T.C. Memo. 1998-98
UNITED STATES TAX COURT
BUYERS HOME WARRANTY COMPANY, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 24774-95. Filed March 9, 1998.
William L. Feinstein, for petitioner.
Mark A. Weiner, for respondent.
MEMORANDUM OPINION
RAUM, Judge: The Commissioner determined a $356,179
deficiency in petitioner's 1990 Federal income taxes. The
Commissioner determined that petitioner's method of accounting
did not accurately reflect petitioner's income. The notice of
deficiency changed the method of accounting and implemented a
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corresponding adjustment under section 481.1 At issue is whether
the year of change, the first year the new accounting method is
applied, is the first open year, 1990, or the year in which the
IRS initiated the audit, 1993. This case was submitted on the
basis of a stipulation of facts.
Petitioner is a California corporation with its principal
office in Burbank, California. Petitioner operates under a
license granted by the California State Department of Insurance.
It sold its first contract on January 12, 1988.
Petitioner sells home warranty contracts to buyers and
sellers of previously owned residential property. Under the
terms of the basic home warranty contract, petitioner agrees to
repair or replace appliances and covered systems (such as heating
systems) that become inoperative during the term of the contract.
Customers can buy additional coverage for other appliances and
systems not covered by the basic coverage for additional
consideration.
The home warranty contracts commence with the close of
escrow and are in effect for 1 year, except for mobile home
contracts which are in effect for 6 months. A homeowner can
renew the contract upon its expiration, but only if petitioner
agrees. Approximately 10 percent of the contracts are renewed.
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the year in issue.
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The contracts are noncancellable and nonrefundable, but can be
transferred to a subsequent buyer if within the contract period
and petitioner is notified. The home warranty contracts do not
cover damage from certain events such as fire, flood, storm,
neglect or other acts of God. They are intended to insure
against inoperation from normal wear and tear.
Petitioner does not directly repair or replace any failed
appliance or covered system. Rather, petitioner has contracted
with a network of independent contractors and technicians to make
the repairs.
Petitioner reported as income 1/12 of the income received
for each month a contract was in effect during a taxable year.
It also incorporated a half-month convention for the month in
which the contract was sold. For example, if a 1-year contract
was sold in July of year 1 for $240, $10 would be recognized as
income for July and $20 would be recognized for each month from
August through December of year 1. Thus, from the $240 received
by petitioner in year 1, it would report $110 ($10 + $20 x 5).
The remaining $130 would be deferred until year 2. In year 2,
petitioner would recognize $20 for each month from January
through June and $10 for July. ($20 x 6 + $10 = $130) A similar
method was used for the 6-month mobile home contracts.
In addition to the above, petitioner deducted as an "other
deduction," an amount of 20 percent of the premiums it
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recognized. (Except for 1988, when it deducted 20 percent of the
entire amount of contracts written in 1988.) It described this
deduction as "provisions for reserves." Thus, continuing the
example used above, when it recognized $110 in year 1, petitioner
would take a deduction of $22 in year 1 ($110 x .2) and called
this deduction a "provision for reserve." In year 2, petitioner
would recognize as income the "provision for reserve" deduction
from the prior year. Thus, in year 1, petitioner effectively
reported $88 ($110 - $22). In year 2, petitioner reported $152
($130 + $22).
Respondent commenced an examination of petitioner's 1990 and
1991 returns in March 1993. (Later during the examination 1992
was included.) Prior to the commencement of the examination,
petitioner made no application to respondent with respect to
changing its method of accounting for its income and deductions.
