South Tacoma Motor Co. v. Commissioner, 3 T.C. 411

(1944) (purchase price of books of coupons redeemable in exchange

for automobile maintenance services, where buyer entitled to

return unused coupons for pro rata refund); Colonial Wholesale

Beverage Corp. v. Commissioner, T.C. Memo. 1988-405, affd. 878

F.2d 23 (1st Cir. 1989) (refundable container deposits on

beverage sales); Handy Andy T.V. & Appliances, Inc. v.
 - 37 -

Commissioner, T.C. Memo. 1983-713 (refundable purchase price of

multiyear television service policy contract); J.J. Little & Ives

Co. v. Commissioner, T.C. Memo. 1966-68 (receipts from magazine

sales under contracts entitling purchaser to return for credit

refund); Smith v. Commissioner, T.C. Memo. 1962-128, affd. 324

F.2d 725 (9th Cir. 1963) (gain from sale of restaurants where

buyer entitled to return assets under certain circumstances).

On the other hand, there are numerous precedents upholding

the taxpayer's characterization of a refundable payment as a

deposit in the absence of a binding agreement to apply the sum to

the purchase of specific goods and services. Consolidated-Hammer

Dry Plate & Film Co. v. Commissioner, 317 F.2d 829 (7th Cir.

1963), affg. in part and revg. in part T.C. Memo. 1962-97

(progress payments made under construction contract prior to

final determination of work specifications and amount due for

work); Clinton Hotel Realty Corp. v. Commissioner, 128 F.2d 968,

969, 970 (5th Cir. 1942), revg. 44 B.T.A. 1215 (1941) (lease

security deposits, where "If the only agreement was that it

should apply to the last year's rent, it would of course be rent

paid in advance", but "there were many things to which it might

become applicable besides the * * * [last year's] rent.");

Veenstra & DeHaan Coal Co. v. Commissioner, 11 T.C. 964 (1948)

(customer advances used to buy inventory prior to formation of

definite sale contract).
 - 38 -

Indianapolis Power & Light did not purport to overrule these

authorities and establish refundability as the exclusive

criterion for distinguishing taxable sales income from nontaxable

deposits in all cases. Continental Ill. Corp. v. Commissioner,

998 F.2d 513 (7th Cir. 1993), affg. on this issue T.C. Memo.

1989-636. What distinguished the nontaxable deposits in the

Indianapolis Power & Light line of cases from taxable income was

not their refundability per se; ultimately the classification of

these amounts as nontaxable deposits turned on the fact that the

taxpayer's right to retain them was contingent upon the

customer's future decisions to purchase services and have the

deposits applied to the bill. Commissioner v. Indianapolis Power

& Light, 493 U.S. at 210-212; Oak Indus., Inc. v. Commissioner,

96 T.C. at 571-572, 574-575; Buchner v. Commissioner, T.C. Memo.

1990-417. The payments at issue in the cases at hand do not

share this characteristic.

To see why this is true, assume that a Dealership sells 500

VSC's, all contract holders elect to receive coverage until their

contracts expire, and they file claims with the Dealership for

covered repairs that fully consume the reserves in the

Dealership's PLRF account. On these facts, all amounts deposited

into the account will be recovered by the Dealership. Now assume

that the facts are the same except that no claims are filed.

Upon expiration of the contracts, all amounts deposited into the
 - 39 -

account become available for release to the Dealership. Thus, in

both scenarios the Dealership recovers all the reserve deposits,

yet only in the first were any amounts applied to payment for

repair services. Finally, assume that in the first week of

coverage due to expire after 5 years or 60,000 miles, one

contract holder files a claim for covered repairs that consumes

the entire amount of the reserves attributable to his contract.

Then, at the end of the first year when he has driven 30,000

miles, he cancels. The contract holder is entitled to a refund

of one-half of the purchase price of the VSC, even though the

entire amount of the reserves attributable to his contract has

already been applied to his claim for repair services. As these

examples demonstrate, the Dealership's right to recover amounts

deposited in the reserve is not contingent upon the contract

holders' actual future claims for repair services. Rather, it

is contingent upon time elapsed and mileage driven while the

contract remains in force, variables that are entirely

independent of the amounts applied to repair services.

The absence of any relationship between the amounts of the

reserves actually applied to the provision of repairs under the

VSC and the determination of how the reserves are earned for

refund purposes highlights the central error in petitioners'

theory. This absence indicates that the contract price is in

fact paid for a service that is measured in terms of time and
 - 40 -

mileage, not parts and labor. In short, the contract price is

consideration for the present sale of a warranty, not a deposit

to be held pending future agreements to provide repairs.

There is a straightforward explanation for the refundability

of the contract holder's payment that does not require us to

obliterate the well-settled distinction between deposits and

sales income and to extend the holding of Indianapolis Power &

Light beyond all recognition: the price of the VSC is subject to

pro rata refund upon cancellation because it is similar to a

premium paid under a standard insurance policy. Since the VSC

serves the function of insuring the vehicle purchaser against

loss, it is not surprising that it is sold on terms similar to

other types of insurance.7

c. Petitioners' Trust Fund Theory

According to the second theory advanced by petitioners, a

Dealership did not realize income from the sale of a VSC to the

7
This Court has previously noted the similarity between an
extended service contract for consumer durables and a contract of
insurance. See Standard Television Tube Corp. v. Commissioner,
64 T.C. 238, 243 (1975). To say that the VSC resembles insurance
from the contract holder's perspective is not to say that it
constitutes insurance from the Dealership's perspective.
According to a view espoused by the Commissioner, the Dealership
bears an insurance risk only to the extent that it agrees to
indemnify the contract holder for repairs performed by other
facilities; to the extent that it may perform covered repairs
itself, the risk it bears is more properly regarded as a business
risk. On this distinction, see Rev. Rul. 68-27, 1968-1 C.B. 315;
see also Jordan v. Group Health Association, 107 F.2d 239, 248
(D.C. Cir. 1939).
 - 41 -

extent of the portion of the contract price deposited in escrow,

because this amount constituted a trust fund for the benefit of

the purchaser. Petitioners argue that the Dealership acted as a

mere conduit in collecting these funds and transferring them to

the Escrow Trustees, that the purchasers owned the funds held in

the PLRF, and that the Dealership first acquired property rights

in the reserve funds when the funds were disbursed to it by the

Trustees. Petitioners find support for this theory chiefly in

Angelus Funeral Home v. Commissioner, 47 T.C. 391 (1967), affd.

on other grounds 407 F.2d 210 (9th Cir. 1969), and Miele v.

Commissioner, 72 T.C. 284 (1979). Petitioners contend that "It

would be impossible to find for Respondent on this issue without

expressly overruling this Court's previous opinion in Angelus

Funeral Home," and "The situation presented in Miele is virtually

indistinguishable from that presented here."

In Angelus Funeral Home the taxpayer was an accrual basis

funeral home that collected payments from its customers under

"pre-need funeral plan agreements” obligating it to perform, or

have performed, certain funeral services for the customer upon

his death. The agreements provided that the customer's payment

be segregated in a special account, be held "in irrevocable trust

for the uses and purposes herein set forth", and be fully

expended for such purposes. The funeral home reported the

amounts so collected as income for the year in which the funeral
 - 42 -

services were provided. In upholding the taxpayer's exclusion

of the payments from gross income for the year of receipt, we

reasoned that the preneed funeral contract "created a custodial

or trust arrangement" for the benefit of the customer, that the

taxpayer received the payments as a custodian or trustee, and

that, accordingly, it did not realize income from sale of the

preneed contracts.

