Bigler v. Comm'r

T.C. Memo. 2008-133

UNITED STATES TAX COURT

JEFFREY M. BIGLER AND CASSANDRA M. BIGLER, ET AL.,1 Petitioners
v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 9541-06, 9542-06, Filed May 19, 2008.
9543-06.

Robert M. Galloway, for petitioners.

William F. Barry IV and Benjamin De Luna, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

VASQUEZ, Judge: Respondent determined deficiencies in

petitioners’ income tax for 2002 and penalties thereon as

follows:

1
Cases of the following petitioners are consolidated
herewith: Bruce Bigler and Wendy Bigler, docket No. 9542-06;
Donald G. Bigler and Linda Bigler, docket No. 9543-06.
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Penalty
Petitioners Deficiency Sec. 6662(a)

Jeffrey and
Cassandra Bigler $236,286 $47,257.20
Bruce and
Wendy Bigler 237,523 47,504.60
Donald and
Linda Bigler 506,443 101,288.60

After concessions, the issues remaining for decision are: (1)

Whether BBB Industries, Inc. (BBB), must include in income the

entire amount shown on a customer’s invoice; (2) whether BBB is

permitted to deduct from income the amount it estimates it will

have to credit customers for the return of cores; and (3) whether

petitioners are liable for the accuracy-related penalty pursuant

to section 6662(a)2 for 2002.

On February 28, 2006, respondent issued petitioners notices

of deficiency based on adjustments to petitioners’ shares of

income as shareholders in BBB, an S corporation. Respondent

determined that BBB’s method of accounting did not clearly

reflect income and therefore changed BBB’s method of accounting.

Further, with regard to the change in accounting method

respondent made a section 481(a) adjustment related to the

deferred core income of $2,082,957. In the stipulation of

settled issues respondent reduced this amount by $1,612,766.84.

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 -

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

The stipulation of facts and the attached exhibits are

incorporated herein by this reference. At the time of filing the

petitions, petitioners Jeffrey and Cassandra Bigler lived in

Texas, and petitioners Bruce and Wendy Bigler lived in Alabama,

as did petitioners Donald and Linda Bigler. Petitioners

Cassandra Bigler, Wendy Bigler, and Linda Bigler are petitioners

in their respective cases by reason of their filing joint Federal

income tax returns for the calendar year 2002 with their

respective spouses. All subsequent references to petitioners

will refer to Jeffrey Bigler, Bruce Bigler, and Donald Bigler

collectively.

Petitioners are the owners of BBB, an S corporation that

uses the accrual method of accounting.3 BBB is in the business

of remanufacturing automobile parts, such as alternators and

starters. BBB’s remanufacturing of an automobile part begins

with a used part called a “core”. BBB sells its remanufactured

parts to retailers. The invoice BBB presents to its customers

comprises two charges for each remanufactured part: A unit price

and a core price. For each remanufactured part sold to a

customer, i.e., starters and alternators, BBB is owed the total

3
Jeffrey Bigler and Bruce Bigler each owned 24 percent,
and Donald Bigler owned 52 percent.
 - 4 -

of the core price and the unit price. For each remanufactured

part purchased, the customer is entitled to return a core to BBB

for a credit. The credit BBB gives the customer for the return

of the core is the core price listed on the invoice. The amount

of the core credit depends on the contract each customer has with

BBB. There is no time limit within which a customer must return

a core to receive a credit. BBB is unable to use all of the

returned cores for remanufacturing. BBB sells unused cores for

scrap but does not reduce the credit to the customer for the

unusable cores. Furthermore, BBB accepts cores and credits

customers for cores even if the customers did not originally

acquire the cores from BBB. Among the reasons BBB does this are

to maintain customer loyalty and to guarantee it has a supply of

cores to remanufacture and later resell.

The amount and percentage of cores returned to BBB vary from

year to year. In some years more cores were returned than sold.

BBB does not know how many cores have not been returned by its

customers at the end of the year. As of December 31, 2002, BBB

did not know how many cores would be returned, when the cores

would be returned, or which cores would be returned. When BBB

sells remanufactured parts to its customers, ownership in the

parts and the cores passes to the customer, with BBB having no

future rights in the core.
 - 5 -

BBB determined the cost of each type of core as of December

31, 2002, on the basis of either the average of the prices listed

on the pricing sheet of its main suppliers for the 2002 year or

the average amount BBB paid for the cores according to the

invoices provided by its suppliers for the 2002 year. BBB

includes in accounts receivable the total amount included in the

invoice to the customer. The “in-house liability” account

represented the amount BBB expected to credit customers for cores

they actually returned. Using the differences between the cores

sold and the cores returned, BBB calculated the amounts it would

have to credit its customers for the return of the cores that BBB

had not received during the tax year from its customers but

expected to receive in a subsequent tax year. BBB created an

account called “deferred core income” which BBB credited for the

potential liability in an amount equal to the core price on the

invoice.

