T.C. Memo. 2001-149
UNITED STATES TAX COURT
ALACARE HOME HEALTH SERVICES, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 9566-99. Filed June 22, 2001.
Robert C. Walthall, for petitioner.
Marshall R. Jones, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
COLVIN, Judge: Respondent determined deficiencies in
petitioner’s Federal income tax of $136,895 for 1995 and $58,726
for 1996 and accuracy-related penalties under section 6662(a) of
$27,379 for 1995 and $11,745 for 1996.
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After concessions,1 the issues for decision are:
1. Whether petitioner, an accrual-basis taxpayer, may
expense in 1995 and 1996 the cost of assets that each cost less
than $500 and that have a useful life of more than one year, or
whether petitioner must capitalize the cost of those assets. We
hold that it must capitalize those costs.
2. Whether petitioner is liable for the accuracy-related
penalty for substantial understatement of income under section
6662(a) for 1995 and 1996. We hold that it is not.
Section references are to the Internal Revenue Code in
effect during the years in issue, and Rule references are to the
Tax Court Rules of Practice and Procedure.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
A. Petitioner
Petitioner is a Medicare-certified home health care
agency whose principal place of business was in Birmingham,
Alabama, when it filed the petition in this case. Petitioner
uses the accrual method of accounting.
1
Respondent concedes that the 1996 adjustment for office
expenses should be $247,413 rather than $259,062. Due to a
mathematical error in the notice of deficiency, the 1995 computer
expenses adjustment should be $104,806 rather than $101,806.
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B. Medicare Guidelines
The Federal Health Care Financing Administration (HCFA)
reimburses certified home health care agencies, such as
petitioner, for the reasonable costs of providing home health
care services to Medicare beneficiaries. About 98-99 percent of
petitioner’s revenues are Medicare reimbursements.
Petitioner must comply with accounting guidelines contained
in the Medicare Provider Reimbursement Manual (HCFA Publication
15-1) (the manual) and must submit to annual compliance audits of
its books and records by one of Medicare’s fiscal intermediaries.
The manual contains guidelines concerning providers’
capitalization and expensing policies. Those guidelines state:
108. GUIDELINES FOR CAPITALIZATION OF HISTORICAL COSTS
AND IMPROVEMENT COSTS OF DEPRECIABLE ASSETS
108.1 Acquisitions.–If a depreciable asset has at the
time of its acquisition an estimated useful life of at
least 2 years and a historical cost of at least $500,
its costs must be capitalized, and written off ratably
over the estimated useful life of the asset, using one
of the approved methods of depreciation. If a
depreciable asset has a historical cost of less than
$500, or if the asset has a useful life of less than 2
years, its cost is allowable in the year it is acquired
* * *.
The provider may, if it desires, establish a:
capitalization policy with lower minimum criteria, but
under no circumstances may the above minimum limits be
exceeded. For example, a provider may elect to
capitalize all assets with an estimated useful life of
at least 18 months and a historical cost of at least
$400. However, it may not elect to only capitalize
assets with a useful life of at least 3 years and a
historical cost of more than $600.
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C. Medicare Guidelines and Petitioner’s Expensing Policy
Petitioner was incorporated in 1982. Since then, petitioner
has expensed all capital items for which it paid less than $500.
Petitioner followed that practice in 1995 and 1996. Its
expensing policy complies with Medicare guidelines for the
capitalization of depreciable assets described above.
The following chart shows the number, total cost, and
average cost of office items petitioner bought in 1995 and 1996
which have an expected useful life of one year or longer and
which cost less than $500 (the disputed assets):
1995 1996
Number of office and computer
items costing less than
$500 each 2,632 2,381
Total cost of office and
computer items $467,944 $351,543
Average cost per item 177.79 147.65
Petitioner’s office items included bookcases, chairs,
credenzas, desks, organizers, file cabinets, hutches,
refrigerators, microwaves, serving carts, panels and accessories,
tables, telephones, and typewriters. Petitioner’s computer items
included modems, CD ROMs, hard drives, keyboards, motherboards,
memory modules, outlets, processors, servers, software, and
terminals.
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D. Petitioner’s Income Tax Returns
Petitioner hired Pearlman, Nebben & Associates, an
accounting firm that specializes in the health care industry, to
prepare its 1995 and 1996 Federal corporate income tax returns.
Petitioner’s director of accounting and chief financial officer
reviewed those returns for accuracy.
Petitioner reported gross receipts of $55,128,001 and
$49,184,394, and taxable income of $284,062 and $420,950 on its
1995 and 1996 returns, respectively.
