T.C. Memo. 2001-145
UNITED STATES TAX COURT
SMARTHEALTH, INC., f.k.a. SEMANTODONTICS, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 8048-99. Filed June 20, 2001.
Jeffrey N. Kelm, Denton N. Thomas, and Dennis I. Leonard,
for petitioner.
David A. Winsten and J. Robert Cuatto, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
VASQUEZ, Judge: Respondent determined deficiencies in
petitioner’s Federal income taxes of $306,731 and $80,346 for
the taxable years ending May 31, 1995, and May 31, 1996,
respectively. The sole issue for decision is whether amounts
which petitioner received from its customers in excess of the
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amounts petitioner was owed (customer overpayments) constitute
gross income in the year of receipt.
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the taxable years in
issue, and all Rule references are to the Tax Court Rules of
Practice and Procedure.
FINDINGS OF FACT
The stipulation of facts and the accompanying exhibits are
incorporated by this reference. Petitioner is an Arizona
corporation whose principal place of business was in Phoenix,
Arizona, at the time the petition in this case was filed. During
the years at issue, petitioner used the accrual method of
accounting for tax reporting purposes.
Petitioner’s Business
Petitioner’s business involved the manufacture, sale, and
distribution of health care marketing materials, health care
educational materials, and clinical and infection control
products. Petitioner’s client base consisted of dental offices,
veterinary clinics, and other health care professional offices
located throughout the United States and Canada. During the
years at issue, petitioner served approximately 55,000 customers.
The majority of petitioner’s business marketing was
conducted through mail-order catalogs. Petitioner took orders
for its products through the mail, over the telephone, and
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through sales representatives. Petitioner’s customers generally
ordered small dollar amounts of merchandise, with the average
order amounting to approximately $100. Many of petitioner’s
customers placed orders on a periodic basis.
During the years in issue, petitioner received approximately
600 orders per day. It was petitioner’s goal and general
practice to ship the ordered product on the same day the order
was received. With each shipment, petitioner enclosed an invoice
containing a description of the product, the sales price, and
applicable shipping and handling charges. In addition,
petitioner mailed monthly statements to those customers who had
outstanding balances payable to petitioner.
Petitioner offered its customers a variety of payment
options, including open credit, cash on delivery, and payment by
credit card. Petitioner’s customers who paid by check sent their
payments directly to a lockbox operated by Marshall and Isley
Thunderbird Bank (the lockbox agent). It was the responsibility
of the lockbox agent to empty the lockbox, process the payments,
and deposit the payments to petitioner’s non-interest-bearing
operating account. Each day, the lockbox agent would send
computer files to petitioner containing the payment data for the
prior day, which petitioner would use to update its accounts
receivable and other records.
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Overpayments, Refunds, and Credit Balances
Some of petitioner’s customers remitted payment in excess of
the amounts they actually owed. In certain instances, the
customer would duplicate the required payment by first paying
pursuant to the product invoice and subsequently making payment
according to a monthly statement issued by petitioner prior to
the receipt of the customer’s initial payment.1 All overpayments
were applied to the customer’s account, generally producing a
credit balance in favor of the customer.
Petitioner’s marketing materials and shipping invoices
contained a statement of its return policy. The policy allowed
customers to return any item with which the customer was not
satisfied, for any reason, within 60 days of receipt.2 The
customer had the option of selecting a replacement, a full
refund, or a credit to his account. Product returns during the
1995 taxable year totaled $1,154,395, which amounted to
1
In their arguments, the parties distinguish between
overpayments and duplicate payments. We, however, see no
principled reason for distinguishing between the two.
Accordingly, in our opinion we shall refer only to customer
overpayments, which include overpayments of any amount.
2
In certain instances in which the customer was not
completely satisfied with the delivered product but nonetheless
intended to use it, petitioner would negotiate with the customer
an adjustment to the amount billed. Where the customer had
previously paid the full invoice amount, this adjustment would
result in a credit in favor of the customer. For purposes of
this opinion, we shall consider invoice adjustments as part of
customer returns.
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approximately 2.89 percent of gross sales. With respect to the
1996 taxable year, product returns totaled $1,251,401,
approximately 2.82 percent of gross sales.
