Osteopathic Medical Oncology and Hematology, P.C. v. Commissioner

113 T.C. No. 26UNITED STATES TAX COURT
OSTEOPATHIC MEDICAL ONCOLOGY AND HEMATOLOGY, P.C., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 11551-98. Filed November 22, 1999.
P, a professional service corporation, specializes
in the treatment of cancer through chemotherapy. P
uses drugs and ancillary pharmaceuticals (collectively,
the drugs) during its treatment. The chemotherapy
treatments are prescribed by P’s professional staff,
and patients do not select the type or quantity of
drugs used during the treatments. P uses the cash
method to expense the cost of the drugs. R determined
that the drugs were "merchandise" under sec. 1.471-1,
Income Tax Regs., and that P must use an accrual method
to report all amounts attributable to the drugs.
Held: The inherent nature of P's business is that
of a service provider, P’s use of the drugs is
subordinate to the provision of its services, and P
uses the drugs as an indispensable and inseparable part
of the rendering of its services; thus, the drugs are
not "merchandise" under sec. 1.471-1, Income Tax Regs.,
and P properly used the cash method to expense the
drugs’ cost.
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David C. May, for petitioner.
Grant E. Gabriel, for respondent.
OPINION
LARO, Judge: The parties submitted this case to the Court
without trial. See Rule 122. Petitioner petitioned the Court to
redetermine respondent's determination of a $50,515 deficiency in
its 1995 Federal income tax. The sole issue for decision is
whether petitioner, a professional service corporation, may use
the cash receipts and disbursements method (cash method) to
expense the drugs and ancillary pharmaceuticals (collectively,
chemotherapy drugs) used by it while providing chemotherapy
treatments to its patients. We hold it may. Unless otherwise
stated, section references are to the Internal Revenue Code as
applicable to 1995, and Rule references are to the Tax Court
Rules of Practice and Procedure.
Background
All facts are stipulated and are so found. The stipulation
of facts and exhibits submitted therewith are incorporated herein
by this reference. Petitioner's principal place of business was
in Clinton Township, Michigan, when it petitioned the Court.
Petitioner is a professional medical corporation that
provides osteopathic services, with a speciality in oncology
(mainly chemotherapy) and hematology. Petitioner's staff
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consists of physicians, nurses and nursing assistants, laboratory
technicians, administrative personnel, and office workers.
Petitioner has three offices in the Clinton Township area. At
each of these offices, petitioner stores chemotherapy drugs and
has the staffing, equipment, and supplies necessary to administer
chemotherapy treatments.
Chemotherapy drugs are pharmaceutical drugs which under
applicable State (Michigan) law must be prescribed by a doctor
and may be sold only by a licensed pharmacist. Petitioner is not
a licensed pharmacist, and it is unlawful for petitioner to sell
the drugs. Petitioner may use the drugs during the performance
of its chemotherapy services.
Chemotherapy drugs come in ready-to-use form or as powders
or liquids that require mixing. Petitioner generally maintains
about a 2-week supply of chemotherapy drugs, and it regularly
purchases chemotherapy drugs from suppliers to insure that it has
enough on hand to administer prescribed treatments. Chemotherapy
drugs, in an unmixed form, have shelf-lives varying from about 6
months to 1 year.
When an individual first becomes a patient of petitioner,
one of petitioner's physicians examines him or her to prescribe
necessary treatments, and that physician records the
individualized chemotherapy treatment in the patient's file.
After the patient is evaluated and the physician prescribes a
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chemotherapy regime, the patient begins regular, periodic
treatments. The patient does not select the type or quantity of
drugs used in the treatments; this selection is within the sole
discretion of petitioner’s professional staff. In accordance
with standard oncology practice, patients are not examined by a
physician at every chemotherapy treatment but are usually
reexamined by a physician every 4 to 6 weeks during the ongoing
course of treatments. Any changes in the future course of
treatments are documented in the patient's file at that time.
Petitioner's personnel mix and otherwise prepare the
chemotherapy drugs that petitioner administers to a patient; the
chemotherapy drugs cannot be self-administered. One of
petitioner's oncology nurses generally performs the
administration, and a physician is always on site to respond to
emergencies. The physician is not always in the room during the
administration.
Petitioner is a participating provider with Medicare1 and
several other private insurance carriers. Virtually all of
petitioner's patients who receive chemotherapy treatments are
covered by Medicare or private insurance, and those patients are
billed only for the cost of the treatments to the extent of
co-payments, deductibles, and other uncovered charges. For each
1
See Health Insurance for Aged Act, Pub. L. 89-97, 79 Stat.
291 (1965), currently codified at 42 U.S.C. secs. 1395 through
1395ccc (1994).
