Toyota Town, Inc. v. Commissioner

T.C. Memo. 2000-40

UNITED STATES TAX COURT

TOYOTA TOWN, INC., A CALIFORNIA CORPORATION, ET AL.,1
Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 4959-95, 4960-95, Filed February 8, 2000.
4961-95, 22741-95,
1254-96, 1255-96,
1256-96.

Bruce I. Hochman and Frederic J. Adam (specially

recognized), for petitioners.

Nancy C. McCurley, for respondent.

1
Cases of the following petitioners are consolidated
herewith: Country Nissan, A California Corporation, docket No.
4960-95; Quality Motor Cars of Stockton, A California
Corporation, docket No. 4961-95; Robert S. and Christina Zamora,
docket No. 22741-95; Bob Wondries Motors, Inc., d.b.a. Wondries
Ford, docket No. 1254-96; Wondries Nissan, Inc., docket No. 1255-
96; and Bob Wondries Associates, Inc., d.b.a. Wondries Toyota,
docket No. 1256-96.
 - 2 -

MEMORANDUM OPINION

GALE, Judge: Respondent determined deficiencies in

petitioners’ Federal income taxes as follows:

Taxable Year Ended Nov. 30
Petitioner 1991 1992 1993

Toyota Town, $8,812 $9,535 $6,762
Inc.

Country Nissan 4,432 4,444 4,373

Quality Motor
Cars of -- 2,429 2,746
Stockton

Bob Wondries
Motors, Inc., -- 6,810 3,457
d.b.a.
Wondries Ford

Wondries
Nissan, Inc. -- 4,131 5,470

Bob Wondries
Motors, Inc., -- 6,683 12,967
d.b.a.
Wondries
Toyota

Respondent also determined deficiencies in the Federal

income taxes of petitioners Robert S. and Christina Zamora for

the taxable years ended December 31, 1992 and 1993, of $212 and

$6,520, respectively.
 - 3 -

These cases were consolidated for trial, briefing, and

opinion.2 Petitioners include the following corporations:

Toyota Town, Inc.; Country Nissan, A California Corporation;

Quality Motor Cars of Stockton, A California Corporation; Bob

Wondries Motors, Inc., d.b.a. Wondries Ford; Wondries Nissan,

Inc.; and Bob Wondries Associates, Inc., d.b.a. Wondries Toyota;

as well as individual petitioners Robert S. and Christina Zamora

(Zamoras), who filed joint returns for the years in issue. The

Zamoras owned, during the years in issue, approximately 48

percent of the issued and outstanding shares of Wondries

Chevrolet, Inc. (Wondries Chevrolet), an S corporation within the

meaning of section 1361(a).3 For convenience, we shall

hereinafter refer to Wondries Chevrolet and the C-corporation

petitioners collectively as petitioners.

The issue for decision is the proper period for petitioners

to deduct insurance premium expense incurred in connection with

sales of extended warranty agreements to their customers.

2
In docket No. 4959-95, the adjustment relating to the 1991
taxable year is not in dispute. In docket No. 4960-95 only the
adjustments relating to the 1992 and 1993 taxable years have been
consolidated, and the adjustment relating to the 1991 taxable
year is not in dispute. In the remaining docket Nos., 4961-95,
22741-95, 1254-96, 1255-96, and 1256-96, all adjustments are
attributable to the common issue in dispute.
3
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
 - 4 -

These cases were submitted fully stipulated pursuant to Rule

122. Our findings of fact are based upon the parties’

stipulation and the attached exhibits, which are incorporated by

this reference. The parties have stipulated that any appeal in

this matter lies to the U.S. Court of Appeals for the Ninth

Circuit.

Background

During the years in issue, petitioners were engaged in

business as retail automobile dealers, in connection with which

they sold extended warranty agreements (EWA’s) to certain retail

purchasers of new and used motor vehicles. Under such EWA’s,

petitioners agreed, in exchange for a single lump-sum fee, to

replace or repair, or to reimburse for the repair of, various

components of a vehicle that failed during an extended multiyear

period.4 After a customer agreed to purchase a vehicle, the

customer was informed of the option to purchase an EWA. The

customer was free to accept or decline and could elect coverages

that varied with respect to years, mileage, or items covered.

The fee or price paid to petitioners by their customers for an

EWA depended upon the coverages selected.

An EWA expressly provides that it is a “SERVICE CONTRACT

4
The coverage period could be denominated 5, 6, or 7 years
or be further restricted by a stated mileage limit, in which case
the coverage would terminate upon the first of either to elapse.
 - 5 -

* * * BETWEEN THE DEALER [i.e., each petitioner] AND YOU [the

vehicle purchaser]” and is “NOT AN INSURANCE POLICY". An EWA

further provides that “Dealer in regards to this contract is

acting as a Principal and not as an Agent on behalf of any

insurer.” An EWA also states: “Issuing Dealer has insurance

with Western General Insurance Co., * * * – a Licensed Insurer.”

