T.C. Memo. 2000-383
UNITED STATES TAX COURT
MID-DEL THERAPEUTIC CENTER, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
D. RICHARD ISHMAEL, M.D., PC, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 9060-97, 9270-97. Filed December 19, 2000.
Bruce A. Moates and LeRoy D. Boyer, for petitioners.
Elizabeth Downs, for respondent.
MEMORANDUM OPINION
MARVEL, Judge: These cases are before the Court on
petitioners’ motion for award of litigation and administrative
- 2 -
costs1 filed pursuant to section 7430 and Rule 231.2 Petitioners
seek to recover litigation costs of $44,456 incurred in
contesting respondent’s deficiency determinations in docket No.
9060-97 for the taxable year ended April 30, 1995, and in docket
No. 9270-97 for the taxable year 1995.
The issues for decision are whether respondent’s position at
trial was substantially justified and, if not, whether the
attorney’s fees and other costs that petitioners seek to recover
are reasonable in amount. Neither petitioners nor respondent
requested an evidentiary hearing, and the Court concludes that
such a hearing is not necessary for the proper disposition of
petitioners’ motion. See Rule 232(a)(2).
Background
Petitioner Mid-Del Therapeutic Center, Inc. (Mid-Del), and
petitioner D. Richard Ishmael, M.D., PC (PC), are Oklahoma
corporations, each of which operates an oncology clinic in the
Oklahoma City metropolitan area. On the dates the petitions in
these consolidated cases were filed, Mid-Del’s principal place of
business was in Midwest City, Oklahoma, and PC’s principal place
1
Although the title of the motion referred to administrative
costs, petitioners claimed only litigation costs in the motion.
Consequently, our discussion is limited to petitioners’ claim for
litigation costs.
2
Unless otherwise indicated, all section references are to
the Internal Revenue Code, and all Rule references are to the Tax
Court Rules of Practice and Procedure.
- 3 -
of business was in Oklahoma City, Oklahoma. Dr. D. Richard
Ishmael, an oncologist, owns 100 percent of the stock of both
Mid-Del and PC. PC is Dr. Ishmael’s personal service
corporation, and Mid-Del is a subchapter C corporation owned and
managed by Dr. Ishmael.
During the relevant periods, petitioners operated medical
clinics that purchased and used chemotherapy drugs (drugs) to
treat patients with cancer and other illnesses. PC maintained an
onsite pharmacy where the drugs purchased by both PC and Mid-Del
were stored and where a pharmacist employed by PC mixed and
prepared chemotherapy treatments for both clinics. Petitioners
used approximately 85 different drugs to treat patients.
With the exception of Mid-Del’s Federal income tax return
for the taxable year 1993, both Mid-Del and PC used the cash
method of accounting (cash method) for income tax purposes and
consistently reported the drugs used in patient treatments as
supplies and not as inventory. Mid-Del’s 1993 return, which
originally was filed using the accrual method of accounting
(accrual method), was amended to report income and expenses on
the cash method after a revenue agent determined on audit that
Mid-Del was required to use the cash method. It was a customary
and accepted practice in the health care industry for health care
practitioners to use the cash method.
- 4 -
By notices of deficiency dated April 23, 1997, respondent
determined deficiencies of $140,025 and $211,979 in Mid-Del’s and
PC’s Federal income taxes, respectively. The crux of the
deficiencies was respondent’s determination, made pursuant to
section 446(b), that petitioners must use an accrual method to
compute their taxable income.
By separate petitions, petitioners commenced their cases in
this Court, and the cases were consolidated for trial.
Respondent argued at trial that the drugs used to treat patients
were merchandise, the purchase and sale of which were income-
producing factors in petitioners’ businesses, and that
petitioners, therefore, were required by section 1.471-1, Income
Tax Regs., to use the accrual method to compute their taxable
income. Petitioners asserted that the drugs were supplies used
in the course of treating patients and that section 1.471-1,
Income Tax Regs., was inapplicable.