During respondent's examination of petitioner, the issue arose as
to whether the home warranty contracts constitute insurance
contracts for purposes of section 832. To resolve that issue,
the parties participated in obtaining technical advice from
respondent's national office. This process of obtaining
technical advice was initiated by respondent's revenue agent by
means of a memorandum (Form 4463, Request for Technical Advice
From Associate Chief Counsels (Technical) and (International))
dated June 17, 1993. Petitioner participated in the technical
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advice process and advocated that the contracts it sold were
insurance contracts. Respondent's revenue agent took the
position that the contracts were something other than insurance
contracts. On December 10, 1993, respondent issued a Technical
Advice Memorandum concluding that the home warranty contracts are
insurance contracts for purposes of section 832. At no time
during the examination did petitioner submit a Form 3115,
requesting a change in method of accounting, although in 1994
petitioner requested of respondent's Appeals Office that
petitioner be treated as if it had requested a change in method
of accounting.2
The parties have since stipulated that the home warranty
contracts described above are insurance contracts; petitioner is
an "insurance company other than a life insurance company" as
described in section 831; and the revenue generated from the
insurance contracts is "gross income" as defined in section
832(b)(1) and (3). Petitioner reported its income and deductions
from the sale of its insurance contracts using what it believed
to be a GAAP (Generally Accepted Accounting Principles) method of
accounting. The method of accounting used by petitioner for
2
In its briefs, petitioner consistently maintains that the
year of change should be 1993. Petitioner argues that in 1993 it
requested of the Appeals Office that it be treated as if it had
requested a change in accounting method. However, the
stipulation of facts states that petitioner made the request of
the Appeals Office in 1994. Since petitioner uses 1993 in its
brief, we use that year henceforth in this opinion.
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taxable years 1988 through 1992 was not in accordance with
section 832(b)(4).
The notice of deficiency made various adjustments to
petitioner's income and "provision for reserves" deductions so as
to put petitioner on the method of accounting prescribed by
section 832(b)(4). The notice of deficiency made these changes
by determining a deficiency in the first open year, 1990. The
notice of deficiency does not take into account any net operating
losses which may have been generated by the 1993 taxable year.
The only remaining issue for consideration is which year, 1990 or
1993, is the year of change.3
Section 446(a) requires a taxpayer to compute his taxable
income using the method of accounting he uses to calculate his
income in keeping his books. Section 446(b) provides that "if
the method used does not clearly reflect income, the computation
of taxable income shall be made under such method as, in the
opinion of the Secretary, does clearly reflect income." When the
taxpayer's accounting method is changed, section 481(a) requires
that adjustments be made to the taxpayer's income "to prevent
amounts from being duplicated or omitted".
3
The stipulation of facts states that petitioner does not
agree that respondent properly applied sec. 481(b). Petitioner
does not argue that point on brief. Therefore, we treat
petitioner as having conceded the issue.
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The adjustments made to implement the new accounting method
are applied in the "year of change", defined by section 1.481-
1(a)(1), Income Tax Regs, as "the taxable year for which the
taxable income of the taxpayer is computed under a method of
accounting different from that used for the preceding taxable
year." Neither section 481 nor the accompanying regulations
explain how the year of change is chosen. When the taxpayer
requests a change in accounting method, the IRS uses Rev. Proc.
92-20, 1992-1 C.B. 685, to determine the year of change. When
the taxpayer makes no request, the changes required by
examination are applied by default to the earliest open year for
which the limitations period has not expired.
Here, the year of change is the earliest open year.
Petitioner has stipulated that before the examination began,
petitioner made no application to the IRS with respect to
changing its method of accounting. At no time during the
examination did petitioner submit a Form 3115, formally
requesting to change its accounting method. Since petitioner did
not initiate a change in its accounting method, Rev. Proc. 92-20,
supra, does not apply. The IRS was free to apply the accounting
method changes to the earliest open year under examination.
Consequently, the year of change is 1990.
Petitioner's sole contention is that the year of change
should be 1993 instead of 1990. Petitioner makes two main
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arguments. First, petitioner asserts that it was not "required"
to change its accounting method pursuant to section 1.481-
1(c)(5), Income Tax Regs. Second, petitioner alleges that Rev.
Proc. 92-20, 1992-1 C.B. 685, violates equal protection.
Section 1.481-1(c)(5), Income Tax Regs., provides that "A
change in the taxpayer's method of accounting required as a
result of an examination of the taxpayer's income tax return will
not be considered as initiated by the taxpayer." (Emphasis
supplied.) Both the regulations and Rev. Proc. 92-20, supra,
differentiate between accounting method changes initiated by the
taxpayer and those initiated by the Commissioner. The year of
change is more favorable if the change is initiated by the
taxpayer.