The issue in Miele was how a law firm should account for

prepaid legal fees. The taxpayer, a cash basis law firm, was

required under the State professional responsibility code to

preserve the identity of advances received from clients by

segregation of the funds in a client trust account and by

separate accounting for each client. When a case was closed, the

firm transferred the earned portion of the client's advances to

its own general account and refunded the unearned portion to the

client. It reported the advances as income only when transferred

to its general account. In consideration of the legal

restrictions on the law firm's use of the advances, we held that

the advances were properly treated as belonging to the client

until transferred to the firm's general account, and hence the

law firm was "not in receipt of income when the payments were

actually received." Miele v. Commissioner, supra at 290.

Respondent would distinguish Angelus Funeral Home and Miele

on the ground that they concerned whether the taxpayer actually
 - 43 -

or constructively received the amounts it was obligated to hold

in trust for the customer. In the cases at hand, respondent

argues, we need not inquire into the effect of contractual

restrictions upon the taxpayer’s use of funds collected from

customers, because even if the taxpayer’s use of the funds was

sufficiently restricted that collection did not constitute

receipt of income, the taxpayer acquired a fixed right to receive

the funds when it collected them and, hence, must include them in

income at that time.

Respondent’s contentions do not dispose of petitioners'

argument. Under the right-to-receive analysis of the Hansen line

of cases, which we have applied by analogy to the cases at hand,

it is clear that the amount withheld to secure the taxpayer's

obligations is income to the taxpayer; the question is only when

it must be accrued. By contrast, the question in Angelus Funeral

Home and Miele was whether the taxpayer received the amounts at

issue as income or as the property of another. Angelus Funeral

Home v. Commissioner, supra at 395, 407 F.2d at 212; Miele v.

Commissioner, supra at 289. A taxpayer cannot receive, or have

the right to receive, funds as income before it acquires a

beneficial interest in the funds. See Healy v. Commissioner, 345

U.S. 278, 282 (1953); Metairie Cemetery Association v. United

States, 282 F.2d 225, 230 (5th Cir. 1960); Portland Cremation

Association v. Commissioner, 31 F.2d 843, 845-846 (9th Cir.
 - 44 -

1929), revg. 10 B.T.A. 65 (1928); Ford Dealers Adver. Fund, Inc.

v. Commissioner, 55 T.C. 761, 770-774 (1971), affd. 456 F.2d 255

(5th Cir. 1972); Artnell Co. v. Commissioner, 48 T.C. 411, 417-

418 (1967), revd. on other grounds 400 F.2d 981 (7th Cir. 1968);

Seven-Up Co. v. Commissioner, 14 T.C. 965, 977-978 (1950); Twin

Hills Meml. Park & Mausoleum Corp. v. Commissioner, T.C. Memo.

1954-206. If and to the extent that the contract holder retains

the beneficial interest in the funds collected by the Dealership,

the Dealership is not required to include them in gross income.8

It is therefore necessary to address petitioners' contention

that the contract holder does not relinquish beneficial ownership

of the portion of the contract price allocable to the PLRF. In

other words, we must decide whether the VSC arrangement, like the

preneed funeral arrangement in Angelus Funeral Home and the

arrangement for prepaid legal fees in Miele, provided for

collection of this money in trust for the contract holder's

benefit.

8
Respondent tries to distinguish the cases on which
petitioners rely by further pointing out that in Miele v.
Commissioner, 72 T.C. 284 (1979), the funds in the client trust
account belonged to the client and that in Angelus Funeral Home
v. Commissioner, 47 T.C. 391 (1967), affd. on other grounds 407
F.2d 210 (9th Cir. 1969), the preneed funeral arrangement created
a grantor trust on behalf of the customer. But respondent’s
observations simply beg the question whether the contract holders
in the cases at hand also retain a beneficial interest in the
reserves.
 - 45 -

Section 301.7701-4(a), Proced. & Admin. Regs., provides

that, in general, the term "trust", as used in the Internal

Revenue Code, refers to an arrangement created by will or by

inter vivos declaration whereby a trustee takes title to property

for the purpose of protecting or conserving it for beneficial

owners under the ordinary rules applied in chancery or probate

courts. Under the case law, for Federal income tax purposes a

relationship generally is classified as a trust if it is "clothed

with the characteristics of a trust"--a standard that tends to be

more inclusive than a technical trust under State law. United

States v. De Bonchamps, 278 F.2d 127, 133 (9th Cir. 1960); Hart

v. Commissioner, 54 F.2d 848, 850-851 (1st Cir. 1932), revg. in

part 21 B.T.A. 1001 (1930); Weil v. United States, 148 Ct. Cl.

681, 180 F. Supp. 407, 411 (1960). No particular words are

necessary to create an express trust; its existence may be

inferred from the pertinent facts and circumstances. Portland

Cremation Association v. Commissioner, supra at 846; Broadcast

Measurement Bureau, Inc. v. Commissioner, 16 T.C. 988, 997

(1951).

For State law purposes, an express private trust arises

where a trustee acquires legal title to specific property (the

trust property or res) subject to enforceable equitable rights in

a beneficiary. 1 Restatement, Trusts 2d, sec. 2 (1959); Bogert,

The Law of Trusts and Trustees, sec. 1, at 1-2 (2d ed. 1984).
 - 46 -

The trust res must be sufficiently described or capable of

identification that its title can pass to the trustee upon actual

delivery of the trust corpus. In re Schnitz, 52 Bankr. 951, 955

(W.D. Mo. 1985); Newton v. Wimsatt, 791 S.W. 2d 823, 827 (Mo. Ct.

App. 1990); cf. 1 Restatement, supra sec. 76; Bogert, supra sec.

113, at 323-329. Thus, only the person who has title or interest

in property can make it the subject matter of a trust. Buhl v.

Kavanagh, 118 F.2d 315, 320 (6th Cir. 1941); Brainard v.

Commissioner, 91 F.2d 880, 881 (7th Cir. 1937), affg. 32 B.T.A.

1036 (1935).

We begin by determining whether the PLRF constituted a trust

fund. The PLRF was established for the purpose of protecting and

conserving funds for the satisfaction of the Dealerships'

obligations to purchasers under the VSC's. The Escrow Trustees

held title to the PLRF accounts in their own names as trustees.

The property to which they took title was distinctly identified

in the Administrator Agreement as comprising all amounts

deposited by a Dealership plus the accumulated investment income.

PLRF assets could inure to the benefit of a Trustee only to the

extent that: (1) They were not used to pay claims or refunds

prior to the expiration of the contracts to which they were

attributable; (2) they were not needed to maintain the

Dealership's account balance at an actuarially safe level; and

(3) they were not otherwise payable to the Dealership or its
 - 47 -

successor. Under the escrow arrangement there was accordingly a

separation of legal and beneficial ownership with respect to

specific property that was inconsistent with a mere bailment.