BBB reported the sum of three accounts: In-house liability,

deferred core income, and adjustment for rebate liability on

Schedule L, Balance Sheets per Books, statement 13 of BBB’s 2002

Form 1120S, U.S. Income Tax Return for an S Corporation. The sum

at the beginning of 2002 was $2,082,957, and the sum at the end

of the year was $2,783,905. As of January 1, 2002, the balance

of the deferred core income account was $406,189.88, and on

December 31, 2002, the balance was $2,080,686.71. For 2002 BBB
 - 6 -

reduced taxable income by $1,674,499.83,4 the amount accrued

during the year in the deferred core income account.

OPINION

I. Method of Accounting

Pursuant to section 446(a), taxable income shall be computed

under the method of accounting on the basis of which the taxpayer

regularly computes income in keeping its books. Section 446(b)

contains an exception in the situation where the method used by

the taxpayer does not clearly reflect income. In such cases, the

computation of taxable income shall be made under such method as,

in the opinion of the Secretary, does clearly reflect income.

A taxpayer may use the accrual method of accounting to report

income. See secs. 446(a), (c), 451(a). If the taxpayer elects

to report its income in that manner, the taxpayer must report

income in the year in which “all the events have occurred which

fix the right to receive such income and the amount thereof can

be determined with reasonable accuracy.” Sec. 1.451-1(a), Income

Tax Regs.; see also sec. 1.446–1(c)(1)(ii)(A), Income Tax Regs.

Generally, all the events that fix the right to receive income

occur on the earliest of the following: (1) The date payment is

4
The difference between the $406,189.88 balance at the
start of the year and the $2,080,686.71 closing balance is $3
less than the $1,674,499.83 amount accrued during the year. Both
parties have stipulated the amounts, and there appears to be no
explanation for the $3 discrepancy. The $3 discrepancy has no
effect as to the outcome of the case.
 - 7 -

received; (2) the date payment is due; or (3) the date of

performance. See Schlude v. Commissioner, 372 U.S. 128 (1963);

Johnson v. Commissioner, 108 T.C. 448, 459 (1997), affd. in part,

revd. in part and remanded on another ground 184 F.3d 786 (8th

Cir. 1999); Firetag v. Commissioner, T.C. Memo. 1999-355, affd.

without published opinion 232 F.3d 887 (4th Cir. 2000).

In addition when applying the all events test, we consider

conditions precedent which are required to be met before a fixed

right to receive income exists. We disregard conditions

subsequent which may terminate an existing right to income but

the presence of which does not preclude the accrual of income.

See Keith v. Commissioner, 115 T.C. 605, 617 (2000); Charles

Schwab Corp. & Subs. v. Commissioner, 107 T.C. 282, 293 (1996),

affd. 161 F.3d 1231 (9th Cir. 1998).

On the deduction side, a liability accrues in the taxable

year in which: (1) All the events have occurred that establish

the fact of the liability, (2) the amount of the liability can be

determined with reasonable accuracy, and (3) economic performance

has occurred with respect to the liability. Sec. 1.461-1(a)(2),

Income Tax Regs.

Petitioners argue that despite the fact that the dollar

amounts stated on the 2002 invoices as the prices of the cores

total $2,080,686.71, the deferred core income account was

actually only worth $841,020. Petitioners contend that BBB
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should not have to include in income the additional receivable

for cores which had not been returned at the end of the year,

$1,239,666.71. Furthermore, petitioners argue that BBB’s

deferred core income account is essentially a contra receivable

reflecting the fact that the receivable is worth less than the

dollar amount stated. On the income side, petitioners do not

dispute that the all events test has been satisfied.

Respondent argues that the entire amount BBB billed its

customers in 2002 should be included in income. Until the cores

are actually returned to BBB, the full amount must be included in

income and no offsetting deduction is allowed. Respondent also

argues that petitioners have failed to prove that the fair market

values of the cores are substantially less than the amounts

billed.

For reasons that follow, we agree with respondent that BBB

was required to include the full amount billed in income. When

BBB sold remanufactured cores to its customers, the bill

contained two charges: One for the remanufactured part and one

for the core. Upon returning a core, the customer was entitled

to a credit in an amount equal to the price of the core on the

invoice. After the sale the amount stated was fixed, and BBB had

the right to collect the entire amount stated on the invoice.

The fact that BBB might have to credit the customer at some point

in the future does not mean that income has not accrued. Thus
 - 9 -

the all events test was satisfied for the entire amount of the

invoice.

The fact that BBB virtually never received cash for cores

does not mean that income did not accrue. In Ertegun v.

Commissioner, T.C. Memo. 1975-27, affd. 531 F.2d 1156 (2d Cir.

1976), Atlantic Records (Atlantic) had a policy whereby it would

allow certain distributors a 10-percent record return allowance.

Atlantic reduced its income on the basis of the 10-percent

allowance for records that had yet to be returned. Atlantic,

like BBB, had specific business reasons for the policy and billed

customers the full amount despite the possibility of a return or

credit. The Court in Ertegun held, and the U.S. Court of Appeals

for the Second Circuit affirmed, that since the event triggering

the credit, i.e., the return of the merchandise, did not occur

until after the period in question, no accrual of a liability for

the credit was permitted. It is firmly established that a

reserve for future or contingent liabilities cannot be deducted.