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patient visit, petitioner's staff prepares a physician's
statement known as a "charge sheet", which is the document from
which petitioner's billing department generates its bills. The
charge sheet specifically lists the type, amount, and cost of
chemotherapy and other drugs administered, and the type and cost
of all professional services rendered. The charge sheets are
specific as to the particulars of chemotherapy treatments so as
to comply with the guidelines of Medicare and the private
insurance industry. Petitioner submits the charge sheets
directly to Medicare or other responsible party, and petitioner
bills its patients for the copayments or other charges not
covered by insurance.
Medicare and private insurers analyze on an item-by-item
basis whether to reimburse the charges shown on the charge
sheets. The dollar amount reimbursed for a drug administered to
a patient is ascertained by reference to the average wholesale
price (AWP) of the units in which the drug is packaged and sold
wholesale, which AWP is published annually with quarterly
updates. Generally, the reimbursement amount for drugs equals
the AWP times the units used, with rounding up to the next whole
unit of a drug when billing for administration of a partial unit.
It is common industry practice to charge for all medical
services provided even when the health care provider anticipates
it will not be paid in full for all charges. The standard charge
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nationally for chemotherapy drugs is 1.5 times the AWP, and
petitioner bills its patients for the drugs at this rate with the
expectation that the patient will pay the excess over the amount
reimbursed. With all reimbursement payments from Medicare or
private insurers, petitioner receives an "Explanation of
Benefits" that details the amounts allowed and disallowed as to
each specific charge, and the amounts for each charge which are
due from secondary insurance and/or the patient.
Petitioner has always used the cash method for purposes of
both financial and tax accounting, and it has never maintained an
inventory of any of the items used in its practice. Petitioner
expenses as supplies the cost of all chemotherapy drugs purchased
during the year; the actual cost of chemotherapy drugs which it
had on hand at the end of 1995 was $31,887. Petitioner deducted
on its 1995 tax return $772,522 in "medical supplies" for the
actual cost of the chemotherapy drugs and $66,305 in "laboratory
supplies" for the actual cost of miscellaneous nonpharmaceutical
items. Petitioner reported on its 1995 tax return $2,938,726 in
gross receipts and no cost of goods sold.
Respondent determined that petitioner had to inventory its
chemotherapy drugs, and, thus, that petitioner's use of the cash
method did not clearly reflect its income. Respondent changed
petitioner's method of accounting to a hybrid method, which
hybrid method accounted for the chemotherapy drugs on an accrual
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method and the balance of petitioner's business on the cash
method. Respondent's change to the hybrid method increased
petitioner's income by: (1) $31,887, the actual cost of the
chemotherapy drugs on hand at the end of 1995, and (2) $148,557,
the value of petitioner's accounts receivable relating to
chemotherapy drugs conveyed to patients as of the end of 1995.
Discussion
We decide for the first time whether the furnishing of
pharmaceuticals by a medical treatment facility as an integral,
indispensable, and inseparable part of the rendering of medical
services is the sale of "merchandise" for purposes of section
1.471-1, Income Tax Regs. In Hospital Corp. of Am. v.
Commissioner, 107 T.C. 116 (1996) (HCA), we held that medical
supplies and pharmaceuticals used by hospitals are so vital to
the furnishing of medical services that income earned therefrom
constitutes income earned from the performance of services for
purposes of the nonaccrual-experience method of section
448(d)(5). In HCA, we explicitly reserved for another day the
question of whether those supplies and pharmaceuticals were
merchandise that had to be inventoried under section 1.471-1,
Income Tax Regs. See id. at 143-144 n.18. That day is here in
the factual setting of a physician’s outpatient chemotherapy
treatment facility.
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We decide this issue in the context of whether it was an
abuse of respondent’s discretion to exercise his authority under
section 446 and require petitioner to change from the cash method
to a hybrid method.2 Presented is the question of whether
petitioner should be required to keep inventories for tax
purposes under section 471. Respondent determined that
petitioner’s chemotherapy drugs were merchandise that was an
income-producing factor, that petitioner therefore was required
2
Sec. 446 provides in pertinent part:
SEC. 446. GENERAL RULE FOR METHODS OF ACCOUNTING.
(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.
(c) Permissible Methods.--Subject to the
provisions of subsections (a) and (b), a taxpayer may
compute taxable income under any of the following
methods of accounting--
(1) the cash receipts and disbursements method;
(2) an accrual method;
(3) any other method permitted by this chapter; or
(4) any combination of the foregoing
methods permitted under regulations
prescribed by the Secretary.
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to inventory the drugs, and that petitioner was required to use
an accrual method to account for this inventory in order to
reflect its income clearly. Petitioner asserts that it is not a
merchandising business but a provider of services; to wit,
chemotherapy treatments for patients stricken with cancer.