See Bogert, supra sec. 11, at 122-123. The Escrow Trustees

exercised some discretion over the investment of the reserves and

the release of unconsumed reserves; through their audit

authority, they also supervised the Dealerships' compliance with

the terms of the VSC program. Neither the Dealerships nor the

contract holders had access to the reserves or the right to

control the actions of the Escrow Trustees. The escrow

arrangement was therefore not an agency relationship. See

generally 1 Restatement, supra sec. 8; Bogert, supra sec. 15, at

163, 168-169, 172-176. Cf. McCrory v. Commissioner, 69 F.2d 688,

689 (5th Cir. 1934), affg. 25 B.T.A. 994 (1932). We are

satisfied that the PLRF accounts would qualify as trusts under

general principles of law as well as the law of the particular

States governing the operative agreements. Cf. Merchants Natl.

Bank v. Frazier, 67 N.E.2d 611 (Ill. App. Ct. 1946) (escrow

treated as express trust); Newton v. Wimsatt, supra; Southern

Cross Lumber & Millwork Co. v. Becker, 761 S.W.2d 269 (Mo. App.

Ct. 1988) (same). The PLRF accounts are also properly regarded

as trusts for Federal income tax purposes.

It does not follow that funds deposited into the PLRF

accounts by the Dealerships were collected from the individual
 - 48 -

purchasers in trust, or that these funds were held in the PLRF

accounts for the purchasers' benefit. In support of their

theory, petitioners point to the language of the operative

agreements. The Administrator Agreement provides that "To the

extent that Dealer receives monies for Reserves, Administrator's

fees or insurance premiums, Dealer agrees to accept and hold such

monies as a fiduciary in trust". It further provides:

All Reserves in the Escrow Account(s) shall be held for
the primary benefit of Contract holders to secure
Dealer's performance under the Contracts and to pay for
valid claims arising under the Contracts. Dealer shall
have no beneficial or other property interest in the
Reserves or investment income in the Escrow Accounts(s)
* * *.

The Escrow Agreement between the Escrow Trustees and the bank

acting as escrow depository likewise recites that "the vehicle

service contract entered into between a dealer in the Dealer

Group and a consumer requires that a Primary Loss Reserve Fund

escrow account be established for the benefit of the consumer."

The language that contracting parties use to describe the

effect of their agreements may accurately reflect their

intentions, but it may also inadvertently or deliberately

misrepresent them. In determining whether the operative

agreements create rights and obligations characteristic of a

trust, we do not regard the language quoted above as controlling.

See Davis v. Aetna Acceptance Co., 293 U.S. 328, 333-334 (1934);

In re Schnitz, supra at 955-956. Petitioners themselves do not
 - 49 -

take all the language quoted above at face value. On brief they

take the position that, unlike the portion of the VSC contract

price allocable to the PLRF, the portions of the contract price

allocable to Fees and Premium "were not received by the issuing

Dealership in trust," notwithstanding the express language in the

Administrator Agreement to the contrary. They offer no

explanation for this apparent inconsistency. If we look beyond

the language to the function and actual effect of the agreements

as well as to the conduct of the parties, we find no support for

petitioners' interpretation.

(1) The Reserves Could Not Have Been Collected From the
Purchaser in Trust Under the VSC, Because the Rights
of the Purchaser Under the VSC Did Not Relate to Any
Specific Trust Property

A trust is a relationship in which rights are created with

respect to the specific property transferred by the settlor to

the trustee. Thus, under the preneed funeral arrangement in

Angelus Funeral Home v. Commissioner, 47 T.C. 391 (1967), and the

arrangement for prepaid legal fees in Miele v. Commissioner, 72

T.C. 284 (1979), each of the taxpayer’s customers acquired

exclusive rights in a trust fund corresponding to the amount he

paid to the taxpayer. Even though, for reasons of administrative

convenience, each customer’s payment was not physically

segregated, it was credited to a separate account and entitled

the customer to have an equivalent amount of assets in the trust

fund used exclusively for his benefit. The individual payment
 - 50 -

became the subject of a trust because its identity as specific

property of the customer was preserved in the form of a fixed

claim to a corresponding portion of a segregated fund.

By contrast, the VSC creates no rights for the purchaser

that are defined by reference to the portion of the contract

price deposited in the PLRF. The amount of this deposit is

determined by reference to the cost that the Dealership expects

to incur in satisfying its warranty obligations to the purchaser.

But plainly the purchaser is not entitled to have the Dealership

incur this cost in all events. Nor does the VSC or any other

operative agreement require the Dealership to maintain a separate

account for each contract holder to preserve a fixed portion of

the reserves for his exclusive benefit. The amount of any

contract holder’s claims that may be satisfied from the reserves

is at all times indefinite. The deposit attributable to each

contract holder makes possible the payment not only of his own

claims, but also those of other contract holders. Conversely,

the amount of reserves available for use on behalf of each

contract holder is as large or small as the pool, up to the

specified coverage ceiling. The pooled aggregate of all deposits

plus accumulated income is the only identifiable trust res, and

no individual contract holder is capable of transferring title to

the pool.
 - 51 -

There are compelling economic reasons for structuring the

VSC arrangement differently from the preneed funeral arrangement.

The purpose of the VSC arrangement, from the contract holder's

perspective, is to insure a risk. Pooling serves the function of

distributing that risk among all the Dealership's contract

holders. Risk distribution is useful because it reduces the

deviation of actual losses from expected losses as a percentage

of both the expected losses and the resources in the pool. See

Sears, Roebuck & Co. v. Commissioner, 96 T.C. 61, 66, 101,

modified 96 T.C. 671 (1991), affd. in part and revd. in part 972

F.2d 858 (7th Cir. 1992). This reduction in "relative risk"

achieved through pooling enables the Dealership and Travelers to

charge less for assuming the contract holder's risk. Using a

structure similar to the preneed funeral arrangement would

preclude risk distribution and cost the contract holder much more

without providing him any greater security.9

The refund provision under the VSC is also probative

evidence that petitioners' theory mischaracterizes the

relationship among the parties. The amount of the Dealership's

9
It is important to distinguish two senses of the word
“pooling”. Risk distribution (“pooling” in the insurance sense)
does not occur simply by holding money received from different
customers in a combined trust account, where each customer
retains exclusive rights to a specific portion of the combined
fund (“pooling” of the sort that appears to have occurred in
Angelus Funeral Home and Miele).
 - 52 -

refund obligation is determined by a formula based on the full

contract price, time elapsed, and mileage driven. The refund is

unaffected by the amount of claims for repairs under the contract

that have been financed from the PLRF. Yet if the VSC created a

specific trust property to finance each contract holder's

repairs, the consumption of that property through repairs would

reduce the refundable balance pro tanto, in the same manner that

the rendition of attorneys' services reduced the refundable

balance of the client trust account in Miele. The actual

operation of the VSC arrangement demonstrates that the funds

collected by the Dealership on the sale of a VSC were not

impressed with a trust in favor of the contract holder.

(2) The Purchaser Had No Beneficial Interest in the PLRF;
the PLRF Existed for the Benefit of the Individual
Dealerships and for the Protection of Travelers

The operative agreements do not grant the purchaser any

rights that the status of beneficiary would imply. None of the

agreements expressly recognizes any right of the purchaser to

enforce the terms for the establishment, funding, administration,

or termination of the trust. On the contrary, the VSC expressly

disclaims any liability of the Administrator to the purchaser.