Lucas v. Am. Code Co., 280 U.S. 445 (1930). BBB must accrue as

income the entire amount in the deferred core income account.

Both petitioners and respondent agree that the facts of this

case are similar to those in Okonite Co. v. Commissioner, 4 T.C.

618 (1945), affd. 155 F.2d 248 (3d Cir. 1946). In Okonite,

customers purchased wire and cable on a reel used for shipping

and could return the reels within a certain period for a credit.
 - 10 -

Like the reels in Okonite, the cores in BBB were sold to

customers, who were free to keep them, to sell them elsewhere, or

to return them to BBB. See also Colonial Wholesale Beverage

Corp. v. Commissioner, T.C. Memo. 1988-405, affd. 878 F.2d 23

(1st Cir. 1989).5 While BBB’s customers can return cores at any

time, this fact does not change the outcome. BBB did not retain

title to the cores and had no way of forcing customers to return

cores. Petitioners argue that over a 4-year period over 97

percent of cores were returned to BBB. Again this does not

change the fact that the customers had complete ownership over

the cores and were not forced to return them. The high rate of

return does not alter the fact that income accrued on the sale

for the entire amount billed.

Petitioners admit that the all events test has been met upon

the sale to customers. Petitioners further admit that customers

have ownership of the cores and are free to do as they please

with them. Petitioners’ argument that the invoice price of the

core is vastly overstated and thus only a portion should be

5
In Colonial Wholesale Beverage Corp. v. Commissioner,
T.C. Memo. 1988-405, affd. 878 F.2d 23 (1st Cir. 1989), pursuant
to State law, customers had to pay a deposit for cans but were
entitled to a refund when the cans were returned. Colonial had
to accrue as income the amount of the deposit and could not claim
a deduction until the cans were returned. Once the cans were
sold, ownership was entirely with the customer, as was true of
the reels sold in Okonite Co. v. Commissioner, 4 T.C. 618 (1945),
affd. 155 F.2d 248 (3d Cir. 1946), and of the cores sold by BBB.
 - 11 -

included in income is unpersuasive. Additionally, BBB cannot

deduct amounts for cores that have yet to be returned. The

liability is contingent on the return of the core and is not

certain to accrue. See United States v. Gen. Dynamics Corp., 481

U.S. 239 (1987). As a result, BBB must report income as

respondent has argued, and petitioners must report income

accordingly.

II. Accuracy-Related Penalty

Respondent determined that petitioners are liable for the

accuracy-related penalty pursuant to section 6662(a).

Petitioners contend that they should not be liable for this

penalty. We agree with petitioners.

Respondent has the burden of production and must come

forward with sufficient evidence that it is appropriate to impose

the penalty. See sec. 7491(c); Higbee v. Commissioner, 116 T.C.

438, 446-447 (2001). Section 6662(a) imposes an accuracy-related

penalty on any portion of an underpayment of tax required to be

shown on a return if that portion is attributable to negligence

or disregard of rules or regulations or any substantial

understatement of income tax. See sec. 6662(a) and (b)(1) and

(2); sec. 1.6662-2(a)(1) and (2), Income Tax Regs.

Negligence is the lack of due care or failure to do what a

reasonable and ordinarily prudent person would do under the same

circumstances. Neely v. Commissioner, 85 T.C. 934 (1985).
 - 12 -

Disregard is characterized as any careless, reckless, or

intentional disregard. See sec. 6662(c); sec. 1.6662-3(b)(2),

Income Tax Regs. Negligence is strongly indicated where a

taxpayer fails to include on an income tax return an amount of

income shown on an information return. See sec. 1.6662-3(b)(1),

Income Tax Regs. There is a substantial understatement of income

tax if the amount of the understatement exceeds the greater of

either 10 percent of the tax required to be shown on the return,

or $5,000. Sec. 6662(d)(1)(A); sec. 1.6662-4(b)(1), Income Tax

Regs. BBB failed to include as income the full amount shown on

the invoices, and as a result, petitioners underreported their

income and there were substantial understatements of their income

tax. Therefore, respondent has met his burden of production with

respect to this penalty. However, the accuracy-related penalty

does not apply to any portion of an underpayment for which there

was reasonable cause and where the taxpayer acted in good faith

with respect to that portion. See sec. 6664(c)(1); sec. 1.6664-

4(a), Income Tax Regs. The determination of whether the taxpayer

acted with reasonable cause and in good faith is made on a case-

by-case basis, taking into account all pertinent facts and

circumstances. Sec. 6664(c)(1); sec. 1.6664-4(b), Income Tax

Regs. BBB kept detailed records of its transactions, BBB’s

bookkeeping was in accordance with generally accepted accounting

principles, and BBB followed industry standards. Although these
 - 13 -

factors are not determinative of the tax consequences to BBB and

petitioners, they do show that petitioners acted reasonably and

in good faith. As a result, petitioners are not liable for the

section 6662(a) penalty.

In reaching all of our holdings herein, we have considered

all arguments made by the parties, and to the extent not

mentioned above, we conclude they are irrelevant or without

merit.

To reflect the foregoing,

Decision will be entered

under Rule 155.