Finally, an EWA provides:

NOTICE: If a Breakdown Claim has been filed with
the Issuing Dealer who has failed to pay the claim
within sixty (60) days after proof of loss has been
filed with the Issuing Dealer, you the Service Contract
Purchaser shall also be entitled to make a Direct Claim
against the Issuing Dealer’s insurance company, Western
General Insurance Company * * *

During the years in issue, each petitioner sold EWA’s

pursuant to an agreement (Western General Agreement) with the

Western General Insurance Co. of Encino, California (Western

General), under which Western General assumed petitioners’

liabilities under the EWA’s in exchange for a single lump-sum

payment with respect to each EWA, referred to in the agreements

as an “insurance premium and policy fee”. Under the Western

General Agreement, Western General agreed “to issue and maintain

individual insurance policy coverage at DEALER’S [i.e., each

petitioner’s] expense which shall insure the DEALER for covered

costs of repairs and/or replacements incurred by the DEALER and

covered under the * * * EWA”. Each petitioner agreed to sell

EWA’s only through the forms provided by Western General and to
 - 6 -

follow the underwriting, rating, instructions, and procedures

outlined by Western General. Each petitioner further agreed to

report to Western General every 10 days the EWA’s sold during the

preceding 10 days and to remit “the insurance premium as provided

in * * * [Western General’s] rate chart/manual”.5

Each EWA sold to a customer included an individual Motor

Vehicle Policy of Mechanical Insurance (Vehicle Policy) naming a

petitioner as the insured and listing a covered vehicle, EWA

purchaser, and (multiyear) coverage period corresponding to the

EWA. A Vehicle Policy provides that the premium “shall become

fully earned” by Western General upon inception of the coverage;

however, the Vehicle Policy subsequently provides exceptions

under which a pro rata refund of the premium will be made,

including an election by the insured (i.e., each petitioner) to

cancel within 90 days after inception or the repossession of the

covered vehicle.

Petitioners were not affiliated with or related to Western

General in any way.

Once a petitioner remitted the premium to Western General,

the risk of loss on the related EWA passed entirely to Western

General. Upon payment of the premium, Western General was solely

responsible to the vehicle purchaser for the cost of repairs

5
The parties have stipulated that petitioners in fact made
all such payments to Western General within 60 days after an EWA
was purchased by one of petitioners’ customers.
 - 7 -

covered by the EWA and was obligated to reimburse the purchaser

for claims covered by the EWA provided the purchaser followed the

proper claims procedures. The purchaser could obtain the repairs

at a repair facility other than the Dealership from which the

vehicle was purchased, so long as the purchaser complied with the

terms of the EWA, which provides:

In the event of a Breakdown [i.e., the failure of
a covered part], you [i.e., the EWA purchaser] must
follow this procedure.
1. Return your vehicle to the Dealer [i.e., each
petitioner]. If this is not possible or practical, you
must call his Claims Service (insurer) [i.e., Western
General] for instructions * * *

Petitioners are accrual method taxpayers. For the years in

issue, petitioners elected to report their income from the EWA’s

using the “service warranty income method” set forth in Rev.

Proc. 92-98, 1992-2 C.B. 512, 514. Rev. Proc. 92-98, supra,

permits certain accrual method sellers of motor vehicles and

other durable consumer goods that receive a lump-sum payment

(advance payment) from the sale of a multiyear service warranty

contract to defer recognition of a portion of the advance payment

generally over the life of the service warranty obligation. The

portion of the advance payment permitted to be deferred under

Rev. Proc. 92-98, supra, is the amount paid by the seller (within

60 days of receipt) to an unrelated third party for insurance

costs associated with a policy insuring the seller’s obligations

under the service warranty contract (the qualified advance
 - 8 -

payment amount). (The excess of the advance payment over the

qualified advance payment amount is included in the seller’s

income in the taxable year of receipt.) The revenue procedure

provides that the qualified advance payment amount, as augmented

by certain imputed income equal to the interest cost of the

income deferral, can be deferred and included ratably in income

over the shorter of (1) the period beginning in the taxable year

the advance payment is received and ending when the service

warranty contract terminates, or (2) a 6-taxable-year period

beginning in the taxable year the advance payment is received.6

For purposes of computing the deferral period and the “interest-

equivalent” imputed income, all advance payments for service

warranty contracts sold during the taxable year are effectively

treated as if they were entered into, and payment received, on

the first day of the taxable year.

Rev. Proc. 92-98, supra, further provides that an election

to use the service warranty income method is not available to a

taxpayer unless the taxpayer uses the proper method of accounting

for amounts paid or incurred for insurance costs that cover the

taxpayer’s risks under the service warranty contracts, as

outlined in a revenue procedure issued simultaneously with Rev.

Proc. 92-98, supra; namely, Rev. Proc. 92-97, 1992-2 C.B. 510.

6
The series of level payments thus generated is designed to
equal the present value of the qualified advance payment amount.
 - 9 -

See Rev. Proc. 92-98, secs. 9, 4.04, 1992-2 C.B. at 517, 513.