Petitioner asserts the following: During the audit, the IRS
suggested petitioner be treated as a warranty company. In
response, petitioner proposed, as a compromise, that it be
treated as an insurance company. According to petitioner, that
compromise was accepted by respondent via the technical advice
memorandum. Because it was a "compromise", petitioner argues
that "there was no requirement that petitioner change accounting
methods." Petitioner's Opening Brief, p. 9.
Despite the spin petitioner attempts to place on events,
nothing in the record indicates that petitioner initiated any of
the events relating to its change of accounting method. The
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stipulation of facts states that petitioner advocated that it was
an insurance company. There is nothing to support its contention
that it "proposed a compromise". After the examination ended,
the Commissioner issued a notice of deficiency. In its
Explanation of Adjustments, the notice of deficiency states:
"it is required that the taxpayer change the accounting methods
previously employed to methods permitted or required under the
provisions of the Code." (Emphasis supplied.) Petitioner was
required to submit to the audit, and it was required by the
notice of deficiency to change its accounting method.
Petitioner's situation falls squarely within the second sentence
of section 1.481-1(c)(5), Income Tax Regs. Petitioner's
accounting method change was "required as a result of an
examination of the taxpayer's income tax return".
Petitioner also contends that Rev. Proc. 92-20, supra,
violates equal protection. The revenue procedure provides that
the year of change depends on whether and when a taxpayer
requests a change of accounting method. Petitioner argues that
equal protection has been violated in its case because there were
no cases or other rulings that indicated that petitioner's
original method of accounting was erroneous. Petitioner attempts
to bolster its argument by pointing out that the IRS agent who
proposed that the warranty method be used was overruled by the
national office. According to petitioner, the fact that the
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national office did not concur with the field agent means
petitioner had no reason to presume its method was incorrect.
Petitioner's argument is fundamentally flawed. First, even
if one method advocated by the IRS was not adopted, it does not
follow that petitioner's existing method was correct. Section
1.446-1(a)(2), Income Tax Regs., acknowledges that the same
method of accounting cannot be used by all taxpayers. It is
required that the method chosen clearly reflect income. In
petitioner's case, it agreed that it was an insurance company.
Thus, it is required by statute to use the method of accounting
prescribed by section 832.
Second, petitioner injects a subjective element into the
Code that does not exist. There is nothing in the statute or
regulations concerning what to do if the taxpayer thought,
incorrectly, that the method used clearly reflected income. The
IRS is concerned with collecting the correct amount of revenue.
Nowhere in the applicable provisions of the Code does the
taxpayer get credit if it thought it correctly calculated income.
If the taxpayer acts in good faith, but is incorrect, it owes the
deficiency. If it is willfully or negligently incorrect, it may
also owe penalties and additions to tax. Petitioner here owes
only the deficiency.
The purpose of Rev. Proc. 92-20, 1992-1 C.B. 685, is to
"encourage prompt voluntary compliance" and correct the
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deficiency of Rev. Proc. 84-74, 1984-2 C.B. 736. That revenue
procedure had been used by a number of taxpayers to request a
change in a later year and on better terms than those contained
in the statute. In other words, a taxpayer, even if aware that
its accounting method did not clearly reflect income, could apply
for a method change, and, in doing so, receive better terms than
if the IRS had mandated the change. Rev. Proc. 92-20, 1992-1
C.B. at 688.
Petitioner has stipulated that it should be following the
method of accounting described in section 832. Petitioner
further stipulated that its method of accounting was not in
accordance with section 832(b)(4). As a result, its method did
not clearly reflect income. However, if petitioner is allowed to
use 1993 as the year of change, it will be allowed to knowingly
use an incorrect method for 3 years. This is the situation Rev.
Proc. 92-20, supra, was implemented to prevent.
Petitioner alludes to various sections of the revenue
procedure to bolster its claim that its year of change should be
1993. These sections do not apply to petitioner for the simple
reason that petitioner was under examination.
The Commissioner is given broad authority to determine
whether a taxpayer's accounting method clearly reflects income.
That determination "is not to be set aside unless it is shown to
be plainly arbitrary or an abuse of discretion." Gustafson v.
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Commissioner, T.C. Memo. 1988-82. Petitioner has failed to
demonstrate an abuse of discretion.
Decision will be entered
for respondent.