T.C. Memo. 2010-211
UNITED STATES TAX COURT
HEALTH INVESTMENT CORP. AND SUBSIDIARIES, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 24831-08. Filed September 30, 2010.
Steven Ray Mather and Elliott H. Kajan, for petitioner.
Joyce M. Marr, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
COHEN, Judge: Respondent determined a Federal income tax
deficiency of $1,829,108 for petitioner’s tax (and fiscal) year
ending April 30, 1997. After concessions, the issue for decision
is whether petitioner is entitled to the section 481(a)
adjustment resulting from a change in the method of accounting
for bad debts as claimed on the tax return. Unless otherwise
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indicated, all section references are to the Internal Revenue
Code in effect for the year in issue, and all Rule references are
to the Tax Court Rules of Practice and Procedure.
FINDINGS OF FACT
Some of the facts have been stipulated, and the stipulated
facts are incorporated in our findings by this reference.
Petitioner is the common parent of an affiliated group of
corporations. At the time the petition was filed, petitioner’s
principal place of business was in California. Petitioner filed
consolidated Federal income tax returns for its tax and fiscal
years ending April 30, 1996, 1997, and 1998. Ernst & Young,
L.L.P., a public accounting firm, prepared petitioner’s tax
returns for fiscal years ending (FYE) in 1997 and 1998.
Petitioner, through its subsidiaries, operated five
hospitals during its FYE April 30, 1997. Before this tax year,
petitioner used a reserve method of accounting for bad debts for
both financial and tax accounting.
In its financial accounting, petitioner maintained combined
contractual and bad debt allowances (sometimes called “bad debt
reserve”) accounts. A contractual allowance reflects amounts
petitioner is not entitled to collect because of contractual
agreements with healthcare payers. The bad debt allowance
reflects the amount petitioner is entitled to collect, but does
not collect.
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During the 1990s, Linda Bentley (Bentley) held the position
of controller and then chief financial officer for petitioner.
At Ernst & Young’s request, Bentley prepared a schedule entitled
“Contractual/Bad Debt Exp Analysis” for three of petitioner’s
subsidiaries that she understood would be used for an application
to the Internal Revenue Service (IRS) to request a change in
methods of accounting. Bentley’s schedule purportedly identified
the bad debt portion in the combined contractual and bad debt
allowance accounts as of April 30, 1996. Bentley used
petitioner’s accounts receivable aging reports, determined a
reserve percentage for what petitioner termed financial classes
(groupings of similar sources of petitioner’s revenue and
accounts receivable), and then categorized the classes as
contractual, bad debt, or a combination of the two using
petitioner’s files and information obtained from petitioner’s
business office. Where petitioner had agreed to a payment
amount, Bentley determined what had been paid, what the charges
were, and whether an unpaid portion was a contractual or a bad
debt allowance. From this historical analysis, Bentley
determined percentages that reflected the general collection
amount for a particular class. Bentley applied the percentages
to the respective financial classes that had combined contractual
and bad debt amounts to determine the bad debt amount.
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Petitioner submitted a Form 3115, Application for Change in
Accounting Method, to the IRS requesting permission to change the
method of accounting for bad debts for the taxable year that
began May 1, 1996, for three of its subsidiaries: (1) Bay Cities
Medical Center (Bay Cities); (2) Jupiter Bellflower Doctors
Hospital (Jupiter Bellflower); and (3) Los Angeles Doctors
Hospital Corp. (LA Doctors). Petitioner included documents with
the Form 3115 indicating that if the method of accounting for bad
debts were changed, under section 481(a) an adjustment for the
amount of the reserve for bad debts as of the close of FYE April
30, 1996, would be required as follows: (1) $310,311 for Bay
Cities; (2) $339,138 for Jupiter Bellflower; and (3) $500,261 for
LA Doctors, for a total section 481(a) adjustment of $1,149,710.
These reported figures correspond to the amounts on the schedules
Bentley prepared for the three subsidiaries.