With regard to client credit balances resulting from
overpayments or returns, petitioner’s customers had the option of
(1) applying any or all of the credit balance to a subsequent
purchase, (2) causing a refund check to be issued, (3) having the
amount credited back to the customer’s credit card, or (4)
retaining the credit balance in the customer’s account with
petitioner. Petitioner did not routinely contact customers
having a credit balance in their accounts due to the large number
of orders, the relatively small amount of the credit balance, and
the likelihood that the credit would be applied toward future
purchases. Nonetheless, it was the practice of petitioner’s
customer service personnel to inform the customer of any credit
balance on his or her account when the customer called to place
an order. In addition, petitioner had a sales force of around 70
employees who were dedicated to serving those customers who
purchased petitioner’s infection control products (approximately
one-third of petitioner’s total customers). The sales personnel
were paid a commission on the amount of goods ordered. Given
that the existence of the credit balance made additional sales
more likely (since the customer did not have to come out of
pocket to the extent of the credit), the sales personnel had an
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incentive to inform their customers of the existence of any
credit balance.
In the absence of direction from the customer, petitioner
retained the credit balance in the customer’s account. If the
customer placed a subsequent order, the credit balance was
automatically applied against the cost of such order. If a
client did not use or otherwise claim the amount reflected as a
credit on his or her account, it was petitioner’s practice to
dispose of such amounts pursuant to the unclaimed property laws
of the jurisdictions in which its customers resided.3 Petitioner
did not pay its customers interest with respect to the credit
balances.
As of the close of the 1995 taxable year, 7,611 customers
had credit balances on account with petitioner. These balances
totaled $760,063. Gross sales during this period totaled
$37,159,244. As of May 31, 1996, the number of customers having
credit balances increased to 9,669, while the outstanding amount
3
During the years in issue, Arizona followed a version of
the Uniform Unclaimed Property Act of 1981 (UUPA 1981). See
Ariz. Rev. Stat. Ann. secs. 44-301 to 44-340 (West 1994). Under
UUPA 1981, intangible property held or owing in the ordinary
course of the holder’s business that has remained unclaimed by
the owner for more than 5 years is considered abandoned. See
UUPA 1981 sec. 2(a), 8B U.L.A. 595 (1993); see also Ariz. Rev.
Stat. Ann. sec. 44-302 (West 1994). As a general rule, abandoned
property must be delivered to the State of the owner’s last known
residence. See UUPA 1981 sec. 3(1), 8B U.L.A. 598 (1993); see
also Ariz. Rev. Stat. Ann. sec. 44-303 (West 1994).
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of such balances grew to $1,049,610. Gross sales during the 1996
taxable year were $40,045,119.4
Money received by petitioner which gave rise to a customer
credit balance was deposited to petitioner’s general
non-interest-bearing bank account. The funds in this bank
account were available to and used by petitioner for regular
operating needs. Although petitioner did not maintain a separate
account for funds attributable to the customer credit balances,
such amounts were reflected as a liability on petitioner’s
general ledger for financial accounting purposes.
Petitioner’s Method of Accounting and Respondent’s Determination
In the course of an audit of petitioner’s 1989 taxable year,
respondent determined that petitioner was required to include in
income the amount of customer credit balances that had been
outstanding for 2 years or more. During the years at issue,
petitioner continued this practice by including in income for
financial and tax accounting purposes the amounts represented by
customer credit balances which had aged for 2 years.5 By way of
4
The record does not reflect what portion of the credit
balances were attributable to customer returns as opposed to
customer overpayments.
5
Petitioner nonetheless continued to consider the amounts
of the customer credit balances that were brought into income as
(continued...)
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the notice of deficiency for the years in issue, respondent
determined that amounts represented by the customer credit
balances outstanding as of the close of the taxable years in
issue constitute income in such year (to the extent not
previously included in income), regardless of how long each
particular credit balance had been outstanding. In response to
respondent’s determination, petitioner contends that the amounts
reflected by the customer credit balances constitute income only
if and when such credit balance is applied toward subsequent
purchases.
OPINION
In his posttrial brief, respondent now concedes that the
portion of the customer credit balances attributable to product
returns does not constitute gross income to petitioner, and we
accept his concession in this regard. Given respondent’s
concession, the sole issue for decision is whether petitioner
must include in income the customer overpayments remaining on
hand at the close of the taxable periods in issue. The parties
agree that the issue should be analyzed under the “claim of
right” doctrine.
The claim of right doctrine was established by the Supreme
5
(...continued)
an obligation in favor of the customer. In other words, the
credit balance still appeared on the customer’s account, and the
customer was still entitled to have the balance refunded or
applied toward additional purchases.
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Court in North Am. Oil Consol. Co. v. Burnett, 286 U.S. 417
(1932). In determining the proper taxable year in which to
include income generated from land the legal title to which was
subject to litigation, the Court stated as follows:
If a taxpayer receives earnings under a claim of right
and without restriction as to its disposition, he has
received income which he is required to return, even
though it may still be claimed that he is not entitled
to retain the money, and even though he may still be
adjudged liable to restore its equivalent. [Id. at
424.]