The obligations of the Escrow Trustees ordinarily do not run to

the purchaser directly. Reserves are released to the issuing

Dealership or to another authorized repair facility. Even

cancellation refunds are remitted to the issuing Dealership for
 - 53 -

forwarding to the purchaser. There is no reporting obligation to

the purchaser concerning the status of the PLRF account. In the

event of the Dealership’s default, the purchaser cannot look to

the PLRF for satisfaction of the Dealership's obligation. His

recourse is to file a claim with Travelers. It is the insurance

company which, after paying the purchaser's claim, is entitled to

recover its loss out of the Dealership's PLRF account. The

accounts are titled in the name of the Escrow Trustees "for the

Dealer Group" or for each Dealership separately, and the

Dealerships are designated as the FDIC insured depositors. These

provisions refute the proposition that the contract holders were

intended to hold a beneficial interest in the trust.

Furthermore, we are unable to see any functional rationale

for petitioners' theory of beneficial ownership. The

accumulation and conservation of the trust fund was clearly a

matter of concern to the Dealerships. As long as they fulfilled

certain minimal conditions, they were entitled to recover at

least the principal portion (if not also the income portion) of

any unconsumed reserves. They were personally liable for any

losses in excess of the reserves and would have to pay for these

losses out of their own pockets if they failed to maintain excess

loss insurance or properly file claims under the insurance

policies. One of the primary purposes of the PLRF arrangement

was to provide the Dealership with greater security than the
 - 54 -

structure of the NADS program had afforded. As excess loss

insurer, Travelers also had a vital interest in the size and

security of the trust fund. The PLRF accounts served as

Travelers' buffer. Release of reserves under any circumstances

(claims for repairs, cancellation refunds, unconsumed reserves)

reduced the account balances and increased the insurance

company's exposure.

The contract holder would have been largely indifferent to

the status of the trust fund. Under the VSC the contract holder

was entitled to have his losses covered up to the maximum amount

specified in the contract from the PLRF, the Dealership's own

funds, or Travelers. If the Dealership failed to satisfy a

covered claim or refund the unearned portion of the contract

price upon cancellation, the contract holder had recourse against

Travelers. With "one of the six largest property and casualty

insurance companies in the United States" providing ultimate

assurance to the contract holder that his interests would be

protected, a beneficial interest in the PLRF would have been

essentially superfluous to him.

If the Dealerships had understood the VSC program to protect

the contract holders by granting them a beneficial interest in

the trust fund, one would expect them to have called attention to

this aspect of the program when they recommended it to their

customers. It generally appears that the Dealerships did not
 - 55 -

mention the PLRF in their sales presentations to prospective VSC

purchasers. The protection that the Dealerships did emphasize

was the major insurance company that was underwriting the

program, symbolized by the red Travelers umbrella that the

manager of one of the Dealerships testified that he kept on hand

for this purpose.

We conclude that VSC purchasers held no beneficial interest

in the PLRF. Recognition of the PLRF as a trust for Federal

income tax purposes provides no basis for the exclusion of

reserve deposits from the Dealerships’ gross income.

2. Investment Income of the PLRF

Investment income earned by the PLRF apparently was not

reported on any tax return for taxable years prior to 1992. For

1992 and subsequent years, the Escrow Trustees filed Forms 1041

for each escrow account, ostensibly reporting this income in a

manner consistent with the treatment of the accounts as complex

trusts. Petitioners advance alternative arguments defending both

treatments:

Code §468B(g), which was enacted in 1986, directed
Respondent to issue regulations which would specify how
investment income such as that credited to the Escrow
Accounts should be taxed. * * * The regulations which
were finally issued do not address situations such as
the one presented here. [Fn. ref. omitted.]

In the absence of regulatory guidance, the Court
should apply the law as it existed before enactment of
Code §468B(g). The principles developed by the courts
would defer taxation of any earnings credited to the
Escrow Accounts until their owner is identified.
 - 56 -

Under the "homeless income" doctrine, these amounts are
not currently reportable by anyone until subsequent
events determine who will ultimately receive them.

Since the funds held in the Escrow Accounts did
not belong to the issuing Dealerships, the interest
which accrued on the accounts is not chargeable to them
either.

If the Court determines that it must develop its own
rules to implement Code §468B(g), it should treat the
Escrow Accounts as separate taxable entities
(presumably trusts). Under either alternative, no
investment income can be currently charged to the
Dealerships.

Prior to 1986 a number of cases and rulings suggested that

the earnings of a litigation settlement fund, receivership, or

escrow account that did not qualify as a trust for Federal income

tax purposes were not taxable until the identity of the person

entitled to receive the income could be determined. See, e.g.,

North Am. Oil Consol. v. Burnet, 286 U.S. 417 (1932); Rev. Rul.

71-119, 1971-1 C.B. 163; Rev. Rul. 70-567, 1970-2 C.B. 133; Rev.

Rul. 64-131, 1964-1 C.B. (Part 1) 485. Section 468B was enacted

as part of the Tax Reform Act of 1986, Pub. L. 99-514, sec.

1807(a)(7), 100 Stat. 2814, to clarify the tax consequences of

certain settlement funds established pursuant to a court order

for payment of tort liabilities ("designated settlement fund").

Sec. 468B(a), (b), (d)(2). The statute provides that a

designated settlement fund is a separate taxable entity subject

to current taxation on its net income at the maximum fiduciary

rate. Sec. 468B(b). A provision relating to the taxation of
 - 57 -

escrow accounts, settlement funds, and similar funds generally

was incorporated in the Technical and Miscellaneous Revenue Act

of 1988 (TAMRA), Pub. L. 100-647, sec. 1018(f)(5)(A), 102 Stat.

3582, and was codified as section 468B(g). Section 468B(g)

provides:

SEC. 468B(g). Clarification of Taxation of
Certain Funds.--Nothing in any provision of law shall
be construed as providing that an escrow account,
settlement fund, or similar fund is not subject to
current income tax. The Secretary shall prescribe
regulations providing for the taxation of any such
account or fund whether as a grantor trust or
otherwise.

The section applies to escrow accounts, settlement funds, or

similar funds established after August 16, 1986. H. Rept. 100-

795, at 377 (1988); S. Rept. 100-445, at 398 (1988).

The committee reports contain the following guidance

concerning the regulations authorized by the statute:

It is anticipated that these regulations will
provide that if an amount is transferred to an account
or fund pursuant to an arrangement that constitutes a
trust, then the income earned by the amount transferred
will be currently taxed under Subchapter J of the Code.
Thus, for example, if the transferor retains a
reversionary interest in any portion of the trust that
exceeds 5 percent of the value of that portion, or the
income of the trust may be paid to the transferor, or
may be used to discharge a legal obligation of the
transferor, then the income is currently taxable to the
transferor under the grantor trust rules.

Id.

Final regulations under section 468B(g) were issued in

December 1992. Sec. 1.468B-1, Income Tax Regs. The scope of the
 - 58 -

regulations is limited to certain types of litigation settlement

funds. Funds that satisfy obligations "to repair or replace,

products regularly sold in the ordinary course of the

transferor's trade or business" are specifically excluded from

coverage. Sec. 1.468B-1(g)(2), Income Tax Regs.

The rules governing the taxation of grantor trusts are

contained in subpart E of subchapter J, sections 671-679.