The parties entered into a consent agreement in November
1997, with the IRS granting permission for the three subsidiaries
to change their method of accounting for bad debts from the
reserve method to the specific chargeoff method. (The three
subsidiaries continued to use the reserve method of accounting
for bad debts for financial accounting purposes.) According to
the executed consent agreement:
The information [petitioner furnished] * * *
indicates that as of the beginning of the year of
change the adjustment required under section 481(a)
* * * is computed as follows:
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Bay Cities Medical Center $310,311
Jupiter Bellflower Doctors Hospital 339,138
Los Angeles Doctors Hospital Corporation 500,261
Total adjustment (increase in computing
consolidated taxable income) $1,149,710
The taxpayers’ request has been determined to be a
change from a Category A method of accounting as
defined in section 3.06 of Rev. Proc. 92-20, 1992-1
C.B. 685. Section 3.06 of Rev. Proc. 92-20 defines a
Category A method of accounting as a method of
accounting that the taxpayer is specifically not
permitted to use under the Internal Revenue Code, the
Income Tax Regulations, or a decision of the Supreme
Court of the United States. A Category A method is
also a method of accounting that differs from a method
the taxpayer is specifically required to use under the
Code, the regulations, or a decision of the Supreme
Court of the United States.
Section 5.03(1)(a) of Rev. Proc. 92-20 provides
that when there is a change in method of accounting
from a Category A method of accounting (as defined in
section 3.06) that results in a net positive section
481(a) adjustment, the taxpayer must, beginning with
the year of change, take the net section 481(a)
adjustment into account ratably over 3 tax years in
computing taxable income.
The amount of the adjustment, which is to be taken
into account over a three-year period (adjustment
period), is subject to verification by the district
director upon examination of the consolidated income
tax return.
* * * * * * *
An examining agent may not propose that the
taxpayers change the same method of accounting as that
changed by the taxpayers under this ruling for a year
prior to the year of change. * * *
Petitioner reported the ratable portion of the claimed
section 481(a) adjustment on Form 1120, U.S. Corporation Income
Tax Return, dated January 15, 1998 (9704 Form 1120), as follows:
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Bay Cities $310,311/3 = $103,437
Jupiter Bellflower 339,138/3 = 113,046
LA Doctors 500,261/3 = 166,754
Total 383,237
On the 9704 Form 1120, petitioner claimed current year
deductions for bad debts of $366,033 for Bay Cities, $729,246 for
Jupiter Bellflower, and $518,099 for LA Doctors. On the attached
Schedule M-1, Reconciliation of Income (Loss) per Books With
Income per Return, petitioner reported the deductions on the
return not charged against book income for this year for the
three subsidiaries. To calculate these book-to-tax adjustments,
petitioner used the figures Bentley calculated as the bad debt
reserve account balances as of FYE April 30, 1996 (and hence the
beginning of the next fiscal year, May 1, 1996), and subtracted
the bad debt allowance amounts as of FYE April 30, 1997, as
follows:
Bad Debt Allowance Amounts 1997 Form 1120
May 1, 1996 Apr. 30, 1997 Schedule M-11
Bay Cities $310,311 $37,018 $273,293
Jupiter Bellflower 339,138 122,736 216,402
LA Doctors 500,261 16,227 484,034
1
Line 8, Deductions on this return not charged against book
income this year.
For the Form 1120 petitioner filed for FYE April 30, 1998,
petitioner used this same method to calculate the bad debt
reserve amounts for these subsidiaries and used the following
fiscal year beginning and ending amounts for the bad debt
allowance amounts:
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Bad Debt Allowance Amounts 1998 Form 1120
May 1, 1997 Apr. 30, 1998 Schedule M-1
1 2
Bay Cities $37,018 -0- $37,018
3
Jupiter Bellflower 122,736 $222,172 (99,436)
4
LA Doctors 16,227 173,624 (157,397)
1
Bay Cities was temporarily closed at the end of FYE Apr.
30, 1998.
2
Line 8, Deductions on this return not charged against book
income this year.
3
Line 5, Expenses recorded on books this year not deducted
on this return.
4
Line 5.
Upon review of documents that petitioner supplied for each
of the three subsidiaries during the IRS examination of
petitioner’s Federal income tax return, an IRS revenue agent
prepared a worksheet on or before January 22, 2001, noting that
those documents identified two different amounts for petitioner’s
bad debt reserve as of April 30, 1996. One amount was
petitioner’s reported section 481(a) adjustment on the Form 3115,
as reported ratably on the 9704 Form 1120. The revenue agent
identified a different amount on worksheets prepared by Ernst &
Young.
The Ernst & Young worksheet amounts were calculated for each
subsidiary by multiplying the subsidiary’s combined contractual
allowance and bad debt allowance account amount by an allowance
percentage to determine the bad debt allowance amount, with the
remainder allocated to the contractual allowance. The bad debt
allowance amounts Ernst & Young calculated for the subsidiaries
as of April 30, 1996, are as follows: (1) $23,615 for Bay
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Cities; (2) $146,547 for Jupiter Bellflower; and (3) $54,889 for
LA Doctors. Using these figures, the ratable portion of the
section 481(a) adjustment is $75,017.