Petitioner argues that it need not maintain inventories for the
chemotherapy drugs used in the treatments.
We agree with petitioner that it is not required to
inventory its chemotherapy drugs. We are mindful of the broad
discretion accorded the Commissioner in applying sections 446 and
471. Taxpayers challenging the Commissioner’s authority must
prove that the Commissioner’s determination is “clearly unlawful”
or “plainly arbitrary”. See Thor Power Tool Co. v. Commissioner,
439 U.S. 522 (1979); see also Wal-Mart Stores, Inc. & Subs. v.
Commissioner, T.C. Memo. 1997-1, affd. 153 F.3d 650 (8th Cir.
1998). The fact that the Commissioner has broad authority under
section 446(b), however, does not mean that the Commissioner may
change a taxpayer’s method of accounting with impunity. See,
e.g., Prabel v. Commissioner, 91 T.C. 1101, 1112-1113 (1988),
affd. 882 F.2d 820 (3d Cir. 1989). The Commissioner, for
example, may not change a taxpayer's method of accounting from
one that clearly reflects income to another one that the
Commissioner believes more clearly reflects income. See
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Ansley-Sheppard-Burgess Co. v. Commissioner, 104 T.C. 367 (1995);
see also Wal-Mart Stores, Inc. & Subs. v. Commissioner, supra.
We focus our inquiry on whether the chemotherapy drugs were
supplies deductible under section 162, or merchandise that must
be inventoried under section 471. Section 162(a) allows a
deduction for “all the ordinary and necessary expenses paid or
incurred during the taxable year in carrying on any trade or
business”. The relevant regulations explain that
Taxpayers carrying materials and supplies on hand
should include in expenses the charges for materials
and supplies only in the amount that they are actually
consumed and used in operation during the taxable year
for which the return is made, provided that the costs
of such materials and supplies have not been deducted
in determining the net income or loss or taxable income
for any previous year. If a taxpayer carries
incidental materials or supplies on hand for which no
record of consumption is kept or of which physical
inventories at the beginning and end of the year are
not taken, it will be permissible for the taxpayer to
include in his expenses and to deduct from gross income
the total cost of such supplies and materials as were
purchased during the taxable year for which the return
is made, provided the taxable income is clearly
reflected by this method. [Sec. 1.162-3, Income Tax
Regs.]
Section 471 provides in pertinent part:
SEC. 471. GENERAL RULE FOR INVENTORIES.
(a) General Rule.--Whenever in the opinion of the
Secretary the use of inventories is necessary in order
clearly to determine the income of any taxpayer,
inventories shall be taken by such taxpayer on such
basis as the Secretary may prescribe as conforming as
nearly as may be to the best accounting practice in the
trade or business and as most clearly reflecting the
income.
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The relevant regulations explain that "inventories at the
beginning and end of each taxable year are necessary in every
case in which the production, purchase, or sale of merchandise is
an income-producing factor." Sec. 1.471-1, Income Tax Regs.
Jurisprudence provides that a taxpayer with inventories must use
an accrual method, unless the taxpayer shows that use of another
method would produce a substantial identity of results and that
the Commissioner’s determination requiring a change is an abuse
of discretion. See Knight-Ridder Newspapers, Inc. v. United
States, 743 F.2d 781, 789, 791-793 (11th Cir. 1984);
Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d 352 (1st Cir.
1970), affg. T.C. Memo. 1969-79; Ansley-Sheppard-Burgess Co. v.
Commissioner, 104 T.C. at 377; see also sec. 1.446-1(c)(2)(i),
Income Tax Regs.
Under the facts at hand, respondent may require petitioner
to utilize an inventory method of accounting only if we find each
of the following as facts: (1) Petitioner produced, purchased,
or sold merchandise, and (2) petitioner's production, purchase,
or sale of that merchandise was an income-producing factor. See
Honeywell Inc. v. Commissioner, T.C. Memo. 1992-453, affd.
without published opinion 27 F.3d 571 (8th Cir. 1994). We need
not reach the second part of this inquiry; i.e., whether the
production, purchase, or sale of merchandise is an
income-producing factor, if we are unable to find first that the
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chemotherapy drugs are merchandise. See Wilkinson-Beane, Inc. v.
Commissioner, supra; Honeywell Inc. v. Commissioner, supra; sec.
1.471-1, Income Tax Regs.
The statute and regulations do not define the words
“merchandise” or “inventory”, nor do they clearly distinguish
between "inventory" and “materials and supplies” that are not
actually consumed and remain on hand. We have held that
“merchandise”, as used in section 1.471-1, Income Tax Regs., is
an item acquired and held for sale. See Wilkinson-Beane, Inc. v.