With respect to accounting for insurance costs, Rev. Proc. 92-97,

supra, provides that lump-sum amounts, paid in advance for

multiyear insurance policies to insure a consumer durable goods

seller’s obligations to customers under multiyear warranty

contracts sold to them, must be capitalized and prorated or

amortized over the life of the insurance policy. See Rev. Proc.

92-97, sec. 2.07, 1992-2 C.B. at 511.

During the years at issue, in accordance with Rev. Proc. 92-

98, supra, petitioners reported as income in the year of receipt

the difference between the total amount received from the sale of

EWA’s and the total amount paid to Western General. The

remaining proceeds from the sale of EWA’s--i.e., the amounts paid

to Western General to insure petitioners’ risks under the EWA’s,

or qualified advance payment amounts--were, as increased by an

interest-equivalent factor, included in income ratably over the

terms of the EWA’s. Pursuant to Rev. Proc. 92-98, supra, for

purposes of computing the income required to be included each

year in connection with the qualified advance payment amount,

petitioners treated the proceeds from the sale of EWA’s as having

been received on the first day of the taxable year in which an

EWA was sold.

Petitioners took deductions for the amounts paid to Western

General for assumption of the EWA liabilities by capitalizing
 - 10 -

such amounts and amortizing them in a manner which departed in

one respect from the method prescribed in Rev. Proc. 92-97,

supra. Whereas Rev. Proc. 92-97, supra, provides that a seller’s

payment for a multiyear insurance policy covering the seller’s

obligations under a service warranty contract must be amortized

over the actual life of the policy, petitioners computed their

amortization deductions using an accounting convention under

which the premium payment and policy inception were deemed to

have occurred on the first day of the taxable year in which the

policy was obtained, irrespective of the actual date of payment

and policy inception. This methodology, which resembled the

convention prescribed in Rev. Proc. 92-98, supra, for the

recognition of income from the qualified advance payment amount,

resulted in petitioners’ taking amortization deductions in the

first taxable year of a policy’s inception equal to a full year’s

worth of amortization, without regard to the actual date of

payment and policy inception. In effect, this increase in the

first year’s amortization deduction caused it, as well as each

ensuing year’s deduction, to match the ratable portion of the

deferred EWA income required to be included pursuant to the terms

of Rev. Proc. 92-98, supra. As a result, the “net” income

recognized by petitioners consisted only of the excess of the

aggregate EWA prices charged to petitioners’ customers over the

aggregate premiums paid by petitioners to Western General in the
 - 11 -

year of inception of an EWA, plus the imputed income represented

by the interest-equivalent factor in each of the years of the

contract term.

In the notices of deficiency, respondent determined that the

service warranty income reported by petitioners had been computed

incorrectly for the years in issue.7 Respondent contends that

petitioners incorrectly computed their deduction for insurance

costs in the year a policy was purchased by taking a full year’s

worth of amortization rather than amortization measured from the

actual date of the policy’s inception and payment of the premium.

In the absence of information regarding the actual dates of sale

of EWA’s, respondent recomputed petitioners’ amortization

deductions on the assumption that the transactions had occurred

ratably over the years in issue.

In their petitions, petitioners alleged that respondent

erred in recomputing the amortization deductions, contending that

their amortization of insurance expense should be computed using

the same methodology as that used in computing receipt of EWA

income; that is, the convention deeming qualified advance payment

amounts as having been received on the first day of the taxable

year should likewise apply for amortization of insurance expense,

7
In the case of the Zamoras, the deficiency was determined
on the basis of the Zamoras’ distributive share of comparable
adjustments made to the warranty income of their S corporation,
Wondries Chevrolet.
 - 12 -

so that payments for insurance of the warranty risk should be

deemed to have occurred on the first day of the taxable year for

all such payments, regardless of when the payments were actually

made.

Discussion

I. Matters Properly Raised

As a preliminary matter, we must first decide which issues

have been properly raised in these cases. In addition to the

proper period for amortizing insurance expense, which was

challenged in respondent’s determination and was the basis on

which petitioners assigned error to that determination in their

petitions, petitioners now argue, for the first time on brief,

that the EWA proceeds that were remitted to Western General are

not income to petitioners, on the basis of the “claim of right”

doctrine and income attribution principles. Should petitioners

prevail with respect to these contentions, they maintain that

they are entitled to refunds for overpayments in the years at

issue. Respondent objects to our consideration of petitioners’

claims that the amounts paid to Western General are not income to

them, on the grounds that respondent did not receive “fair

warning” of petitioners’ intention to raise this issue.

We believe the inclusion of the amounts paid to Western

General in petitioners’ income is not an issue properly before us

for two reasons. First, petitioners fully conceded this issue
 - 13 -

before submission of these cases. Petitioners have stipulated

that the portion of the EWA proceeds that was paid over to

Western General “was * * * properly included in [petitioners’]

income over the terms of the EWA in accordance with Revenue

Procedure 92-98". (Emphasis added.) Second, to the extent there

is any conceivable ambiguity in this stipulation (and we do not

suggest that there is), we believe that respondent is correct

that he did not receive “fair warning” of petitioners’ intention

to raise any issue concerning income inclusion.