E. The Notice of Deficiency
Respondent determined that petitioner’s policy of expensing
assets that cost less than $500 was not a proper method of
accounting, and that petitioner must capitalize the cost of the
disputed assets over their useful lives.2
OPINION
A. Whether Petitioner Must Capitalize the Cost of the Disputed
Assets
We must decide whether petitioner, an accrual basis
taxpayer, must capitalize the cost of items that cost less than
$500 and that have a useful life of more than one year.
1. Section 263 and Section 446
In general, amounts paid to acquire machinery and equipment,
furniture and fixtures, and similar property having a useful life
2
Respondent allowed depreciation for the disputed assets
of $72,802 for 1995 and $178,819 for 1996.
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substantially beyond the taxable year must be capitalized. See
sec. 263(a)(1); Otis v. Commissioner, 73 T.C. 671, 674 (1980),
affd. without published opinion 665 F.2d 1053 (9th Cir. 1981);
sec. 1.263(a)-2(a), Income Tax Regs.
Section 446 provides in pertinent part:
SEC. 446(a). General Rule.--Taxable income shall
be computed under the method of accounting on the basis
of which the taxpayer regularly computes his income in
keeping his books.
(b) Exceptions.--If no method of accounting has
been regularly used by the taxpayer, or 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.
2. Petitioner’s Position
Petitioner relies on Cincinnati, New Orleans & Tex. Pac. Ry.
Co. v. United States, 191 Ct. Cl. 572, 424 F.2d 563, 569 (1970);
and Union Pac. R.R. Co. v. United States, 208 Ct. Cl. 1, 524 F.2d
1343 (1975). The taxpayers in Cincinnati and Union Pacific were
required by the Interstate Commerce Commission (ICC) to expense
purchases of certain property costing less than $500 (i.e., the
minimum rule expenses). See Cincinnati, New Orleans & Tex. Pac.
Ry. Co. v. United States, supra at 565; Union Pac. R.R. Co. v.
United States, supra at 1347. The Court of Claims held in both
cases that the taxpayer may deduct a de minimis amount of
expenses for low-cost capital assets having a useful life greater
than 1 year if the accounting method established by the ICC
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clearly reflects income. See Cincinnati, New Orleans & Tex. Pac.
Ry. Co. v. United States, supra at 567-578; Union Pac. R.R. Co.
v. United States, supra at 1347-1348. The Court of Claims in
Cincinnati relied on our prior rejection of the Commissioner’s
contention that section 263 is dispositive without considering
section 446:
We reject as without merit respondent’s contention
that section 263 of the Code is in and of itself
dispositive of the issue before us. By requiring the
capitalization of amounts “paid out for new buildings
or for permanent improvements or betterments made to
increase the value of any property,” such section begs
the very question we are asked to answer. We are
satisfied that, under the circumstances involved
herein, sections 263 and 446 are inextricably
intertwined.
Cincinnati, New Orleans & Tex. Pac. Ry. Co. v. United States,
supra at 568-569 (quoting Fort Howard Paper Co. v. Commissioner,
49 T.C. 275, 283-284 (1967)). The Court of Claims in Cincinnati
also said that “The determinative question, therefore, is not
what is the useful life of the asset in question, although that
inquiry is relevant, but does the method of accounting employed
clearly reflect income.” Id. at 568. The court noted that the
disputed items were a minute fraction of the taxpayer’s net
income, yearly operating expenses, and yearly depreciation
deduction. See id. at 571. The court concluded that the ICC’s
minimum expensing rule was in accordance with generally accepted
accounting principles, see id. at 569-570, and that the
taxpayer’s financial statements clearly reflected income, see id.
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at 572-573. In Union Pac. R.R. Co. v. United States, supra at
1347-1348, the Court of Claims rejected the Commissioner’s
attempt to distinguish Cincinnati.
Petitioner contends that, like the taxpayers in Cincinnati
and Union Pacific, its method of accounting clearly reflected its
income within the meaning of section 446, and that respondent’s
attempt to change petitioner’s accounting method was an abuse of
discretion. Petitioner also contends that respondent cannot
change its method of accounting because petitioner has
consistently used an accounting method that clearly reflects
income.
3. Comparison of Facts in Cincinnati, Union Pacific, and
This Case
The following chart compares petitioner to the taxpayers in
Cincinnati and Union Pacific (to the extent a comparison can be
made based on the record in this case and the Court of Claims’
opinions in Cincinnati3 and Union Pacific):
Cincinnati Union Pacific Petitioner
(1947, 1948 and 1949) (1942) (1995 and 1996)
1. Disputed Items
Disputed $12,854
items 11,006 $467,944
24,715 $113,718 351,543
3
See Cincinnati, New Orleans & Tex. Pac. Ry. Co. v. United
States, 191 Ct. Cl. 572, 600 (1970). The numerical data from
Cincinnati can be found only in the Court of Claims reports.