Commissioner, T.C. Memo. 1969-79. Upon appeal, the Court of
Appeals for the First Circuit agreed, stating:
A canvassing of authorities in the accounting field
yields several definitions, such as “goods purchased in
condition for sale,” “goods awaiting sale,” “articles
of commerce held for sale,” and “all classes of
commodities held for sale.” Clearly, the meaning of
the term must be gathered from the context and the
subject. * * * The common denominator, however, seems
to be that the items in question are merchandise if
held for sale. [Wilkinson-Beane, Inc. v. Commissioner,
420 F.2d at 354-355; citations omitted.]
Whether an item is acquired and held for sale is governed by
the substance of the transaction and not its form. See Honeywell
Inc. v. Commissioner, supra. We take into account the particular
facts and circumstances of the taxpayer in each case and the
manner and context in which the taxpayer operates the business at
hand. See Wilkinson-Beane, Inc. v. Commissioner, supra; Thompson
Elec., Inc. v. Commissioner, T.C. Memo. 1995-292; Honeywell Inc.
v. Commissioner, supra; J.P. Sheahan Associates, Inc. v.
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Commissioner, T.C. Memo. 1992-239. We have previously examined
service transactions in a variety of industries to determine
whether the transactions in substance involved solely the sale of
a service, or whether the transactions involved the sale of both
a service and merchandise. Those cases are not readily
reconcilable and underscore the fact-intense nature of this
inquiry.3 We have not, however, explored this issue in the
context of the health care industry and have never had a
situation where, as here, applicable laws would prohibit the
taxpayer from selling the items in issue without provision of the
attendant service.
We find the instant setting distinguishable from the setting
of those cases in which we have held that goods utilized by a
service provider were merchandise for purposes of the inventory
rules. We give significance to the uniqueness of the industry in
3
See, e.g., Addison Distribution, Inc. v. Commissioner,
T.C. Memo. 1998-289 (electronic materials were merchandise);
Thompson Elec., Inc. v. Commissioner, T.C. Memo. 1995-292(electrical contractor’s wire, conduit, and electrical panels
were merchandise); Honeywell Inc. v. Commissioner, T.C. Memo.
1992-453 (rotable spare parts used in maintenance service
business were not merchandise; Court rejected argument that
taxpayer’s “consideration” of the parts' cost to set its fixed
fee established that the parts were acquired and held for sale),
affd. without published opinion 27 F.3d 571 (8th Cir. 1994); J.P.
Sheahan Associates, Inc. v. Commissioner, T.C. Memo. 1992-239(contractor’s roofing materials were merchandise); Surtronics,
Inc. v. Commissioner, T.C. Memo. 1985-277 (electroplating metals
were merchandise); Wilkinson-Beane, Inc. v. Commissioner, T.C.
Memo. 1969-79 (funeral business’ caskets were merchandise), affd.
420 F.2d 352 (1st Cir. 1970).
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which petitioner operates in relation to the other service
industries we have addressed on this issue and bear in mind the
recent case of Hospital Corp. of Am. v. Commissioner, 107 T.C.
116, 143-145 (1996). There, as explained in more detail below,
we held that the income attributable to the pharmaceuticals and
various medical supplies frequently used by the personnel of the
taxpayer/hospital while performing medical services was not
income from the sale of goods for purposes of the nonaccrual-
experience method of section 448(d)(5).4 We held that those
items were "inseparably connected" to the taxpayer's services.
See id. at 143.
Like the taxpayer in HCA, petitioner's business is a
quintessential service business. It is a health care provider
that administers chemotherapy treatments to patients with cancer.
Although it furnishes chemotherapy drugs to its patients as part
of its service, a person cannot obtain the drugs but for the
chemotherapy treatments, and the treatments require the extensive
and specialized service of petitioner's professional staff.
Petitioner's professional staff, as an integral and indispensable
part of furnishing chemotherapy drugs to a patient, must examine
the patient and prescribe a treatment regime, monitor the length,
4
The medical supplies included items such as radiological
dyes, casts, crutches, canes, walkers, bandages, sutures,
splints, skin staples, various implants such as joint
replacements, pacemakers, heart valves, orthopedic devices, and
physical and occupational therapy items.
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kind, quantity, and frequency of the treatments, and reevaluate
the patient on an ongoing basis. That these services are
critical and essential to the furnishing of the chemotherapy
drugs by petitioner's staff cannot be denied.
Petitioner is not a merchandiser. Although it is true that
petitioner transfers the tangible quality of the chemotherapy
drugs to its patients when it administers the drugs to them,
petitioner does so only as an integral and inseparable part of
its service. Petitioner is precluded by law from selling the
chemotherapy drugs to any person without providing the medical
service, and the drugs are not susceptible of self-
administration. In fact, the only way that a person may legally
receive the chemotherapy drugs from petitioner is to agree to
petitioner's overall chemotherapy service, and, when they do
agree to this service, they have no say in the type or quantity
of chemotherapy drugs which petitioner uses in their care.