As a pleading, the petition has as its purpose “to give the

parties and the Court fair notice of the matters in controversy”.

Rule 31(a). Generally speaking, issues not raised in the

assignments of error in the petition are deemed conceded. See

Rule 34(b)(4). Whether issues not raised in the pleadings will

nonetheless be considered is a matter for the Court’s discretion,

taking into account the prejudice to the opposing party.

The rule that a party may not raise a new issue on
brief is not absolute. Rather, it is founded upon the
exercise of judicial discretion in determining whether
considerations of surprise and prejudice require that a
party be protected from having to face a belated
confrontation which precludes or limits that party’s
opportunity to present pertinent evidence. * * * [Ware
v. Commissioner, 92 T.C. 1267, 1268 (1989), affd. 906
F.2d 62 (2d Cir. 1990).]

It is clear that petitioners did not provide notice in their

petitions of an intention to contest the inclusion in income of

the amounts paid to Western General. The error alleged in the
 - 14 -

petitions, which are substantially identical, was respondent’s

failure to permit consistent treatment of service warranty income

and associated insurance expense. As phrased in the petitions,

“The narrow issue involved herein is the consistent treatment of

the service warranty income and the offsetting premium expense”.

There were no claims of overpayments. No amendments of the

pleadings have been sought or granted. The parties agreed to

submit these cases fully stipulated in accordance with Rule 122.

Approximately 2 weeks before submission of the cases, petitioners

served a trial memorandum upon respondent in which they listed

the sole issue in the cases as: “What is the proper tax period

for deducting amounts paid by a retail auto dealer in connection

with its obligations to its customers under extended warranty

agreements?”.8

We believe respondent justifiably concluded that petitioners

were not contesting the inclusion in their income of amounts paid

to Western General. We further find that respondent would be

prejudiced if petitioners were permitted to raise this issue for

the first time on brief in fully stipulated cases. “‘Of key

importance in evaluating the existence of prejudice is the amount

8
Although in the analysis section of their trial memorandum
petitioners at one point characterize the amounts they paid to
Western General as “phantom income” in which they have “no
interest”, we do not believe this single reference in an extended
discussion constitutes adequate notice that petitioners intended
to raise “claim of right” or income attribution issues.
 - 15 -

of surprise and the need for additional evidence on behalf of the

party opposed to the new position.’” Sundstrand Corp. v.

Commissioner, 96 T.C. 226, 347 (1991) (quoting Pagel, Inc. v.

Commissioner, 91 T.C. 200, 211-212 (1988), affd. 905 F.2d 1190

(8th Cir. 1990)). Because the parties agreed to submit these

cases fully stipulated, respondent made his decisions regarding

what evidence to proffer on the basis of the pleadings and the

stipulations, including the stipulation that the amounts paid to

Western General were “properly” included in petitioners’ income.

To be confronted with this new issue after the evidentiary record

is closed is prejudicial to respondent. Accordingly, we will not

consider whether the amounts paid to Western General were not

includable in petitioners’ income on the basis of the “claim of

right” doctrine or income attribution principles. Instead, we

shall consider only the issue that was properly raised; namely,

the appropriate period for deducting the amounts paid by

petitioners to a third-party insurer to assume petitioners’ risks

under the EWA’s that petitioners sold to their customers.

II. Proper Period To Deduct Amounts Paid for Multiyear Insurance

A. Petitioners’ Arguments

To support their position that respondent’s determinations

are erroneous, petitioners argue that respondent abused his

discretion by requiring petitioners to change their method of
 - 16 -

accounting9 from one that clearly reflects income to a method

that distorts income, or, alternatively, that the qualified

advance payment amounts should be fully deductible in the year

paid to Western General. We consider each in turn.

B. Abuse of Discretion

1. In General

Petitioners contend that respondent’s effort to limit their

amortization deduction for insurance costs to a pro rata portion

of the premium in the first year, measured by the portion of the

year for which the policy was actually in force, constitutes an

abuse of discretion. In petitioners’ view, the method of

accounting for insurance costs for multiyear policies that they

employed, which involved deducting a full year’s worth of premium

in the first year, regardless of the actual date of commencement

of coverage, effects a clear reflection of income because it more

closely matches expense with associated income-–given the

requirement of Rev. Proc. 92-98, 1992-2 C.B. 512, that the

corresponding income be recognized under a convention that treats

it as received on the first day of the year without regard to

actual receipt. The method sought by respondent, petitioners

9
The parties do not dispute that the timing of petitioners’
deductions for the amounts paid to Western General constitutes a
“method of accounting” within the meaning of sec. 446. See sec.
1.446-1(a)(1), Income Tax Regs. (“The term ‘method of accounting’
includes not only the over-all method of accounting of the
taxpayer but also the accounting treatment of any item.”).
 - 17 -

contend, distorts income because it limits the deduction of the

expense associated with an EWA to a partial year’s portion when a

full year’s portion of associated income must be recognized

pursuant to Rev. Proc. 92-98, supra. Petitioners summarize their

argument as follows:

Because petitioner’s method of accounting is an
acceptable method which clearly reflects its income,
Respondent is not allowed to require petitioner to
change its method of accounting. Prabel v.
Commissioner, * * * [91 T.C. 1101, 1112 (1988), affd.
882 F.3d 880 (3d Cir. 1989)]; Hallmark Cards, Inc. v.
Commissioner, * * * [90 T.C. 26, 31 (1988)]. To force
a change from a method which clearly reflects
excessive[10] income to a method which materially
distorts income, is an abuse of discretion. Molsen v.
Commissioner, 85 T.C. 485, 498, 509 (1985). * * *

Petitioners’ position, in effect, is that they may report

their income from EWA’s in accordance with the provisions of Rev.