The revenue agent requested documentation to verify
petitioner’s determination of the bad debt reserve amounts as of
April 30, 1996, for the three subsidiaries as claimed on the tax
return. In response, an Ernst & Young accountant acting as
petitioner’s representative during the examination provided for
each subsidiary the calculation used to derive the bad debt
reserve amount. The documents provided showed each subsidiary’s
bad debt reserve equal to the gross accounts receivable
multiplied by a bad debt percentage “(per client)”. The revenue
agent concluded that the percentages could not be explained or
verified and thus the bad debt reserve amounts were not proper.
The revenue agent did not question petitioner’s calculated
balances of the bad debt reserves as of April 30, 1997, used to
compute the corresponding Schedule M-1 adjustments for each of
the three subsidiaries, according to the Ernst & Young worksheets
supplied: (1) $37,018 for Bay Cities; (2) $122,736 for Jupiter
Bellflower; and (3) $16,227 for LA Doctors. To calculate these
amounts, the same method was used as that used for FYE April 30,
1996.
The revenue agent concluded that the amounts of the bad debt
reserves as of April 30, 1996, on the Ernst & Young worksheets
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were the correct figures--not the amounts that Bentley calculated
that were reported on the consent agreement and tax return.
Using the Ernst & Young worksheet amounts, the revenue agent
determined that: (1) Petitioner’s section 481(a) adjustment
should be reduced by $308,220 because petitioner included an
adjustment in income of $383,237 that should have been $75,017
and (2) petitioner should have reported aggregate Schedule M-1
adjustments decreasing taxable income by $62,473 and a Schedule
M-1 adjustment decreasing taxable income by $13,403, rather than
aggregate Schedule M-1 adjustments of $973,729, thus decreasing
the section 166 bad debt deduction by $924,659. The revenue
agent’s calculations resulted in a net increase to taxable income
of $616,439 ($924,659 less $308,220) for FYE April 30, 1997.
The Form 886-A, Explanation of Adjustments, attached to the
July 17, 2008, notice of deficiency sent to petitioner, stated
that
It is determined that the deductions for bad debts,
resulting from an authorized change in accounting
method for taxable year ending April 30, 1997, is
disallowed to the extent of $616,439.00 because the IRC
Section 481(a) adjustment was computed incorrectly.
Accordingly, your taxable income for the taxable year
ending April 30, 1997 is increased $616,439.00.
OPINION
Petitioner argues that respondent’s redetermination of the
April 30, 1996, bad debt reserve amount is barred by the consent
agreement and is not properly raised in the notice of deficiency.
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Petitioner further asserts that respondent bears the burden of
proof regarding the redetermination of the bad debt reserve
amount because this is a “new matter” according to Rule 142(a).
Petitioner argues that respondent violated the consent
agreement term that prohibits respondent from proposing that
petitioner change the method of accounting for a year before the
year of change. Petitioner asserts that respondent applied an
“improper” accounting method to determine the bad debt reserve
amount that resulted in a taxable income increase.
Respondent’s revenue agent explained at trial that he did
not adjust the April 30, 1996, bad debt reserve amounts using an
accounting method that petitioner began using in FYE April 30,
1997. He analyzed documents that petitioner supplied and
determined that the Ernst & Young bad debt reserve amounts for
FYE April 30, 1996, and hence for the fiscal year that began May
1, 1996, were the figures that should be used for the section
481(a) adjustment and not those reported on the Form 3115 and tax
return that Bentley calculated. No change in method of
accounting was proposed for FYE April 30, 1996, and the consent
agreement, subject to verification by the district director upon
examination of petitioner’s consolidated tax return, was not
violated.
We also reject petitioner’s argument that the notice of
deficiency did not provide notice that the basis for respondent’s
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adjustment to the bad debt deduction included a determination of
bad debt allowance amounts as of April 30, 1996. Section 7522(a)
provides that a notice of deficiency “shall describe the basis
for, and identify the amounts (if any) of, the tax due, interest,
additional amounts, additions to the tax, and assessable
penalties included in such notice. An inadequate description
* * * shall not invalidate such notice.” The purpose of section
7522 is to give the taxpayer notice of the Commissioner’s basis
for determining a deficiency. See Shea v. Commissioner, 112 T.C.