Section 446(b) vests the Commissioner with broad discretion
to determine whether a particular method of accounting clearly
reflects income. See Knight-Ridder Newspapers, Inc. v. United
States, 743 F.2d 781, 788 (11th Cir. 1984); Ansley-Sheppard-
Burgess Co. v. Commissioner, 104 T.C. 367, 370 (1995). In
reviewing the Commissioner’s determination that a taxpayer’s
method of accounting does not clearly reflect income, the
function of the Court is to decide whether the Commissioner
- 5 -
abused his discretion in making that determination under section
446(b). See RCA Corp. v. United States, 664 F.2d 881, 886 (2d
Cir. 1981). Consequently, at trial, petitioners had the burden
of proving that respondent’s determination was arbitrary,
capricious, or without sound basis in fact or law. See Knight-
Ridder Newspapers, Inc. v. United States, supra.
After these cases were tried but before the opinion was
issued, the Court’s opinion was filed in Osteopathic Med.
Oncology & Hematology, P.C. v. Commissioner, 113 T.C. 376 (1999),
which presented facts strikingly similar to those involved in the
present cases. In Osteopathic Med. Oncology & Hematology, P.C.,
a taxpayer, specializing in the treatment of cancer through
chemotherapy, used the cash method to expense the cost of drugs
used during treatments. The Commissioner argued that the drugs
were merchandise under section 1.471-1, Income Tax Regs., and,
therefore, the taxpayer had to use the accrual method to report
income and costs attributable to the drugs. This Court held that
the drugs were not merchandise and that the taxpayer properly
used the cash method to expense the cost of the drugs and report
income. Osteopathic Med. Oncology & Hematology, P.C., was not
appealed, and the decision became final on April 7, 2000. See
secs. 7481(a)(1), 7483; cf. Fed. R. App. P. 13(a).
In Mid-Del Therapeutic Ctr., Inc. v. Commissioner, T.C.
Memo. 2000-130 (Mid-Del I), we held that respondent’s
- 6 -
determination, requiring petitioners to change from the cash
method to the accrual method, was arbitrary, capricious, or
without sound basis in fact or law. In so doing, we relied
heavily on Osteopathic Med. Oncology & Hematology, P.C.
Petitioners thereafter filed their motion seeking to recover
litigation costs.
Discussion
In general, section 74303 provides for the award of
reasonable litigation costs to a taxpayer who: (1) Is the
prevailing party in a court proceeding brought against the United
States involving the determination of any tax, interest or
penalty pursuant to the Internal Revenue Code; (2) has exhausted
his or her administrative remedies within the IRS; and (3) did
not unreasonably delay or protract the court proceedings.
Respondent concedes that petitioners exhausted their
administrative remedies and that they did not unreasonably delay
or protract these proceedings.
To be a prevailing party, a taxpayer must satisfy the
applicable net worth requirement and must substantially prevail
3
Sec. 7430 as most recently amended by Congress in the IRS
Restructuring and Reform Act of 1998, Pub. L. 105-206, sec. 3101,
112 Stat. 685, 727, applies to that portion of the claimed costs
incurred after Jan. 18, 1999. Sec. 7430 as amended by the
Taxpayer Relief Act of 1997, Pub. L. 105-34, secs. 1285, 1453,
111 Stat. 788, 1038, 1055, applies to that portion of the claimed
costs incurred on or before Jan. 18, 1999.
- 7 -
with respect to either the amount in controversy or the most
significant issue or set of issues presented. See sec.
7430(c)(4)(A). Respondent concedes that petitioners have
substantially prevailed and that they meet the applicable net
worth limitation but argues that his litigating position was
substantially justified. If respondent can establish that the
position taken in Mid-Del I was substantially justified, then
petitioners fail to qualify as prevailing parties. See sec.
7430(c)(4)(B). In deciding whether to award reasonable costs,
therefore, we address only the issue of whether respondent’s
position was substantially justified.