Proc. 92-98, supra, but with respect to the computation of

deductions arising from EWA transactions, they are free to

disregard the method outlined in Rev. Proc. 92-97, 1992-2 C.B.

510, and devise a method that more closely matches the income and

expense associated with the qualified advance payment amount.

Petitioners are wrong, for at least two reasons. First, it

is not an abuse of discretion for the Commissioner to establish

10
Petitioners’ reference to “excessive” income is
apparently an allusion to their belief that the imputed income
required to be recognized under Rev. Proc. 92-98, 1992-2 C.B.
512, is not appropriate.
 - 18 -

reasonable conditions upon the use of an accounting method that

has been established administratively. Second, even disregarding

any authority of the Commissioner to impose conditions upon the

use of an administratively established accounting method,

petitioners are not entitled to use the amortization method they

have employed because it contravenes the regulations.

2. Reasonable Administrative Conditions

Petitioners describe the instant cases as ones where

respondent is attempting to “force” petitioners to change from a

method of accounting which clearly reflects income to one which

does not. We disagree with this characterization. Respondent

has not attempted to “force” a change in petitioners’ accounting

methods. Rather, the Commissioner, relying upon his authority

under section 446(b), administratively established in Rev. Proc.

92-98, supra, a method of accounting for certain prepaid services

income of accrual basis taxpayers engaged in the sale of

multiyear service warranty contracts for which third-party

insurance is obtained. Petitioners elected this method, which

permits deferral of a portion of the prepaid services income

(equal to the amount which is paid over to a third party to

assume the risk under the warranty contracts).

The Commissioner imposed certain conditions, however, upon a

taxpayer’s eligibility to elect the method provided in Rev. Proc.

92-98, supra, including specifically the requirement that an
 - 19 -

electing taxpayer account for the insurance expense associated

with the warranty contracts under the method described in Rev.

Proc. 92-97, supra. Petitioners disregarded this requirement and

used a different method to account for insurance expense.

Petitioners effectively argue that they are entitled to do so

because their method of amortizing insurance expense, which

treats the coverage period as if it commenced on the first day of

the taxable year regardless of the actual date, results in better

matching with the prepaid income that is deferred under Rev.

Proc. 92-98, supra, since such income is recognized under a

convention that likewise deems all amounts received on the first

day of the taxable year regardless of actual date. Because of

the matching achieved under their method, petitioners contend it

clearly reflects income while the method sought by respondent

does not.

Petitioners may not avail themselves of the benefits of

deferral provided in Rev. Proc. 92-98, supra, without adhering to

the conditions imposed by the Commissioner. See Mulholland v.

United States, 28 Fed. Cl. 320, 344 (1993) (taxpayers’ failure to

adhere to conditions of a revenue procedure renders them

ineligible for its benefits), affd. 22 F.3d 1105 (Fed. Cir.

1994). Rev. Proc. 92-98, supra, is the only authority cited by

petitioners for the method which defers recognition of a portion
 - 20 -

of a prepayment for a multiyear warranty agreement.11 Absent

Rev. Proc. 92-98, supra, the Commissioner generally would have

discretion under section 446(b) to deny taxpayers the right to

defer prepaid services income until the periods when related

costs will be incurred and taken into account. See 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,

664 F.2d 881, 885-888 (2d Cir. 1981); Johnson v. Commissioner,

108 T.C. 448, 491-492 (1997), affd. in part, revd. in part and

remanded 184 F.3d 786 (8th Cir. 1999); see also Hinshaw’s, Inc.

v. Commissioner, T.C. Memo. 1994-327 (requiring recognition of

prepayment for extended warranty services in year of receipt, in

circumstances nearly identical to instant cases). Thus, the

basis for deferral that petitioners claim is only available to

them if they meet the conditions of eligibility. See Mulholland

v. United States, supra. It is not an abuse of discretion for

respondent to impose as a condition on the election of the method

in Rev. Proc. 92-98, supra, the requirement that petitioners use

the method in Rev. Proc. 92-97, supra, to account for their

11
Petitioners attempted to advance the argument on brief
that the amounts paid to Western General were not income to them
at all. We concluded, supra, that this issue was not properly
raised. In any event, such an argument offers no basis for the
deferral of income; it concerns exclusion of income, not
deferral.
 - 21 -

insurance expense, since this condition, as discussed more fully

below, does no more than require adherence to existing

regulations. We think the Commissioner’s broad discretion to

determine whether a method of accounting clearly reflects income

under section 446(b), see Thor Power Tool Co. v. Commissioner,

439 U.S. 522 (1979); Commissioner v. Hansen, 360 U.S. 446, 467

(1959), coupled with the requirement in section 446(e) that the

Commissioner’s consent be secured for any change in method,

encompasses the authority to impose the condition at issue

herein.