183, 196 (1999). The objective language in the notice of
deficiency remains the controlling factor. Id. at 192.
The notice sent to petitioner stated that the section 481(a)
adjustment was “computed incorrectly”. Petitioner supplied the
figures for the section 481(a) adjustment with the application
for the accounting method change and subsequently used them for
the filed 9704 Form 1120. Bentley’s schedules for the three
subsidiaries identified these figures as the bad debt allowance
amounts as of April 30, 1996. These computed amounts were
different from those respondent contends are correct, as
identified on the Ernst & Young worksheets, and resulted in
respondent’s income adjustments. During the examination, the
revenue agent identified the issue and requested that petitioner
verify the amounts petitioner reported. Nothing in the notice is
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inconsistent with respondent’s position in this case (unlike Shea
v. Commissioner, supra).
Petitioner objects to our consideration of how respondent’s
adjustments occurred as “going behind” the statutory notice. The
events of the audit, however, are relevant to petitioner’s claims
regarding the adequacy of the notice. See generally id. They
are also relevant to petitioner’s claims that the Court should
excuse petitioner’s belated production at trial of additional
schedules used by Bentley because petitioner was surprised by
respondent’s position. We conclude that the notice apprised
petitioner of the basis for respondent’s adjustment and that
petitioner was neither surprised nor prejudiced regarding
respondent’s position that the amounts of the bad debt reserves
as of April 30, 1996, are in dispute.
Petitioner next asserts that respondent raised a “new
matter” regarding the redetermination of the bad debt allowance
amounts and thus the burden of proof shifts to respondent. See
Rule 142(a). Respondent acknowledges that the recomputation of
the amounts of petitioner’s bad debt reserves as of April 30,
1996, was not expressly mentioned in the notice but asserts that
it is implicit in respondent’s explanation that the section
481(a) adjustment was computed incorrectly.
If the Commissioner advances a new theory that either alters
the original deficiency or requires presentation of new evidence,
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the Commissioner bears the burden of proof as to this new matter.
Shea v. Commissioner, supra at 191-197; Wayne Bolt & Nut Co. v.
Commissioner, 93 T.C. 500, 507 (1989). We conclude that
respondent has not advanced a new theory by redetermining the
amounts of the bad debt reserves as of April 30, 1996, because
these amounts are a direct component of the section 481(a)
adjustment. See sec. 481(a); Bird Mgmt., Inc. v. Commissioner,
48 T.C. 586 (1967). Thus, the burden of proof remains with
petitioner. See Shea v. Commissioner, supra at 197.
Respondent argues that petitioner overstated the ratable
portion of the section 481(a) adjustment for the year in issue by
$308,220 (aggregate bad debt reserve amount for three
subsidiaries as of April 30, 1996: $383,237 (as identified by
Bentley and reported by petitioner) less $75,017 (as identified
on the Ernst & Young worksheets and determined as the correct
amount by respondent)). This difference results in a decrease of
petitioner’s claimed deduction for bad debts under section 166
and an increase in income. Respondent asserts that petitioner
has not established that the amounts it claimed as the balances
of the bad debt reserves for the three subsidiaries as of April
30, 1996, equaled the deductions previously claimed for Federal
income tax purposes. Petitioner counters that petitioner’s
determination of the bad debt allowances as of April 30, 1996, is
“vastly more reliable and accurate than respondent’s
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determination” and that respondent “used the wrong concept, the
wrong accounting method and the wrong schedules” to redetermine
the bad debt allowances as of April 30, 1996, for the three
subsidiaries. Despite petitioner’s rhetoric, neither the Ernst &
Young calculations nor respondent’s reliance on them has been
shown to result in an erroneous adjustment.