The Commissioner’s position is substantially justified if
the Commissioner acted reasonably in pursuing his litigating
position on the basis of all of the facts and circumstances and
the applicable legal precedents. See Pierce v. Underwood, 487
U.S. 552, 564 (1988); Sher v. Commissioner, 89 T.C. 79, 84
(1987), affd. 861 F.2d 131 (5th Cir. 1988). Although the
Commissioner’s litigating position may have been incorrect in
hindsight, it is substantially justified “if a reasonable person
could think it correct”. Pierce v. Underwood, supra at 566 n.2.
The fact that the Commissioner eventually loses a case does not
establish that the position was unreasonable. See Anthony v.
United States, 987 F.2d 670, 674 (10th Cir. 1993); Sokol v.
Commissioner, 92 T.C. 760, 767 (1989). We decide whether the
- 8 -
Commissioner’s position was reasonable by examining applicable
facts and circumstances at the time he asserted his position in
the answer and during the trial. See Maggie Management Co. v.
Commissioner, 108 T.C. 430, 443 (1997).
Petitioners contend that the decision of this Court in
Mid-Del I, which held that respondent’s determination was
arbitrary, capricious, or without sound basis in fact or law,
necessarily leads to a conclusion that respondent’s position at
trial was unreasonable. In support of this assertion,
petitioners rely on Mauerman v. Commissioner, T.C. Memo. 1995-237
(Mauerman II), which held that a failure by the Commissioner to
waive an addition to tax was unreasonable. Respondent argues
that Mauerman II does not stand for the proposition for which it
is cited by petitioners and that respondent’s litigating position
was reasonable.
In Mauerman v. Commissioner, T.C. Memo. 1993-23, revd. 22
F.3d 1001 (10th Cir. 1994) (Mauerman I), the issue that was
litigated was whether the taxpayer should be subject to additions
to tax under section 6661(a). At trial, the taxpayer had the
burden of proving that the Commissioner’s imposition of the
additions to tax was arbitrary, capricious, or without sound
basis in fact or law. This Court upheld the additions to tax and
decided that the Commissioner had not abused his discretion. The
Court of Appeals for the Tenth Circuit reversed the decision of
- 9 -
this Court, holding that the Commissioner’s determination to
impose the additions to tax was arbitrary, capricious, or without
sound basis in fact or law and remanded for further proceedings.
On remand, the taxpayer filed a motion for litigation costs.
In Mauerman II, the taxpayer contended that the
determination of the Court of Appeals that the Commissioner’s
failure to waive the addition to tax was an abuse of his
discretion necessarily led to a conclusion that the
Commissioner’s position was unreasonable and urged us to grant
the taxpayer’s motion for reasonable litigation costs. Although
we agreed with the taxpayer’s conclusion that the Commissioner’s
litigating position in Mauerman I was unreasonable under the
circumstances involved there, we recognized the possibility that
a different conclusion might be reached in other cases. We
explained our position as follows:
In Mauerman I, we stated that, in order to prevail
on the addition to tax issue, “petitioner must show
* * * that respondent’s refusal to waive is an abuse of
discretion.” In reversing our decision, the Court of
Appeals agreed with petitioner * * * that the
Commissioner should have waived the addition to tax.
The question before us, then, is whether respondent was
substantially justified in defending, in the instant
litigation, an administrative determination that was
held by the Court of Appeals to be an abuse of
discretion; i.e., arbitrary, capricious, or without
sound basis in fact. While there may be other
situations where such a holding would not necessarily
determine that respondent was not substantially
justified, our review of the record in the instant case
persuades us that petitioner has carried his burden in
that respect.
- 10 -
Accordingly, on the basis of the record in the
instant case, we conclude that respondent’s position
was not substantially justified. [Mauerman v.
Commissioner, T.C. Memo. 1995-237; emphasis added.]