Usually, they are not even aware of the type or quantity of
chemotherapy drugs used on them as part of their treatment.
Where, as here, the service provider dispenses the drugs as an
indispensable and inseparable part of the rendering of its
services, the service provider is not selling “merchandise”. The
service provider is using the items as supplies which are
essential to the provision of its services. A medical practice
such as petitioner’s is inherently a service business, and the
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drugs administered in the practice are subordinate to the
provision of the medical services.
We disagree with respondent's contention that "The transfer
of the drugs is clearly a commercial transaction" to the extent
he implies a commercial transaction is the conveyance of
merchandise. Given the nature of the services petitioner
provides and the substance of the service transactions, we are
convinced petitioner is not selling merchandise when it
administers chemotherapy drugs. The case of Abbott Labs. v.
Portland Retail Druggists Association, Inc., 425 U.S. 1 (1976),
parallels that conviction. There, the Supreme Court decided
whether drugs purchased by a nonprofit hospital at prices lower
than those charged commercial pharmacists were exempt from the
antiprice discrimination provisions of the Robinson-Patman
Antidiscrimination Act, ch. 592, 49 Stat. 1526 (1936), 15 U.S.C.
sec. 13(a) (1994). The exemption generally applies where the
nonprofit institution is purchasing the drugs for its "own use"
as opposed to for sale to patients. In siding with the
hospital's contention that it was exempt, the Court stated:
it seems to us to be very clear that a hospital's
purchase of pharmaceutical products that are dispensed
to and consumed by a patient on the hospital premises,
whether that patient is bedded, or is seen in the
emergency facility, or is only an outpatient, is a
purchase of supplies for the hospital's "own use," * *
*. In our view, * * * this is so clear that it needs
no further explication. [Abbot Labs. v. Portland
Retail Druggists Association, supra at 10-11; emphasis
added.]
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This Court has also stated similarly. See St. Luke's Hosp. v.
Commissioner, 35 T.C. 236, 238 (1960), wherein the Court stated
that the taxpayer hospital was "not a merchandising business, and
* * * has no merchandise inventories which would require the use
of an accrual method in keeping its books or reporting its
income. Its income is derived from providing hospital and
professional care to the sick."
Respondent's characterization of the chemotherapy drugs as
merchandise offends the natural and ordinary meaning of the term
"merchandise". The word "merchandise" denotes commodities or
goods that are bought and sold in business. See Merriam
Webster's Collegiate Dictionary 727 (10th ed. 1996). Although
pharmaceuticals could reasonably be construed to be merchandise
in some contexts; e.g., when purchased at a grocery store for
self-administration at home, it does not necessarily follow that
pharmaceuticals are merchandise in all contexts. The latter
proposition is especially true under the facts at hand where
petitioner's patients generally cannot be understood to consider
themselves as purchasers of "merchandise" during the course of
their medical treatment. The chemotherapy drugs are administered
by petitioner's trained, licensed, and specialized physicians and
other health-related professionals during the rendition of a
unique medical service, and, when administered, the drugs are not
"goods [that were] purchased in condition for sale," or "articles
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of commerce held for sale." Simply put, petitioner is not
peddling products.
Respondent looks to the value of the chemotherapy drugs and
asserts that petitioner's business is part service, part sale.
We disagree. The mere fact that the chemotherapy drugs are
expensive is insufficient to transmute the transaction from the
sale of a service to the sale of merchandise and a service. The
common denominator that the items be held for sale is lacking on
these facts. Petitioner's chemotherapy treatment business is a
pure service business and not, as respondent asserts, a mixed
service and merchandising business. See, e.g., Hewlett-Packard
Co. v. United States, 71 F.3d 398 (Fed. Cir. 1995) (taxpayer's
computer maintenance business was a service business, not mixed
service and merchandise business, despite installation of parts);
Honeywell, Inc. v. Commissioner, T.C. Memo. 1992-453 (taxpayer's
computer maintenance business was a service business, not mixed
service and merchandise business, despite installation of parts),
affd. without published opinion 27 F.3d 571 (8th Cir. 1994).
We find no cases on this issue analogous, much less
controlling. The reported authorities, including those cases
where the court found that the merchandise at issue there was
sold either with or without a service, are all materially
distinguishable from the facts herein given the uniqueness of the
service provided. Respondent relies on the seminal case of
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Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d 352 (1st Cir.