Petitioners’ argument that their method of accounting for

insurance expense produces superior matching of income and

related expense is unavailing. Matching of income and related

expense does not necessarily result in a clear reflection of

income for tax purposes. See Thor Power Tool Co. v.

Commissioner, supra at 543. A prepayment for services to be

performed in the future must be recognized when received, even

though this would mismatch expenses and revenues. See American

Auto. Association v. United States, supra; Automobile Club of

Michigan v. Commissioner, supra. Absent Rev. Proc. 92-98,

supra, existing law would require an even greater mismatch of EWA

income and associated insurance expense than the “distortion”

that petitioners complain is produced by Rev. Procs. 92-98 and

92-97, supra. Existing law would require the recognition of the
 - 22 -

entire amount of EWA income in the year of receipt without regard

to the period in which related insurance expense would be

deferred. See Schlude v. Commissioner, supra; American Auto.

Association v. United States, supra; Automobile Club of Michigan

v. Commissioner, supra; Johnson v. Commissioner, supra;

Hinshaw’s, Inc. v. Commissioner, supra. The Commissioner acted

within his authority under section 446(b) to allow taxpayer-

favorable deferral of income in Rev. Proc. 92-98, 1992-2 C.B.

512; the Commissioner is not required to make the further

concession of accelerating deductions beyond the requirements of

existing law.

3. Compliance With Regulations

Relying on Prabel v. Commissioner, 91 T.C. 1101 (1988), and

Hallmark v. Commissioner, 90 T.C. 26 (1988), petitioners argue

that respondent may not require petitioners to change their

current method because it is “an acceptable method which clearly

reflects * * * [petitioners’] income”. Petitioners’ reliance is

misplaced. Prabel and Hallmark hold that the Commissioner may

not disturb a taxpayer’s method of accounting that is

specifically authorized in the Internal Revenue Code or income

tax regulations. The method used by petitioners to amortize the

amounts paid to Western General, by contrast, violates the

regulations.
 - 23 -

For accrual basis taxpayers such as petitioners, a liability

is incurred in the taxable year in which all events have occurred

that establish the fact of the liability, the amount of the

liability can be determined with reasonable accuracy, and

economic performance has occurred with respect to the liability.

See secs. 1.446-1(c)(1)(ii)(A), 1.461-1(a)(2), Income Tax Regs.

With respect to economic performance, the regulations provide

that where the liability arises out of the provision of insurance

to the taxpayer, economic performance occurs when payment is made

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

Section 1.461-1(a)(2), Income Tax Regs., further provides

that while a liability is generally taken into account for

Federal income tax purposes in the taxable year in which it is

incurred, the Internal Revenue Code and income tax regulations

provide exceptions to the general rule, including where

capitalization is required.

Applicable provisions of the Code, the Income Tax
Regulations, and other guidance published by the
Secretary prescribe the manner in which a liability
that has been incurred is taken into account. For
example, * * * under section 263 or 263A, a liability
that relates to the creation of an asset having a
useful life extending substantially beyond the close of
the taxable year is taken into account in the taxable
year incurred through capitalization (within the
meaning of § 1.263A-1(c)(3)), and may later affect the
computation of taxable income through depreciation or
otherwise over a period including subsequent taxable
years, in accordance with applicable Internal Revenue
Code sections and guidance published by the Secretary.
* * * [Sec. 1.461-1(a)(2)(i), Income Tax Regs.]
 - 24 -

A prepayment for multiyear insurance coverage creates an asset

having a useful life longer than a taxable year, which must be

capitalized. See Higginbotham-Bailey-Logan Co. v. Commissioner,

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

Tax Regs.; see also USFreightways Corp. v. Commissioner, 113 T.C.

___ (1999); Johnson v. Commissioner, supra at 488; Hinshaw’s,

Inc. v. Commissioner, T.C. Memo. 1994-327. The prepaid insurance

is an intangible, and its coverage period gives it a determinable

useful life, making it eligible for a “depreciation allowance”.

Sec. 1.167(a)-3, Income Tax Regs. The rules for computing the

proper period for a depreciation allowance are provided in

section 1.167(a)-10(b), Income Tax Regs., which states in

relevant part:

(b) The period for depreciation of an asset shall
begin when the asset is placed in service and shall end
when the asset is retired from service. A
proportionate part of one year’s depreciation is
allowable for that part of the first and last year
during which the asset was in service. * * *

In general, “an asset is ‘placed in service’ for depreciation

purposes when it is acquired and available for use.” Clairmont

v. Commissioner, 64 T.C. 1130, 1136 (1975), affd. without

published opinion 538 F.2d 332 (8th Cir. 1976). Petitioners’

claim of a full year’s amortization in the first year that a

multiyear insurance policy is acquired or placed in service,

without regard to when during the year the policy was in fact
 - 25 -

placed in service, directly contravenes the rule in section

1.167(a)-10(b), Income Tax Regs., which allows only a

“proportionate part of one year’s depreciation” in the first and

last years of a period of service. We have so held in similar

circumstances where the taxpayer sought to claim a full year’s

depreciation for assets placed in service at any time during the

first 5 months of the taxable year. See Clairmont v.