Section 671 provides that when the grantor is treated as the

owner of any portion of a trust, the grantor's taxable income and

credits are computed taking into account those items of the

trust's income, deductions, and credits attributable to the

portion of the trust that the grantor is treated as owning.

Section 677(a) provides that the grantor is treated as the owner

of any portion of a trust whose income without the approval or

consent of any adverse party is, or, in the discretion of the

grantor or a nonadverse party, or both, may be: (1) Distributed

to the grantor, or (2) held or accumulated for future

distribution to the grantor. The regulations provide the

following interpretive gloss on the scope of the statutory

language:

Under Section 677 the grantor is treated as the owner
of a portion of a trust if he has retained any interest
which might, without the approval or consent of an
adverse party, enable him to have the income from that
portion distributed to him at some time either actually
or constructively * * *. [Sec. 1.677(a)-1(c), Income
Tax Regs.; emphasis added.]
 - 59 -

Use of the income of the trust for the purpose of discharging a

legal obligation of the grantor constitutes a distribution to the

grantor within the meaning of section 677(a). Anesthesia Serv.

Med. Group, Inc. v. Commissioner, 85 T.C. 1031, 1055 (1985),

affd. on other grounds 825 F.2d 241 (9th Cir. 1987); sec.

1.677(a)-1(d), Income Tax Regs.

Section 672(a) defines an "adverse party" as any person

having a substantial beneficial interest in a trust that would be

adversely affected by the exercise or nonexercise of a power that

the party possesses respecting the trust. Section 672(b) defines

"nonadverse party" as any person who is not an adverse party.

The legislative history of the Internal Revenue Code of 1954

explains that section 677 contemplates situations in which

payment of trust income to or for the benefit of the grantor is

either required under the terms of the trust or discretionary.

H. Rept. 1337, 83d Cong., 2d Sess. A217 (1954). The

classification of persons that participate in the administration

of the trust as adverse or nonadverse parties becomes relevant to

the application of section 677 only if such persons exercise

discretion. The theory behind this distinction is that where a

power to pay trust income to the grantor or for his benefit is

held by some person other than the grantor, the power should

nevertheless be attributed to the grantor if the holder of the

power has no substantial beneficial interest that would be
 - 60 -

adversely affected by exercise of the power for the grantor's

benefit. The presumption is that there is a sufficient

likelihood that the holder will exercise his power for the

benefit of the grantor unless it would be detrimental to his own

interests to do so. Id. at A212; 3 Bittker & Lokken, Federal

Taxation of Income, Estates and Gifts, par. 80.1.3, at 80-13 (2d

ed. 1991).

We do not agree with petitioners that the investment income

earned by the PLRF is “homeless income” whose taxation must be

deferred until its ultimate disposition is determined. At the

inception of the PLRF its owners were identifiable under the

grantor trust rules.

In the previous section of this Opinion, we concluded that

the PLRF is classified as a trust for Federal income tax

purposes. The Dealerships were the grantors of the trust because

it was they who supplied the trust property. As explained in the

previous section, unlike the preneed funeral arrangement under

which the funeral home acted as a mere conduit in transferring

trust property from its customers, the money collected from VSC

purchasers did not constitute identifiable trust property before

it left the hands of the Dealerships. Cf. Buhl v. Kavanagh, 118

F.2d at 319; Smith v. Commissioner, 56 T.C. 263, 289-291 (1971).

Pursuant to the Administrator Agreement, the PLRF was established

to fund the Dealerships' obligations under the VSC's. All income
 - 61 -

earned by the PLRF was available for use to discharge the

Dealerships' obligations either currently or in future, as

needed. It follows that the Dealerships are treated as owners of

the entire trust, provided that the application of trust income

for the Dealerships' benefit in this manner did not depend upon

the approval or consent of an adverse party. Sec. 1.677(a)-1(c)

and (d), Income Tax Regs.

The Administrator Agreement requires the authorization of

both Escrow Trustees (the Managing Agent and Administrator) for

release of any reserves from the PLRF. Since the Administrator

is entitled to receive any investment income of the PLRF not paid

to or used for the benefit of the Dealerships, the Administrator

plainly holds an interest in the PLRF that is adversely affected

by the release of income to or for the benefit of the

Dealerships. However, the authorization contemplated by the

Administrator Agreement is not the exercise of a "power" within

the meaning of section 672(a). A power for purposes of subpart E

of subchapter J means a discretionary right to control the

beneficial enjoyment of trust income, and it is relevant to the

question of the grantor's ownership of the trust only to the

extent that it can be exercised out of self-interest at the

grantor's expense. See H. Rept. 1337, supra at A212, A217; sec.

1.677(a)-1(e), Income Tax Regs.
 - 62 -

The Administrator possesses no such discretion over the

payment of claims. Under the trust arrangement, the Escrow

Trustees are obligated to release reserves upon receipt of any

claim meeting specified conditions. As fiduciaries, they are

required by law to administer the PLRF in accordance with its

stated purpose to fund the Dealerships' obligations under the

VSC's. The Administrator's own rights to trust income are

similarly fixed by the terms of the trust. The Administrator has

no power to withhold consent to a payment from the PLRF for a

Dealership's benefit in order to appropriate those funds for its

own benefit. The authorization requirement must therefore be

intended only to ensure orderly administration of the trust. To

the extent that the Administrator Agreement does confer

discretionary authority upon the Administrator, it is not

authority to determine the use of trust assets but an authority

limited to procedural matters incidental to the use of trust

assets to satisfy the Dealerships' obligations.

In spite of having an interest adverse to the use of trust

income for the Dealerships' benefit, the Administrator is not an

adverse party. Cf. In re Sonner, 53 Bankr. 859, 61 AFTR 2d 88-

755, 85-2 USTC par. 9810 (Bankr. E.D. Va. 1985). Accordingly,

pursuant to sections 671 and 677(a), the Dealerships are each

treated as owning an allocable portion of the PLRF and must
 - 63 -

include the income attributable to their respective portions as

if earned by them directly. Sec. 1.671-2(c), Income Tax Regs.

Section 468B(g) does not warrant a different result. The

statute and regulations issued thereunder do not prescribe rules

for identifying the person currently taxable on the income earned

by the PLRF. However, the statute plainly requires that this

income be taxed currently and does not purport to override any

existing rules that may apply to tax the income of the PLRF

currently. Nor does the statute purport to suspend the

application of such rules pending issuance of implementing

regulations. The TAMRA committee reports contemplate that if an

escrow arrangement creates a trust relationship, the rules of

subchapter J will control. See supra p. 57. Taxation of the

PLRF as a grantor trust is therefore consistent with the

statutory mandate and the intention of Congress.

3. Administrator's Fees and Insurance Premiums

The Dealerships’ Federal income tax returns for the years at

issue do not reflect the portions of the VSC purchase price that

the Dealerships promptly remitted to the Administrator in payment

of the Administrator's Fees and excess loss insurance premiums.

Petitioners' defense of this treatment rests squarely on the

matching principle: "The clear reflection of the Dealership’s

net income requires that the recognition of income and related

expenses attributable to these two items occur concurrently."
 - 64 -

While petitioners consistently maintain that these receipts and

expenses should have no net effect on the Dealerships' taxable

income, they advance alternative arguments concerning when the

individual items should be taken into account. Prior to trial

they took the position, inter alia, that the expenses were

currently deductible. On brief they contend that both Premiums

and Fees are "period expenses" that should be capitalized and

amortized over the VSC term, and that the portions of the

contract price corresponding to these expenses should accordingly

be included in gross income ratably over the contract term as

well.