Mauerman II does not stand for the blanket proposition,
asserted by petitioners, that, if this Court finds that the
Commissioner’s determination is arbitrary, capricious, or without
sound basis in fact or law, it necessarily follows that his
litigating position cannot be substantially justified. Rather,
Mauerman II acknowledges that there may be situations in which
the Commissioner’s litigating position in support of a
determination is substantially justified even though the
determination ultimately is held to be arbitrary, capricious, or
without sound basis in fact or law. We must decide whether this
is one of those situations.
Respondent contends that this case presents one of the
“other situations” contemplated in Mauerman II. In respondent’s
objection to petitioners’ motion for award of litigation and
administrative costs filed June 13, 2000, respondent summarizes
his position as follows:
Whenever respondent determines a taxpayer’s method of
accounting does not clearly reflect income, the
standard of review is abuse of discretion. Thor Power
Tool Co. v. Commissioner, 439 U.S. 522, 532 (1979);
Cole v. Commissioner, 586 F.2d 747, 749 (9th Cir.
1978), affg. 64 T.C. 1091 (1975). The Court’s
conclusion that a change in accounting method was
unwarranted requires a finding that the Commissioner
abused his discretion; however, the record does not
support a finding that respondent had no factual or
- 11 -
legal basis for his position. Moreover, it is clear
that there was no existing legal authority that would
have made respondent’s arguments under sections 446 and
471 unreasonable since, at least until the issuance of
Osteopathic Medical, the pivotal issue in this case,
whether oncology drugs administered by health care
providers constituted merchandise, was an issue of
first impression. Accordingly, unlike Mauerman, the
record in this case does not warrant a determination
that respondent’s position was not substantially
justified.
Respondent urges us, as we did in Stieha v. Commissioner, 89
T.C. 784, 790-791 (1987), to allow respondent a reasonable amount
of time following adverse litigation on an issue of first
impression to adjust his litigating position before we determine
that his litigating position warrants an award of costs under
section 7430. Respondent points out that the decision in
Osteopathic Med. Oncology & Hematology, P.C. v. Commissioner, 113
T.C. 376 (1999), became final on April 7, 2000, just 4 days
before the opinion in the instant case was rendered. Twenty-one
days after the decision in Osteopathic Med. Oncology &
Hematology, P.C. became final, the Commissioner issued an action
on decision acquiescing in that case as to result only. See
Action on Decision 2000-005 (Apr. 28, 2000).
Respondent’s litigating position at trial in Mid-Del I
flowed from his conclusion that the drugs purchased and used by
petitioners were merchandise and an income-producing factor in
their businesses. In support of this position, respondent argued
that the drugs were tangible products that were purchased by
- 12 -
petitioners and consumed by the patients, that the cost of the
drugs was significant, and that the permissible charges for the
drugs were listed separately on bills submitted by petitioners to
third-party insurers. Respondent relied on the seminal case of
Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d 352 (1st Cir.
1970), affg. T.C. Memo. 1969-79,4 for the proposition that the
drugs were merchandise. See also Tebarco Mechanical Corp. v.
Commissioner, T.C. Memo. 1997-311; Thompson Elec., Inc. v.
Commissioner, T.C. Memo. 1995-292; J.P. Sheahan Associates., Inc.
v. Commissioner, T.C. Memo. 1992-239; Surtronics, Inc. v.
Commissioner, T.C. Memo. 1985-277; Epic Metals Corp. & Subs. v.
Commissioner, T.C. Memo. 1984-322, affd. without published
opinion 770 F.2d 1069 (3d Cir. 1985).
Our evaluation of the facts and circumstances presented by
Mid-Del I, as well as the legal environment from which
respondent’s litigating position evolved, leads us to the
conclusion that respondent’s litigating position in Mid-Del I was
substantially justified. See Stieha v. Commissioner, supra at
790-791. The issue of whether drugs used in treating patients
4
In Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d 352 (1st
Cir. 1970), affg. T.C. Memo. 1969-79, the Court of Appeals for
the First Circuit held that caskets sold by service-oriented
businesses were merchandise even though the caskets were not held
for sale in the traditional retail context. The taxpayer was a
funeral home that sold caskets as part of the funeral services it
provided to customers.