1970), affg. T.C. Memo. 1969-79. There, the taxpayer was an
undertaker that sold caskets as part of its funeral service. In
finding that the caskets were merchandise for purposes of section
471, the Court of Appeals for the First Circuit noted that the
taxpayer normally kept an inventory of some 35 caskets, that the
caskets were not necessarily used during the year but were
purchased and occasionally carried for long periods of time, that
the caskets were on display and played a central role in the
"sale" of the taxpayer's service, and that there was a direct
relationship between the magnificence of the caskets and the cost
of the service. See id.Those factors are not present here. Petitioner kept no more
than a 2-week supply of chemotherapy drugs on hand and used
virtually all the drugs during the taxable year. The drugs also
were not displayed to patients for selection, and patients played
no role in determining the type or amount of drugs used on them.
Furthermore, unlike the taxpayer’s business in Wilkinson-Beane,
Inc., the type of chemotherapy drugs or the "magnificence"
thereof played no role in whether patients chose to purchase
petitioner's services. The variable factor in the cost of a
patient's treatment is a factor out of the patient's control;
i.e., the type and severity of the patient's condition. We also
find it critical that a person is unable to obtain the
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chemotherapy drugs without purchasing petitioner's service. We
find nothing in the case of Wilkinson-Beane, Inc. that would
cause us to believe that the taxpayer's services there depended
on the purchase of caskets from it. Instead, the taxpayer in
Wilkinson-Beane, Inc., by choice, sold the funeral services and
caskets as a package.
Respondent also relies on Knight-Ridder Newspapers, Inc. v.
United States, 743 F.2d 781 (11th Cir. 1984). There, the Court
of Appeals for the Eleventh Circuit considered whether the
taxpayer, who produced and sold newspapers, was required to keep
inventories. The taxpayer argued that it was a service business
in that it provided information for its readership and
advertisement for its clients. The court found that even though
the taxpayer sold an extremely perishable commodity (a 2-day-old
newspaper is stale) and had no inventory of finished goods, the
taxpayer was required to account for inventories because the
newspapers were merchandise and there was a significant
fluctuation of newsprint and ink on hand.
The facts of Knight-Ridder Newspapers, Inc. v. United
States, supra, are materially distinguishable from the facts at
hand. In contrast to the instant case, the taxpayer in Knight-
Ridder, Inc. clearly manufactured a product (newspapers) and used
raw materials (paper and ink) in the manufacturing process. We,
like the Court of Appeals for the Eleventh Circuit, find
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unconvincing the taxpayer's argument that the readership was
purchasing a service.
We also find the facts herein to be markedly different from
the facts presented in the various cases on this issue involving
contractors and subcontractors. In all of those cases where we
found the taxpayer was selling merchandise, the contractor's
services involved installation of products and the customers came
to the contractors to purchase the products as well as the
installation services. See, e.g., Thompson Elec., Inc. v.
Commissioner, T.C. Memo. 1995-292 (taxpayer was selling
merchandise in connection with a service when he installed
wiring, conduits, electrical panels, and lighting fixtures); J.P.
Sheahan Associates, Inc. v. Commissioner, T.C. Memo. 1992-239(contractor's roofing materials were merchandise); Surtronics,
Inc. v. Commissioner, T.C. Memo. 1985-277 (electroplating metals
were merchandise). The customers of the taxpayers also could
have personally purchased the merchandise elsewhere and either
installed the merchandise themselves, if they had the time and
expertise to do so, or contracted with a third party to install
the merchandise for them. In the instant case, by contrast,
persons seeking chemotherapy treatment may not buy the drugs
elsewhere, and they may not apply the drugs themselves.
Respondent unduly focuses on the fact that petitioner listed
on the bills submitted to Medicare and private insurers the type
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and amount of chemotherapy drugs used on its patients but did not
itemize the less expensive supplies. While we agree with
respondent that the itemization of the drugs on the bills is a
fact properly considered, see, e.g., Thompson Elec., Inc. v.
Commissioner, supra, we disagree with respondent that it is
dispositive of the issue. The substance of the transactions at
issue is that a service is provided by and purchased from
petitioner. Petitioner and other health care providers today
must operate under a myriad of statutory, regulatory, and
contractual mandates the purpose of which is aimed at management
of care and cost containment in the health care industry. See,
e.g., 42 U.S.C. secs. 1395 through 1395ccc (1994); 42 C.F.R.
secs. 405.201 through 405.2470 (1998); Health Care Finance
Administration, Medicare Provider Reimbursement Manual (Pubs. 15-
1 and 15-2) (Rev. 3-93). Undoubtedly, as the costs of medical
supplies increase, so do the regulatory and contractual
directives for itemization and justification. There is no
evidence petitioner provided those itemizations for merchantable
purposes or because it was selling merchandise. Rather, the
manner and form in which petitioner prepares its bills are
dictated by applicable laws, contracts with private insurers, and
the environment of the industry in which it operates. We decline
to attach further accounting or other significance thereto.