Respondent determined that the Dealerships' method of

accounting for these expenses and the corresponding receipts

improperly accelerated deductions or deferred income, resulting

in a distortion of the Dealerships' income.10 We agree.

However, we conclude that some of these deductions may be taken

earlier than respondent has allowed.

a. Timing of Deductions

Under the accrual method of accounting, a liability is

incurred and generally taken into account for the taxable year in

which all events have occurred that establish the fact of the

10
Respondent does not challenge the Dealerships' treatment
of the Commissions that they paid out of VSC sale proceeds.
Respondent concedes that the Commissions were a currently
deductible expense.
 - 65 -

liability, the amount of the liability can be determined with

reasonable accuracy, and economic performance has occurred with

respect to the liability. Secs. 1.446-1(c)(1)(ii)(A), 1.461-

1(a)(2), Income Tax Regs. The time when economic performance

occurs is determined in accordance with section 461(h) and the

regulations thereunder. These rules provide generally that:

(1) Where the liability requires the taxpayer to provide services

or property, economic performance occurs as the taxpayer incurs

costs in connection with satisfaction of the liability, sec.

461(h)(2)(B); sec. 1.461-4(d)(4)(i), Income Tax Regs.; (2) where

the liability arises out of the provision of services or property

to the taxpayer by another person, economic performance occurs as

the services or property is provided by that person, sec.

461(h)(2)(A)(i); sec. 1.461-4(d)(2)(i), Income Tax Regs.; (3)

where the liability arises out of the provision of insurance to

the taxpayer, economic performance occurs when payment is made to

the insurer, sec. 1.461-4(g)(5), Income Tax Regs.

Section 1.461-1(a)(2), Income Tax Regs., clarifies that a

liability that relates to the creation of an asset having a

useful life extending substantially beyond the close of the

taxable year in which the liability is incurred is taken into

account through capitalization, and may affect the computation of

taxable income in later years through appropriate cost recovery

deductions. See sec. 263; Commissioner v. Lincoln Sav. & Loan
 - 66 -

Association, 403 U.S. 345 (1971). Lump-sum payments for

multiyear insurance coverage generally are capital expenditures

that may be recovered only through amortization over the period

of coverage. Commissioner v. Boylston Market Association, 131

F.2d 966 (1st Cir. 1942), affg. a Memorandum Opinion of the Board

of Tax Appeals; Higginbotham-Bailey-Logan Co. v. Commissioner, 8

B.T.A. 566, 577 (1927); secs. 1.461-4(g)(8), Example (6),

1.167(a)-3, Income Tax Regs.

The VSC's required the Dealerships to obtain excess loss

insurance coverage for periods of 1 to 7 years. The Dealerships

incurred the liability for this insurance in the year the Premium

was paid. However, to the extent that part of any Premium was

allocable to coverage for subsequent years, it must be

capitalized and amortized by deductions in those years.

The Administrator's Fees are subject to different treatment.

The VSC required the Dealerships to establish the PLRF to fund

their repair obligations. Economic performance with respect to

this liability occurred as the Dealerships incurred costs in

connection with the establishment and administration of the PLRF.

Sec. 1.461-4(d)(4), Income Tax Regs. The Dealerships incurred

these costs as the Administrator actually rendered services to

them. Sec. 1.461-4(d)(2), Income Tax Regs.; see sec. 1.461-

4(d)(7), Example (1) (performance of reclamation services through

independent contractor), Example (2) (performance of services
 - 67 -

under multiyear warranty requiring procurement of replacement

parts), Examples (4) and (5), Income Tax Regs. Since no portion

of the Fees is incurred for a taxable year preceding the year in

which the corresponding service benefits are provided, the Fees

do not constitute capital expenditures like the Premiums that are

recovered through amortization. The result under section 461(h)

marks a departure from the law in effect prior to its enactment

as part of the Deficit Reduction Act of 1984, Pub. L. 98-369,

sec. 91(a), 98 Stat. 494, 598. See, e.g., Seligman v.

Commissioner, 84 T.C. 191 (1985), affd. 796 F.2d 116 (5th Cir.

1986); Thielking v. Commissioner, T.C. Memo. 1987-201, affd.

without published opinion 860 F.2d 1084 (8th Cir. 1988) (both

holding under prior law that amounts paid at the inception of

equipment leases for lease administration and management services

were capital expenditures that must be amortized over the lease

term).

While the rule for identifying when prepaid service expenses

are incurred is clear, its application to the facts of these

cases is problematic. If it were known at the inception of the

contract that, for example, X percent of the services would be

provided in the first year and the remaining (100-X) percent in

the final year, then the rule would be applied by recognizing

proportional amounts of the expense for the first and final

years. If it were not known at the inception of the contract
 - 68 -

when the services would be performed, but they could only be

performed within the same year, then the rule would be applied by

recognizing the entire cost for the year in which services were

performed. Here however, the services consist to a substantial

extent in the processing of breakdown claims and contract

cancellations, and hence are contingent in both timing and

amount. As a result, the amount of the liability properly

allocable to any of the years under the contract cannot be

accurately determined until the contract expires. Neither the

statute nor the regulations provide specific guidance for

handling these uncertainties.

The responsibility for developing fair and administrable

standards for implementing statutory requirements lies with the

Commissioner. Respondent acknowledges on brief the practical

difficulty of applying the economic performance requirement under

the circumstances of these cases. It appears to be respondent’s

position, at least for purposes of these cases, that where the

timing and amount of services to be provided to the taxpayer

cannot be determined before expiration of the service contract,

but the taxpayer can demonstrate “a reasonable manner in which to

estimate the amount and timing of the services that will be

required", respondent will permit the taxpayer to accrue its

liability over the term of the contract in accordance with the

taxpayer's estimates. Respondent determined that the Dealerships
 - 69 -

failed to make the requisite showing, and accordingly may not

deduct the Fees until expiration of the VSC’s to which they

relate.

We accept respondent’s interpretation of the economic

performance rule and adopt it as the evidentiary standard for

these cases. However, we do not agree with respondent’s

application of this standard.

One index for measuring the Administrator’s performance may

be found in the provisions of the operative agreements that

govern how the Fees are earned for refund purposes. Under the

refund formula, the Fees attributable to a contract are earned in

proportion to the greater of time elapsed or mileage driven under

the contract. This formula reflects two important aspects of the

Administrator’s performance. First, the Administrator was

obligated to incur substantial costs simply in making certain

resources available at all times for processing claims and

cancellations, whether or not a claim or cancellation notice was

actually filed. Second, the Administrator provided recordkeeping

and reporting services regularly throughout the term of the VSC.