Commissioner, supra at 1136.

Petitioners cite no authority for their method of

amortization, other than to claim that, by precisely matching the

recognition of the deferred insurance expense with the

recognition of the deferred income permitted in Rev. Proc. 92-98,

supra, for their EWA’s, they have effected a clear reflection of

income, which respondent may not disturb. However, a method of

accounting that is “plainly inconsistent” with valid regulations

does not clearly reflect income within the meaning of section

446(b). Thor Power Tool Co. v. Commissioner, 439 U.S. at 533;

see Van Raden v. Commissioner, 71 T.C. 1083, 1105 (1979), affd.

650 F.2d 1046 (9th Cir. 1981).

4. Whether Petitioners Purchased Insurance

Petitioners also argue that the agreement they entered with

Western General did not constitute insurance-–specifically, that

petitioners’ liability to Western General did not arise out of

the provision of insurance and therefore the payments to Western
 - 26 -

General neither created a capital asset nor required

amortization. Petitioners employ the contention that they did

not purchase insurance from Western General both in an effort to

avoid the dictates of the foregoing capitalization rules and as

the basis for their alternative argument that the payments to

Western General were fully deductible in the year paid.

Nevertheless, the record contradicts petitioners’ contention

that the arrangement with Western General did not constitute the

provision of insurance to them. In their petitions, petitioners

assert as a fact that they managed the risks associated with the

future obligations they assumed under the EWA’s “by obtaining

commercial insurance coverage therefor from an unrelated third-

party insurer, Western General Insurance Co.”. Because

petitioners did not dispute the nature of their arrangement with

Western General as constituting the purchase of insurance until

after submission of these cases fully stipulated, the record with

respect to this issue is not exhaustive. However, the available

evidence belies petitioners’ claim. First, petitioners have

stipulated that the amounts paid to Western General were for

insurance costs. Specifically, petitioners stipulated that “All

amounts paid to Western General during the years at issue by

* * * petitioners constitute qualified advance payment amounts.”

Rev. Proc. 92-98, 1992-2 C.B. at 513, to which reference is

repeatedly made in the stipulations, defines the term “qualified
 - 27 -

advance payment amount” as “the portion of an advance payment

received by a taxpayer under a multi-year service warranty

contract that is paid by that taxpayer to an unrelated third

party * * * for insurance costs associated with a policy insuring

that taxpayer’s obligations under the contract”. Moreover, the

EWA’s between petitioners and their customers warrant that the

“Issuing Dealer has insurance with Western General Insurance Co.,

* * *-–a Licensed Insurer.” The Western General Agreement

entered into by each petitioner and Western General states that

Western General agrees to “issue and maintain individual

insurance policy coverage at DEALER’S [i.e., each petitioner’s]

expense which shall insure the DEALER for covered costs of

repairs and/or replacements incurred by the DEALER and covered

under the * * * [EWA]” and that each petitioner agrees to remit

to Western General “the insurance premium as provided in its rate

chart/manual”.

In addition to the foregoing admissions, stipulations, and

agreement terms, the evidence of the substance of petitioners’

arrangements with Western General supports the conclusion that

petitioners’ liability to Western General arose from the

provision of insurance. The regulations which define “economic

performance” in the case of a liability for insurance provided to

the taxpayer further provide that “insurance” for this purpose

“has the same meaning as is used when determining the
 - 28 -

deductibility of amounts paid or incurred for insurance under

section 162.” Sec. 1.461-4(g)(5)(ii), Income Tax Regs. The

arrangements between petitioners and Western General involved an

insurance risk (namely, the risk of loss associated with the

liability assumed by the seller of an EWA), the shifting of that

risk from each petitioner to Western General (as the parties have

stipulated that the risk of loss under the EWA’s passed from

petitioners to Western General once petitioners made payment to

Western General), and the distribution or pooling of that risk

(since the record establishes that Western General assumed the

risks of multiple sellers of EWA’s). Thus we believe petitioners

purchased “insurance” from Western General for purposes of

section 162. Cf. Sears, Roebuck & Co. v. Commissioner, 96 T.C.

61, 100-101 (1991), affd. in part, revd in part and remanded on

another issue 972 F.2d 858 (7th Cir. 1992). We also note that

applicable State law requires retail automobile dealers, such as

petitioners, that sell vehicle service contracts incident to

automobile sales either to purchase insurance covering their

liabilities under such contracts or to become insurers subject to

the provisions of the California Insurance Code and regulation by

the California Department of Insurance. See Cal. Ins. Code sec.

116(c) (West 1993); Clemens v. American Warranty Corp., 238 Cal.