- 23 -
Our declining to attach accounting significance to the bills
is supported by Federal Medicare statutes and regulations. As
stipulated by the parties, the chemotherapy treatments and drugs
at issue are covered by Medicare. Medicare covers only medical
"services" and does not cover prescription drugs that can be
self-administered. See 42 C.F.R. sec. 410.29 (1998).5 In
creating legislative coverage for medical services, Congress was
astutely aware that health care providers may need to use
supplies or administer drugs incident to and as an integral part
of their services. As pertinent, the Health Insurance for Aged
Act, Pub. L. 89-97, sec. 1861, 79 Stat. 291, 321 (1965), 42
U.S.C. sec. 1395x(s) (1994), provides as follows:
The term "medical and other health services" means
any of the following items or services:
(1) physicians' services;
(2)(A) services and supplies (including drugs
and biologicals which cannot, as determined
in accordance with regulations, be self-
administered) furnished as an incident to a
physician's professional service, of kinds
which are commonly furnished in physicians'
offices and are commonly either rendered
without charge or included in the physicians'
bills.
5
This is true for the fee-for-service statutory coverage
under Medicare. The Secretary of Health and Human Services may
contract with private insurers (health maintenance organizations)
to provide benefits to beneficiaries under Medicare. See Health
Insurance for Aged Act, Pub. L. 89-97, 79 Stat. 291 (1965), 42
U.S.C. sec. 1395mm (1994). The beneficiaries that opt for
coverage under a health maintenance organization plan may have
prescription drug coverage under their contract with the insurer.
- 24 -
The chemotherapy treatments administered by petitioner, including
the chemotherapy drugs, are considered part of the medical
service under Medicare and are within the scope of Medicare's
coverage. Congress explicitly provided that charging for the
drugs on the bill does not change the nature of the transaction
from the provision of a covered "service" to the sale of
noncovered prescription drugs. See 42 U.S.C. sec. 1395x(s)
(1994); see also 42 C.F.R. secs. 410.10, 410.26, 410.27 (1998).
Respondent is also unduly impressed by the fact that
petitioner's physicians do not administer the treatments and are
generally not present when treatments are administered by
oncology nurses. This is irrelevant to the inquiry of whether
petitioner is selling a service or a service and merchandise, and
we place no significance on it. We disagree with respondent's
likening the facts herein to "prescription drugs in a drug store
-- drugs which are clearly merchandise requiring the use of
inventories." When a drug store sells drugs, there is little if
any specialized and personalized service element attendant to the
sale. Respondent's analogy is flawed.
Respondent argues the chemotherapy drugs comprised 26
percent of petitioner's gross receipts, that the drugs are billed
to responsible parties at 1.5 times the AWP, and that the cost of
the chemotherapy drugs was dramatically higher than the cost of
other supplies. These factors go to whether the sale of the
- 25 -
"merchandise" is an income-producing factor. Without addressing
the merits of these arguments, we do not interpret section
1.471-1, Income Tax Regs., to require that if a material is an
income-producing factor it must, per se, be “merchandise”. The
section provides that “inventories * * * are necessary in every
case in which the production, purchase, or sale of merchandise is
an income-producing factor”. See sec. 1.471-1, Income Tax Regs.
Because we conclude that the chemotherapy drugs used in the
administration of the chemotherapy treatments are not
merchandise, we need not and do not reach the question of whether
merchandise is an income-producing factor in petitioner’s
business.
As mentioned above, our conclusion parallels our holding in
Hospital Corp. of Am. v. Commissioner, 107 T.C. 116 (1996), where
the hospital's professional staff frequently used pharmaceuticals
and medical supplies to provide medical care to patients.
Respondent argued in that case that the income attributable to
the pharmaceuticals and supplies could not be reported using the
nonaccrual-experience method of section 448(d)(5) because the
income was attributable to the sale of “goods”. Id. at 141.
Under that method, an accrual method taxpayer need not accrue
amounts to be received for the performance of services that, on
the basis of experience, will not be collected. See sec.
448(d)(5). The nonaccrual-experience method may not be used to
- 26 -
the extent amounts are attributable to a "taxpayer's activities
with respect to * * * selling goods". Sec. 1.448-2T(d),
Temporary Income Tax Regs., 52 Fed. Reg. 22775 (June 16, 1987).
We held in HCA that the taxpayer's income attributable to
the pharmaceuticals and medical supplies was service income
because it was "inseparably connected" to the performance of
services. Hospital Corp. of Am. v. Commissioner, 107 T.C. at
143. Consistent with that holding, the income that petitioner
earned here from its use of the chemotherapy drugs must also be
considered service income. Service income, by definition, does
not include income from the sale of goods. See, e.g., sec.