We think that the refund formula represents “a reasonable

manner in which to estimate the amount and timing of the

[Administrator’s] services” for purposes of section 461(h), and

neither party has established the validity of any other

estimation approach. The formula implies that, for any taxable
 - 70 -

year while a VSC is in effect, the cumulative amount of Fees

incurred up to and including that year must bear the same

relation to the total Fees attributable to the contract as the

greater of time elapsed or mileage driven bears to the applicable

limit specified in the contract. In general, while a contract

remained in effect the issuing Dealership would have known only

the amount of time elapsed; it would have had no means of

ascertaining the amount of mileage driven, unless the contract

holder brought the covered vehicle in for repairs. In the

absence of mileage information, the Fees would have been

incurred, and may be recognized, in equal annual increments over

the maximum time period provided for in the contract to which

they relate.11 If for any taxable year the Dealership had

mileage information establishing a higher cumulative amount of

Fees incurred than the amount implied by time elapsed, then a

compensating adjustment would be made for that year.12

b. Timing of Income

Petitioners argue that "proper matching of income and

expense under the accrual method requires deferred recognition of

the portion of the purchase price allocable to Administrator Fees

11
Cf. Hinshaw’s, Inc. v. Commissioner, T.C. Memo. 1994-327
(reaching a consistent result on similar facts).
12
We leave to the parties the task of applying this formula
to each of the VSC’s in the random sample that respondent used to
compute the revised adjustments and that the parties have agreed
to use as the basis for Rule 155 computations.
 - 71 -

and Premiums until the corresponding deductions are allowed."

The authority on which they rely is Artnell Co. v. Commissioner,

400 F.2d 981 (7th Cir. 1968), revg. and remanding 48 T.C. 411

(1967).

Inasmuch as the use of the accrual method serves different

purposes under the Federal income tax laws and under financial

accounting, the matching of income with related expenses often

will not result in the clear reflection of income for Federal

income tax purposes. Thor Power Tool Co. v. Commissioner, 439

U.S. 522, 539-544 (1979); RCA Corp. v. United States, 664 F.2d

881, 885-886 (2d Cir. 1981). Section 446(b) provides that if the

method of accounting used by the taxpayer does not clearly

reflect income, the computation of taxable income shall be made

under such method as, in the Commissioner's opinion, does clearly

reflect income. The courts generally have upheld the

Commissioner's discretion under section 446(b) to deny taxpayers

the right to defer prepaid service income until the periods when

related costs will be incurred and taken into account. Schlude

v. Commissioner, 372 U.S. 128 (1963); American Auto. Association

v. United States, 367 U.S. 687 (1961); Automobile Club of

Michigan v. Commissioner, 353 U.S. 180 (1957); RCA Corp. v.

United States, supra at 885-888.

In Artnell Co. v. Commissioner, supra, the Court of Appeals

for the Seventh Circuit held that a baseball team owner's
 - 72 -

deferral of income from advance sales of season tickets and

broadcasting rights until the taxable year in which the games to

which the income was allocable would be played could clearly

reflect income. In so holding, the court distinguished the three

Supreme Court cases cited above, "where the time and extent of

performance of future services were uncertain." "The uncertainty

stressed in those decisions is not present here. The deferred

income was allocable to games which were to be played on a fixed

schedule. Except for rain dates there was certainty." Artnell

Co. v. Commissioner, 400 F.2d at 983-984.

This Court generally has limited Artnell Co. to its facts.

Chesapeake Fin. Corp. v. Commissioner, 78 T.C. 869, 880-881

(1982); T.F.H. Publications, Inc. v. Commissioner, 72 T.C. 623,

644-645 (1979), affd. without published opinion 622 F.2d 579 (3d

Cir. 1980); Standard Television Tube Corp. v. Commissioner, 64

T.C. 238, 242 (1975); Continental Ill. Corp. v. Commissioner,

T.C. Memo. 1989-636, affd. 998 F.2d 513 (7th Cir. 1993); cf.

Collegiate Cap & Gown Co. v. Commissioner, T.C. Memo. 1978-226

(following Artnell Co. in a case appealable to the Seventh

Circuit, under the rule of Golsen v. Commissioner, 54 T.C. 742

(1970), affd. 445 F.2d 985 (10th Cir. 1971). As we stated in

T.F.H. Publications, Inc. v. Commissioner, supra at 644: "Since

Artnell Co. this Court has indicated that it will not follow the
 - 73 -

rationale of that case unless the facts present a certainty, of

performance or fixed dates, such as was presented in Artnell Co."

The cases at hand are distinguishable from Artnell Co. on

their facts. First, the evidence does not establish that the

Dealerships incurred costs for administration of the PLRF

arrangement according to a fixed schedule. We concluded above

that, in the absence of mileage information, the Dealerships

could reasonably estimate their administrative costs in

accordance with the passage of time. But the amount of mileage

driven under a contract would be ascertainable for any year in

which a mechanical breakdown or cancellation occurred, and might

control the determination of costs incurred for that year. Thus,

the proper schedule for accrual of these costs remained at all

times contingent upon wholly unpredictable variables. Cf. T.F.H.

Publications, Inc. v. Commissioner, supra; Standard Television

Tube Co. v. Commissioner, supra. Second, as petitioners

themselves argued with respect to the reserve deposits issue, the

Dealerships' performance is not certain, because the purchaser

retains the right to cancel. If the Dealerships were permitted

to defer income until the period when they are allowed offsetting

deductions for Fees and Premiums, they might never report the

income. Cf. Continental Ill. Corp. v. Commissioner, supra. It

was not an abuse of discretion for respondent to refuse to permit

the Dealerships to match their income with their expenses.
 - 74 -

4. Section 481 Adjustment

Respondent made an additional adjustment to the income of

petitioner DFM Investment Co. for its taxable year ended

March 31, 1990, pursuant to section 481. The adjustment purports

to reflect the aggregate of the unreported income realized from

the sale of VSC's in prior taxable years plus accumulated

investment income, reduced by allowable deductions for refunds,

payments to other repair facilities, Commissions, and an

amortization allowance for Premiums. The controversy concerns

whether section 481 authorizes an adjustment under the

circumstances of this case.

Section 481(a) provides that where taxable income for any

year is computed under a method of accounting that is different

from the method used for the preceding year, then the computation

of taxable income for the year of the change shall take into

account those adjustments that are determined to be necessary

solely by reason of the change in order to prevent amounts from

being duplicated or omitted. A change in method of accounting to

which section 481 applies includes a change in the overall plan

of accounting for gross income or deductions or a change in the

treatment of any material item used in the overall plan. Secs.

1.481-1(a)(1), 1.446-1(e)(2)(ii)(a), Income Tax Regs. A material

item is "any item which involves the proper time for the

inclusion of the item in income or the taking of a deduction."
 - 75 -

Sec. 1.446-1(e)(2)(ii)(a), Income Tax Regs. In determining

whether a change in a reporting practice involves the proper time

for the inclusion or deduction of an item, the relevant question

generally is whether the change affects the aggregate amount of

taxable income over the taxpayer's lifetime. If the change

affects the amount of taxable income for 2 or more taxable years

without altering the taxpayer's lifetime taxable income, then it

is strictly a matter of timing and constitutes a change in method

of accounting. Copy Data, Inc. v. Commissioner, 91 T.C. 26, 30-

31 (1988); Schuster's Express, Inc. v. Commissioner, 66 T.C. 588,

597 (1976), affd. without published opinion 562 F.2d 39 (2d Cir.

1977).

Petitioners argue that respondent's adjustments to the

method used by the Dealerships to report income and expense under

the VSC program do not trigger application of section 481. They

correctly point out that to the extent unreported amounts were

ultimately refunded to the purchaser or paid to Travelers, the

Administrator, the Administrator’s sales agent, BPI, or other

authorized repair facilities, the Dealerships’ reporting practice

resulted not in deferral of income but rather in permanent

exclusion. "Here * * * the issue is whether income should be

reported by the Dealerships, not when it should be reported.