- 13 -
constituted merchandise in the context of whether the accrual
method must be used was an issue of first impression on which no
court had ruled until we filed our opinion in Osteopathic Med.
Oncology & Hematology, P.C. v. Commissioner, supra. The
Commissioner generally is not subject to an award of litigation
costs under section 7430 where the underlying issue presents a
question of first impression. See TKB Intl., Inc. v. United
States, 995 F.2d 1460, 1468 (9th Cir. 1993); Estate of Wall v.
Commissioner, 102 T.C. 391 (1994). Moreover, the Commissioner
has been granted considerable discretion, by statute, to
determine whether a method of accounting clearly reflects income.
See sec. 446; Don Casey Co. v. Commissioner, 87 T.C. 847, 862
(1986). Before our decision in Osteopathic Med. Oncology &
Hematology, P.C., Wilkinson-Beane, Inc. v. Commissioner, supra,
and its progeny provided at least a colorable factual and legal
basis for the Commissioner’s conclusion that drugs used in
treating patients constituted merchandise, thereby requiring
petitioners to use the accrual method.5
5
The earlier determination made by a revenue agent, that the
cash method should have been used by Mid-Del on its 1993 Federal
income tax return, has no bearing on the decision that the
position taken by respondent at trial was substantially
justified. Although a presumption of unreasonableness exists if
the Commissioner argues a position in the administrative
proceeding that is contrary to any applicable published guidance
of the Commissioner, an initial determination by a revenue agent
does not qualify as guidance that leads to such a presumption.
(continued...)
- 14 -
Petitioners argue in the alternative that respondent was not
substantially justified with regard to other issues that we did
not find necessary to address in Mid-Del I. On brief, in Mid-Del
I, petitioners argued that even if the drugs were merchandise
petitioners could continue to use the cash method. We need not
address the substantive issue involved in this argument but only
whether the position taken by respondent at trial in response to
it was substantially justified.
Respondent’s position at trial was that section 1.471-1,
Income Tax Regs., mandates that if petitioners maintain
inventories, then petitioners may not use the cash method unless
petitioners demonstrate that the cash method produces a
substantially identical result to that produced by the accrual
method. In support of this argument, respondent relied on
Asphalt Prods. Co. v. Commissioner, 796 F.2d 843, 848 (6th Cir.
1986), affg. in part and revg. in part Akers v. Commissioner,
T.C. Memo. 1984-208, revd. in part on other grounds 482 U.S. 117
(1987); Ansley-Sheppard-Burgess Co. v. Commissioner, 104 T.C. at
5
(...continued)
See sec. 7430(c)(4)(B)(ii); sec. 301.7430-5, Proced. & Admin.
Regs. Furthermore, the Commissioner is not estopped from
attempting to change a method of accounting approved in earlier
years if, in later years, the Commissioner concludes that method
does not clearly reflect income. See Thomas v. Commissioner, 92
T.C. 206, 225-226 (1989); Ezo Prods. Co. v. Commissioner, 37 T.C.
385, 391 (1961).
- 15 -
377; and Addison Distribution, Inc. v. Commissioner, T.C. Memo.
1998-289. Respondent’s litigating position was substantially
justified under the circumstances.
We hold, therefore, that respondent has established that his
litigating position challenging petitioners’ method of accounting
in Mid-Del I was substantially justified because respondent’s
challenge was reasonable given the facts and circumstances of
petitioners’ cases and the applicable law. Accordingly,
petitioners are not entitled to recover litigation costs. In
light of our ruling, we need not decide whether the costs claimed
by petitioners are reasonable.
We have considered carefully all remaining arguments made by
petitioners for a result contrary to that expressed herein, and,
to the extent not discussed above, we consider them to be
irrelevant or without merit.
To reflect the foregoing,
Appropriate orders and
decisions will be entered.