Rptr. 339, 344-345 (Ct. App. 1987). Petitioners state on brief

that they are not in the insurance business.
 - 29 -

On this record, petitioners have failed to show error in

respondent’s determination insofar as it is premised on the

conclusion that petitioners purchased insurance from Western

General.

Moreover, in Hinshaw’s, Inc. v. Commissioner, T.C. Memo.

1994-327, we held in virtually identical circumstances that the

prepayment of a multiyear insurance policy covering the

taxpayer’s obligations under a multiyear vehicle service contract

is not deductible in the year of payment but must be amortized

over the life of the coverage. We reasoned that the taxpayer

acquired a long-term asset by purchasing insurance covering a

period greater than 1 year and that, since the taxpayer benefited

from the coverage for more than 1 year, the cost must be

capitalized. See id.; see also Johnson v. Commissioner, 108 T.C.

at 488.12

Petitioners attempt to distinguish Hinshaw’s, Inc. v.

Commissioner, supra, on the basis that the “policies” obtained

12
In Johnson v. Commissioner, 184 F.3d 786 (8th Cir. 1999)
affg. in part, revg. in part and remanding 108 T.C. 448 (1997),
the Court of Appeals for the Eighth Circuit affirmed our holding
that the cost of insurance premiums was required to be
capitalized and amortized over the life of the coverage.
However, the Court of Appeals reversed with respect to certain
fees paid for administrative services provided by an
administrator unrelated to the insurer, holding that such fees
were deductible in the year of payment. See id. at 789. Here,
petitioners have stipulated, and the other evidence indicates, as
discussed supra, that all amounts paid to Western General were
for insurance costs.
 - 30 -

from Western General had no surrender value, and on the basis

that petitioners remained primarily liable on their service

contracts (i.e., the EWA’s). Petitioners’ assertion that the

policies had no surrender value appears to be in error. Although

the Vehicle Policies provide that Western General’s premium is

fully earned upon the inception of coverage, the Policies provide

exceptions where a pro rata refund of the premium would be

provided to petitioners, such as when a vehicle is repossessed.

Further, we are not persuaded that the absence of a surrender

value affects the capitalization requirement for a prepaid

multiyear insurance policy. Regardless of surrender value, the

policies herein afforded protection to petitioners with respect

to covered claims for a period of years, and there is no

indication in recent decisions involving prepaid insurance

coverage for extended service agreements that surrender value was

important. See, e.g., Johnson v. Commissioner, supra; Hinshaw’s,

Inc. v. Commissioner, supra.

As to petitioners’ claim that Western General, not they,

remained “primarily liable” to the vehicle purchaser, the EWA’s

provide as follows:

The Dealer [i.e., each petitioner] will repair
and/or replace, or at its option either pay for or
reimburse you [i.e., the EWA purchaser] or the repair
facility for reasonable costs to repair any of the
covered parts * * * which break down.

* * * * * * *
 - 31 -

Dealer in regards to this contract is acting as a
Principal and not as an Agent on behalf of any insurer.

* * * * * * *

In the event of a Breakdown, you must follow this
procedure.
1. Return your vehicle to the Dealer. If this is not
possible or practical, you must call his Claims Service
(insurer) for instructions * * *

* * * * * * *

NOTICE: If a Breakdown Claim has been filed with
the Issuing Dealer who has failed to pay the claim
within sixty (60) days after proof of loss has been
filed with the Issuing Dealer, you the Service Contract
Purchaser shall also be entitled to make a Direct Claim
against the Issuing Dealer’s insurance company, Western
General Insurance Company * * * [Emphasis in original.]

The foregoing terms contradict petitioners’ assertions and

satisfy us that petitioners remained primarily liable on the

EWA’s, notwithstanding that they had transferred the risk of loss

associated with that liability to Western General.

III. Conclusion

Because petitioners’ payments to Western General were for

the provision of multiyear insurance policies, petitioners’

method of taking a full year’s amortization of the insurance

expense in the year of a policy’s inception, irrespective of the

actual commencement date of the policy, violates the regulations.

Accordingly, petitioners’ method does not clearly reflect income,

and respondent is not proscribed from seeking to change

petitioners’ method so that it conforms with the requirements of
 - 32 -

sections 1.461-1(a)(2)(i) and 1.167(a)-10(b), Income Tax Regs.

Where the taxpayer has used a method of accounting that does not

clearly reflect income, the Commissioner has considerable

discretion to determine a method clearly reflecting income that

the taxpayer must use. See sec. 446(b); Thomas v. Commissioner,

92 T.C. 206, 220 (1989). The Commissioner has broad discretion

in determining whether a method of accounting clearly reflects

income. See Commissioner v. Hansen, 360 U.S. at 447.

Petitioners have offered no evidence of the actual

commencement dates of the policies obtained from Western General

during the years at issue or otherwise shown error in

respondent’s determination that such policies were obtained on a

ratable basis. Therefore we sustain respondent’s determination

that petitioners must amortize their insurance expenses on the

basis that such expenses were incurred ratably during the years

in issue.

To reflect the foregoing,

Decisions will be entered

for respondent.