The amounts which Respondent proposes to include in a Code sec.

481 adjustment were not reported at all." Consequently,
 - 76 -

"Respondent's proposed adjustments do not represent a change in

the Dealerships' method of accounting".13 We disagree.

Respondent corrected the Dealerships' use of the accrual

method to report income and expense under the VSC program. If

the proper application of the accrual method to the collection

and ultimate disposition of the unreported portion of the

contract price and investment income would not change a

Dealership's lifetime taxable income, then correction of the

Dealership's erroneous practice constitutes a change in method of

accounting for purposes of section 481. The unreported amounts

were either applied to payment of expenses immediately following

13
In addition, petitioners contend that even if
respondent's adjustments do constitute a change in method of
accounting, a further adjustment will not be required in order to
prevent duplication or omission of income or expense. They
arrive at this conclusion by at least two lines of reasoning.
First, they point out that "there would not be any duplication or
omission due to the 'change' if the Dealerships are simply
permitted to continue their current practice for VSC's sold in
prior periods". This observation appears to be correct, but it
has no relevance whatever to the applicability of sec. 481.
Second, they observe that respondent computed the sec. 481
adjustment by initially increasing DFM Investment Co.'s gross
income by unreported receipts from the sale of VSC's and then
making "a second set of Code §481 adjustments to eliminate its
initial Code §481 adjustment over time. If, as Respondent
contends, these adjustments merely affect timing, then no
duplication or omissions will occur, and neither of these
proposed adjustments are required." This argument is difficult
to follow, but it appears either: (1) To confuse the sec. 481
adjustment with the adjustments to the Dealership's method of
accounting that necessitate the sec. 481 adjustment; or (2) to
deny the applicability of sec. 481 for the very reason that it
applies; or both. At any rate, the argument is plainly without
merit.
 - 77 -

collection from the purchaser or deposited in the PLRF pending

ultimate disposition. They could be released from the PLRF as a

cancellation refund, payment for covered repairs, or a

distribution of unconsumed reserves. Thus, the following six

cases cover all possibilities for the ultimate disposition of the

unreported amounts:

(1) Payment for Premium, Commissions, or Fees;

(2) refund upon cancellation of the contract;

(3) release to another repair facility to pay for covered

repairs;

(4) release to the Administrator upon expiration of the

contract or termination of the Dealership’s participation in the

program;

(5) release to the Dealership to pay for covered repairs; or

(6) release to the Dealership upon expiration of the

contract or termination of the Dealership's participation in the

program.

The Dealership's practice was to report income only when and

to the extent that reserves were released to the Dealership under

cases (5) and (6). Amounts disposed of under each of the other

cases were never recovered by the Dealership and hence would

never have been reported as income. The proper application of

the accrual method is to include the full contract price in

income for the year the VSC was sold and, to the extent that the
 - 78 -

Dealership is treated as owner of the PLRF, to include investment

income as it accrues. For cases (1) through (4), a deduction is

allowable for the year in which the expense is incurred or, if

capitalized, the year in which it is taken into account through

amortization.

Thus, the Dealership's practice resulted in permanent

exclusion only where a deduction would have been allowable for a

later period. Compared with the proper application of the

accrual method, the Dealership's practice had the effect of

either deferring income (cases (5) and (6)) or accelerating a

deduction (cases (1) through (4)). Correction of this practice

cannot affect the Dealership's lifetime taxable income under any

circumstances: it can only affect the time when an increase or

offsetting reduction to lifetime income is taken into account.

Cf. Knight-Ridder Newspapers v. United States, 743 F.2d 781, 798-

799 (10th Cir. 1984). Accordingly, the correction represents a

change in method of accounting for purpose of section 481.

The second requirement for application of section 481 is

that, in the absence of an adjustment for prior years, amounts

would be duplicated or omitted in the computation of taxable

income solely by reason of the change in method of accounting.

This requirement is also satisfied. Income attributable to

contracts in prior years which the Dealership would have reported

in some later years in cases (5) and (6) would be omitted as a
 - 79 -

result of the change, because the proper time for reporting this

income under the accrual method would have passed. In cases (1)

through (4) the accrual method would allow the Dealership to

claim a deduction for expenses corresponding to amounts

previously excluded from gross income. Since excluding an amount

from income is essentially equivalent to recognizing income and

offsetting it by a current deduction, the change in method of

accounting would effectively result in the duplication of

deductions. Cf. Western Cas. & Sur. Co. v. Commissioner, 571

F.2d 514, 519 (10th Cir. 1978), affg. 65 T.C. 897 (1976).

The courts have repeatedly held that a change in method of

accounting subject to section 481 results where a taxpayer is

required to cease a practice of improperly reducing gross

receipts by amounts allocable to a reserve for estimated losses

or contingent liabilities. Knight-Ridder Newspapers, Inc. v.

United States, supra; North Cent. Life Ins. Co. v. Commissioner,

92 T.C. 254 (1989); Copy Data, Inc. v. Commissioner, 91 T.C. 26

(1988); Klimate Master, Inc. v. Commissioner, T.C. Memo. 1981-

292. In substance, the cases at hand present the same issue and

they require the same result.

Petitioners correctly cite a number of our decisions for the

proposition that correction of practices under which a taxpayer

improperly excluded items from gross income does not necessarily

constitute a change in method of accounting or may not otherwise
 - 80 -

warrant an adjustment under section 481. But the cases

petitioners cite are readily distinguishable on their facts.

In Saline Sewer Co. v. Commissioner, T.C. Memo. 1992-236,

the taxpayer was a utility company that excluded customer

connection fees from gross income on the theory that they were

contributions to capital. We found that the mischaracterization

caused a permanent distortion of Saline Sewer's taxable income,

and accordingly respondent's recharacterization of these receipts

as taxable income did not give rise to a section 481 adjustment.

In Schuster's Express, Inc. v. Commissioner, 66 T.C. 588

(1976), the result turned in part on the unusual procedural

posture of the case. The Commissioner, who bore the burden of

proof, failed to establish that under the taxpayer's method of

reserve accounting for estimated insurance expenses "there was

any procedure or intention to restore the excessive deductions to

income in future years so as to properly reflect * * * [the

taxpayer's] total lifetime income." Id. at 596. In the absence

of proof by the Commissioner that the change was solely a matter

of timing, we declined to sustain a section 481 adjustment.

In Security Associates Agency Ins. Corp. v. Commissioner,

T.C. Memo. 1987-317, the taxpayer was required to include advance

payments of insurance commissions for the year when received

rather than for the following year when earned. We held that

although there had been a change in the taxpayer's method of
 - 81 -

accounting, the Commissioner had improperly computed the section

481 adjustment by including certain items that did not constitute

taxable income, items that may already have been included in the

taxpayer's income, and items for which an offsetting deduction

would have been allowable under the proper method for the year of

the change.

None of the authorities on which petitioners rely conflicts

with the section 481 analysis set forth above. We conclude that

an adjustment under section 481 is proper.14

To reflect the foregoing,

Decisions will be entered

under Rule 155.

14
The sec. 481 adjustment must be recomputed under Rule 155
in accordance with the treatment for Fees prescribed herein.