Section 166(a) provides that taxpayers are allowed a
deduction for “any debt which becomes worthless within the
taxable year” (the specific chargeoff method). Before being
repealed by the Tax Reform Act of 1986, Pub. L. 99-514, sec. 805,
100 Stat. 2361, section 166(c) provided that, alternatively,
accrual basis taxpayers could use the reserve method to deduct “a
reasonable addition to a reserve for bad debts.” See Thor Power
Tool Co. v. Commissioner, 439 U.S. 522, 546 (1979). As we
explained in Bird Mgmt., Inc. v. Commissioner, supra at 595-596:
Essentially a bad debt reserve constitutes an
estimate of the loss which can reasonably be expected
to result from worthlessness of debts outstanding at
the close of the taxable year. Under the reserve
method when specific debts become worthless they are
charged against the reserve and serve to reduce the
credit balance therein. Then, if any amount which has
been charged against the reserve is subsequently
collected the collection does not result in the receipt
of income but the amount collected is credited to the
reserve. If the credit balance in the reserve at the
end of the year is not adequate to cover the reasonably
expected loss with respect to the debts outstanding at
the end of the year, then an addition is made to the
reserve to bring the credit balance to the appropriate
amount, and such addition is deductible. * * * And the
general rule is well established that any balance in a
reserve for bad debts existing when the reserve becomes
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no longer necessary must be included in taxable income,
since the amount of such balance represents amounts
which have been previously deducted. * * *
When a taxpayer changes from the reserve method of bad debt
accounting to the specific chargeoff method, the credit balance
in the reserve account is returned to income in the year of
change. See Arcadia Sav. & Loan Association v. Commissioner, 300
F.2d 247, 250 (9th Cir. 1962), affg. 34 T.C. 679 (1960). Section
481(a) requires that the adjustments necessary to prevent amounts
from being duplicated or omitted be taken into account when the
taxpayer’s taxable income is computed under a method of
accounting that is different from the method used to compute
taxable income the preceding year. Section 481(c) and section
1.481-4, Income Tax Regs., provide that the adjustment required
may be taken into account in determining taxable income in the
manner and subject to the conditions agreed to by the
Commissioner and the taxpayer or prescribed by regulations. The
taxpayer has the burden of proof as to the proper section 481(a)
adjustment. See Hitachi Sales Corp. of Am. v. Commissioner, T.C.
Memo. 1994-159, supplemented by T.C. Memo. 1995-84.
Because of the change in accounting method for bad debts
from the reserve method to the specific chargeoff method,
petitioner was required to report the credit balance remaining in
the bad debt reserve accounts as of April 30, 1996. See sec.
481(a); Arcadia Sav. & Loan Association v. Commissioner, supra.
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Whether a taxpayer is on the specific chargeoff or the
reserve method of treating bad debts, there must be an annual
review of doubtful accounts receivable to ascertain whether
certain accounts are either uncollectible or that there is
reasonable probability that they are not collectible. Rogan v.
Commercial Disc. Co., 149 F.2d 585, 587-588 (9th Cir. 1945).
Accordingly, Ernst & Young prepared worksheets for each
subsidiary that identified the bad debt reserve account amounts,
including fiscal years 1996-98. (Petitioner used the reserve
method of accounting for financial purposes during all relevant
years.) Respondent contends that it is these amounts that
petitioner should have used to calculate the section 481(a)
adjustment--not the figures that Bentley calculated and
petitioner used.
Although Bentley conducted an extensive exercise to analyze
the combined contractual and bad debt allowance accounts as of
April 30, 1996, we are not persuaded that the ascertained bad
debt allowance amounts are more accurate than those of the Ernst
& Young worksheets for purposes of determining petitioner’s
section 481(a) adjustment. Petitioner did not call anyone from
Ernst & Young to explain those worksheets or to reconcile
discrepancies. According to Bentley’s prepared schedule and
explanation, it appears her determination regarding each
outstanding receivable supports an analysis of bad debts for
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partial or total worthlessness. A determination of partial and
total worthlessness of bad debts is important for the specific
chargeoff method because a taxpayer may claim a deduction when a
business debt becomes either partially or wholly worthless. Sec.
166.
As respondent notes, Bentley’s calculations do not purport
to reconcile the amounts that she determined to be the balances
of the bad debt reserve accounts as of April 30, 1996, to the
amounts deducted on petitioner’s Federal income tax returns for
bad debt expenses in earlier years (and before the accounting
method change). The bad debt credit balance remaining in
petitioner’s allowance account as of April 30, 1996, is reported
for tax purposes under section 481(a). See Arcadia Sav. & Loan
v. Commissioner, supra at 250. We sustain respondent’s
determination that the bad debt reserve account amounts
calculated by Ernst & Young should be used for purposes of the
section 481(a) adjustment because petitioner has not established
that those amounts are incorrect.
Petitioner argues that respondent’s position causes
petitioner to be taxed twice on the same income. The testimony
of Bentley is inconclusive about whether a protective claim for
refund protects petitioner in this regard. In any event, we
address only the year before us.
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In reaching our decision, we have considered all arguments
made by the parties. To the extent not mentioned or addressed,
they are irrelevant or without merit. To reflect concessions and
our conclusions stated above,
Decision will be entered
under Rule 155.