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2. Taxable Income1
Taxpayer’s 8,087,437
net taxable 11,012,143 284,062
income 7,657,574 420,950
Disputed items/ .16%
Net taxable .10% 165.0%
income .32% 83.5%
3. Capital Expenses
Taxpayer’s 2,805,532
total capital 751,690
expenses 3,341,014
Disputed items/ .46%
total capital 1.46%
expenses .74%
4. Operating Expenses2
Taxpayer’s total 23,413,171
operating 26,239,267 218,307,770
expenses 24,451,126
Disputed items/ .06% .05%
Yearly operating .04%
expense .01%
5. Total Investment
Account3
Taxpayer’s total 71,305,124
investment 75,626,528
account 75,813,924 442,726,752
Disputed items/ .02% .03%
Total investment .01%
account .03%
6. Depreciation4
Disputed items/ 1.0% 288%
total depreciation .8% 189%
expenses 1.8%
7. Gross Receipts
Taxpayer’s gross 34,854,625 55,128,001
receipts 40,272,864 49,184,394
36,180,454
Disputed .04% .85%
items/gross .03% .71%
receipts .07%
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1
The ratio of the taxpayer’s expenses for disallowed minimum rule
items to its net taxable income was considered in Cincinnati, New Orleans &
Tex. Pac. Ry. Co. v. United States, 424 F.2d at 571.
2
The ratio of the taxpayer’s expenses for disallowed minimum rule
items to its yearly operating expenses was considered in Cincinnati, New
Orleans & Tex. Pac. Ry. Co. v. United States, 424 F.2d at 571, and Union Pac.
R.R. Co. v. United States, 524 F.2d at 1348.
3
The ratio of the taxpayer’s expenses for disallowed minimum rule
items to its total investment account was considered in Union Pac. R.R. Co. v.
United States, 524 F.2d at 1348.
4
The ratio of the taxpayer’s expenses for disallowed minimum rule
items to its yearly depreciation expenses was considered in Cincinnati, New
Orleans & Tex. Pac. Ry. Co. v. United States, 424 F.2d at 571.
4. Whether Petitioner’s Method of Accounting Clearly
Reflects Income
As discussed next, we conclude that the Cincinnati and Union
Pacific cases do not establish that petitioner’s expensing of
capital items costing less than $500 results in a clear
reflection of its income. See, e.g., Knight-Ridder Newspapers,
Inc. v. United States, 743 F.2d 781, 791-793 (11th Cir. 1984)
(Court used mathematical analysis to decide that the taxpayer’s
accounting method did not clearly reflect income).
First, the above chart shows that the ratios of disputed
items to various measures of petitioner’s size are substantially
larger than in Cincinnati and Union Pacific. For example, in
Cincinnati, the taxpayer’s disputed items were less than one
percent of the taxpayer’s net income in the 3 years at issue,
see Cincinnati, New Orleans & Tex. Pac. Ry. Co. v. United States,
424 F.2d at 571; in the instant case, the disputed items were 165
percent of petitioner’s 1995 taxable income and 83.5 percent of
its 1996 taxable income. In Cincinnati, the taxpayer’s disputed
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items were less than 2 percent of its total deduction for
depreciation for the years in issue; in contrast, petitioner’s
disputed items were 288 percent and 189 percent of its total
depreciation deduction for 1995 and 1996.
Petitioner contends that comparing the disputed items to its
gross receipts shows that its accounting method did not
materially distort its income. We disagree. First, the disputed
items of the taxpayer in Cincinnati were .04 percent, .03
percent, and .07 percent of its gross receipts in the years at
issue, whereas petitioner’s disputed items were .85 percent and
.71 percent of its gross receipts in 1995 and 1996. Thus,
petitioner’s ratios were 10 to 28 times larger than those in
Cincinnati. Petitioner points out that the court in Cincinnati
compared the taxpayer’s disputed items to its total operating
expenses, and contends that we should compare petitioner’s
disputed items to its total expenses. We disagree that this
helps petitioner. In Cincinnati, the taxpayer’s disputed items
were .06 percent, .04 percent, and .01 percent of its total
operating expenses for the years in issue; petitioner’s disputed
items were .84 percent and 1.12 percent of its total expenses.
Petitioner’s ratios are 14 to 112 times larger than those in
Cincinnati.
Second, additional factors were present in Cincinnati that
have not been shown to be present here. The court in Cincinnati
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considered 17 years of data such as the taxpayer’s gross
receipts, capital expenses, total investment, net taxable income,
total operating expenses, total depreciation, and the disputed
minimum items, in deciding that the taxpayer’s method of
accounting clearly reflected income. See id. at 569, 571.