The Supreme Court elaborated on the claim of right doctrine in
James v. United States, 366 U.S. 213, 219 (1961), as follows:
When a taxpayer acquires earnings, lawfully or
unlawfully, without the consensual recognition, express
or implied, of an obligation to repay and without
restriction as to their disposition, “he has received
income which he is required to return, even though it
may still be claimed that he is not entitled to retain
the money, and even though he may still be adjudged
liable to restore its equivalent.” North American Oil
Consolidated Co. v. Burnet, supra, at p. 424. In such
case, the taxpayer has “actual command over the
property taxed–-the actual benefit for which the tax is
paid,” Corliss v. Bowers, supra [281 U.S. 376, 378
(1930)]. This standard brings wrongful appropriations
within the broad sweep of “gross income”; it excludes
loans. * * *
Accordingly, in order for the customer overpayments to be
excluded from income, petitioner must establish either of the
following: (1) The existence of a consensual recognition of
petitioner’s obligation to repay the overpayments to the
remitting customers, or (2) the presence of a restriction on
petitioner’s disposition of the customer overpayments.
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While the Supreme Court in James held that an explicit or
implicit consensual recognition of the taxpayer’s obligation to
repay a given sum is sufficient to avoid that sum's being treated
as income pursuant to the claim of right doctrine, the Court did
not elaborate on what constitutes a “consensual” recognition.
Numerous cases discussing the tax implications of the receipt of
misappropriated funds have since interpreted the phrase (either
explicitly or through application) as requiring a recognition of
the repayment obligation on the part of the obligee as well as
the obligor. See Webb v. IRS, 15 F.3d 203, 207 (1st Cir. 1994);
Collins v. Commissioner, 3 F.3d 625, 632 (2d Cir. 1993), affg.
T.C. Memo. 1992-478; Solomon v. Commissioner, 732 F.2d 1459, 1461
(6th Cir. 1984), affg. T.C. Memo. 1982-603; Moore v. United
States, 412 F.2d 974, 980 (5th Cir. 1969); Howard v.
Commissioner, T.C. Memo. 1997-473.
The present case, however, does not involve the receipt of
misappropriated funds. Petitioner did not acquire the customer
overpayments through any form of deceit; rather, the overpayments
were the product of inattentive bookkeeping on the part of
petitioner’s customers. Furthermore, there is no indication that
petitioner acted in bad faith with respect to the overpayments.
When petitioner processed the customer’s payment and realized
that the customer had remitted an amount in excess of the amount
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owed, petitioner immediately posted a credit to such customer’s
account and treated the overpayment as a liability for financial
accounting purposes.
While respondent notes that petitioner did not routinely
inform its customers of the existence of the customer credit
balances, we do not view this factor as decisive. First, we
accept the testimony of Dr. Hamann, petitioner’s president and
chief executive officer, that the credit balances tended to be
eliminated through their application toward the purchase price of
subsequent orders. Second, we do not believe that petitioner
intended for its customers to remain ignorant of the credit
balances. It was the practice of petitioner’s customer service
personnel to inform those customers who placed calls to
petitioner of the existence of any credit balance to their
account. Furthermore, the sales personnel charged with servicing
approximately one-third of petitioner’s customers had an
incentive to inform their customers of any credit balances, as
the existence of the credit balance would increase the likelihood
of additional sales upon which such personnel collected a
commission. Third, Dr. Hamann testified that customer
satisfaction is of paramount importance to the financial success
of petitioner’s operation, given the limited number of health
care professionals in need of the product line offered by
petitioner. We therefore do not believe petitioner would risk
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offending its customers by attempting to prevent their knowledge
and use of the credit balance posted on their accounts.
There existed an implicit recognition on the part of
petitioner and its customers that the customers would be entitled
to have any amounts which they overpaid returned to them.
Additionally, the customers who submitted overpayments had at
their disposal all of the information necessary to determine that
they had in fact overpaid. The invoice which petitioner included
with the product shipment, combined with a record of the
customer’s disbursements, would be sufficient for the customers
to determine that they had a credit balance in their favor with
petitioner. Given that the overpayments resulted from the
conduct of petitioner’s customers as opposed to that of
petitioner, we believe that the level of knowledge which
petitioner’s customers possessed in this case is sufficient to
satisfy the existence of a consensual recognition of petitioner’s
obligation to return the overpayments.6 Accordingly, petitioner
is not required to include in income pursuant to the claim of
right doctrine the amount of the customer credit balances
attributable to customer overpayments which remain outstanding as
of the close of the taxable year.
6
Given this determination, we need not decide whether
there existed a restriction on petitioner’s ability to dispose of
the customer overpayments.
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To reflect the foregoing,
Decision will be entered
under Rule 155.