Petitioner did not offer evidence from its years other than the
years at issue.
The court in Cincinnati noted that the record there
contained evidence that the ICC had adopted the minimum rule
after concluding that imposition of the minimum rule would not
distort income or cause the railroads' financial statements not
to clearly reflect income. See id. at 570. In contrast, here
petitioner offered no evidence that HCFA considered whether a
minimum expensing policy would cause financial statements of home
health care agencies not to clearly reflect income.
The taxpayer’s expensing method in Cincinnati was in
accordance with generally accepted accounting principles (GAAP).
See id. at 569-570. Petitioner contends that its minimum
expensing rule also complies with GAAP but offered no evidence to
support that contention.
The ICC required the taxpayers in Cincinnati and Union
Pacific to expense the items that were the subject of the
disallowed deductions. In contrast, Medicare guidelines permit,
but do not require, petitioner to expense the disputed assets.
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Cf. Commissioner v. Idaho Power Co., 418 U.S. 1, 14-15 (1974)
(where a taxpayer’s generally accepted method of accounting is
made compulsory by a regulatory agency and that method clearly
reflects income, it is almost presumptively controlling for
Federal tax purposes); Sprint Corp. v. Commissioner, 108 T.C.
384, 403-404 (1997).
Petitioner contends that we have sanctioned the use of a
minimum expensing rule, citing Galazin v. Commissioner, T.C.
Memo. 1979-206, in which we allowed the taxpayer to deduct the
cost of a calculator due to the small amount of the expenditure
($52.45) and the relatively short (2-year) useful life of the
asset. Here, respondent disallowed deductions of $467,944 and
$351,543 for the disputed items. These amounts are not
comparable to the amount at issue in Galazin. Cf. Sharon v.
Commissioner, 66 T.C. 515, 527 (1976) (taxpayer must capitalize
$801 bar examination fees and expenses to practice law in
California because amount was too large to disregard its capital
nature), affd. 591 F.2d 1273 (9th Cir. 1978).
We conclude that petitioner has not shown that its
accounting method clearly reflected income nor that it was an
abuse of discretion for respondent to require petitioner to
change that method of accounting. Thus, we hold that petitioner
may not expense the cost of its assets that cost less than $500
and that have a useful life greater than 1 year.
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B. Whether Petitioner Is Liable for the Penalty Under Section
6662 for Substantial Understatement
Respondent determined that petitioner is liable for the
accuracy-related penalty for substantial understatement for 1995
and 1996 under section 6662.
The accuracy-related penalty may not apply if the taxpayer
reasonably relied on the advice of a professional, such as an
accountant, and acted in good faith. See sec. 6664(c)(1); sec.
1.6664-4(c), Income Tax Regs. The understatement is reduced to
the extent that it (1) is based on substantial authority, or (2)
is attributable to an item that was adequately disclosed and that
has a reasonable basis. See sec. 6662(d)(2)(B).
Respondent contends that petitioner offered no evidence that
it gave its tax preparer all of the information needed to
correctly prepare its 1995 and 1996 tax returns or that its
preparer and petitioner thoroughly reviewed petitioner’s return
information. We disagree. Petitioner relied on Pearlman,
Nebben, a C.P.A. firm with experience in the health care
industry, to prepare petitioner’s tax returns for the years in
issue. Petitioner has consistently followed a minimum expensing
policy since it was incorporated. Pearlman, Nebben prepared
petitioner’s tax returns for those years, which reasonably led
petitioners to believe that it agreed with petitioner’s minimum
expensing policy. Cf. Bokum v. Commissioner, 94 T.C. 126, 147-
148 (1990) (accountant's failure to sign the tax return should
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have put the taxpayer on notice that he was not backing the
advice embodied in the return), affd. 992 F.2d 1132 (11th Cir.
1993). Respondent contends that petitioner did not have
substantial authority or reasonable cause for its minimum
expensing position because petitioner’s chief financial officer,
Pamela Rau (Rau), did not discuss the deductibility of the
disputed assets with petitioner’s tax return preparer for 1995
and 1996. We disagree. Rau reasonably explained that she did
not discuss petitioner’s expensing policy with the preparer
because petitioner’s expensing policy in 1995 and 1996 was the
same as it had been in previous years. Petitioner's reliance on
its preparer was reasonable cause for expensing the disputed
assets in 1995 and 1996.
We hold that petitioner is not liable for the accuracy-
related penalty under section 6662 for 1995 and 1996.
To reflect the foregoing,
Decision will be entered
under Rule 155.