1.448-2T(d), Temporary Income Tax Regs., 52 Fed. Reg. 22775 (June
16, 1987). The logical conclusion is that the underlying items
giving rise to service income also are not "merchandise". As we
discussed above, the meaning of the word “merchandise” is no
broader than the meaning of the word "goods", and, if anything,
the word “merchandise” is a subset of the word “goods”. As a
matter of fact, not even respondent has argued that an item can
be “merchandise” for one purpose of the Code but not a “good” for
a different purpose. Nor has respondent argued that an item the
income from which may be reported on the nonaccrual-experience
method may be inventory for purposes of section 471.
The notice of deficiency is worded broadly as to the
specific basis for respondent's determination that the cash
- 27 -
method does not clearly reflect petitioner’s income. On brief,
however, respondent’s argument as to why petitioner's use of the
cash method does not clearly reflect income articulates that the
chemotherapy drugs are merchandise that must be inventoried.
Respondent does not dispute that petitioner's use of the cash
method clearly reflects income to the extent that the
chemotherapy drugs are not merchandise. We need not and do not
engage in further analysis of the clear reflection of income
standard of section 446.6 See Concord Consumers Housing v.
Commissioner, 89 T.C. 105, 106 n.3 (1987); Estate of Fusz v.
Commissioner, 46 T.C. 214, 215 n.2 (1966). Based on the
foregoing, we hold that respondent abused his discretion in
requiring petitioner to use the hybrid method and that petitioner
may report all its income and expenses under the cash method.
We have considered all arguments in this case for a contrary
holding and, to the extent not discussed above, find those
6
We are mindful of Asphalt Prods. Co. v. Commissioner, 796
F.2d 843 (6th Cir. 1986), affg. in part and revg. in part Akers
v. Commissioner, T.C. Memo. 1984-208, revd. on another issue 482
U.S. 117 (1987), wherein the Court of Appeals for the Sixth
Circuit held that the taxpayer’s method of accounting did not
clearly reflect its income. The setting of Asphalt Prods. Co. is
distinguishable from the setting at hand. The issue there was
not the issue before us today; i.e., whether the furnishing of
pharmaceuticals by a medical treatment facility as an integral,
indispensable, and inseparable part of the rendering of medical
services is the sale of "merchandise" for purposes of section
1.471-1, Income Tax Regs. That case also involved primarily a
significant accumulation of accounts receivable at yearend and
neither involved nor addressed whether the disputed items of
inventory (asphalt) were merchandise in the first place.
- 28 -
arguments to be without merit or irrelevant. To reflect the
foregoing,
Decision will be entered
for petitioner.
Reviewed by the Court.
CHABOT, PARR, WELLS, COLVIN, BEGHE, FOLEY, VASQUEZ, GALE,
and THORNTON, JJ., agree with this majority opinion.
MARVEL, J., concurs in the result only.
RUWE, J., dissents.
- 29 -
PARR, J., concurring: I agree with the majority's opinion,
and write separately merely to emphasize that each case that
comes before this Court presents a unique set of facts and is
decided on its own merits. Although we now find that the facts
of this case are "markedly different" from the facts of some of
the cases we have decided involving construction contractors, I
believe that the principles enunciated here also apply to
construction cases. This is true, for example, when a building
material is indispensable and inseparable from the service
provided by the construction contractor. See, e.g., Galedrige
Constr., Inc. v. Commissioner, T.C. Memo. 1997-240.
BEGHE, J., agrees with this concurring opinion.
- 30 -
BEGHE, J., concurring: I write separately to tie up or at
least pick at a loose end left by respondent’s determination and
arguments: the proper tax treatment of the slightly more than 2-
week supply of chemotherapy drugs costing $31,887 on hand at the
end of the taxable year.1
Respondent, having tried to put petitioner on the accrual
method with respect to “sales” of chemotherapy drugs, determined
that petitioner’s income should be increased not only by the cost
of such drugs on hand at yearend in the amount of $31,887, but
also by $148,557, the value of petitioner’s accounts receivable
relating to such drugs transmitted to patients during the year.
Rejecting respondent’s “sales” characterization in favor of
treating petitioner’s operations as an overall service business,
we have thereby rejected respondent’s determination putting
petitioner on a hybrid method that would require accrual of its
yearend receivables with respect to transmissions of such drugs.
Respondent did not assert or argue, as an alternative fall-
back position, that petitioner’s deduction of the cost of drugs
on hand at yearend should be deferred to the following year. The
Court need not sua sponte make that adjustment, particularly
where the proper result in this case is not clear, in part
because respondent did not make a stand-alone clear-reflection-
1
$772,522 ÷ 26 = $29,712.384 (average cost of 2-week
supply) ‹ $31,877 (actual on hand).
- 31 -
of-income determination (or even argument) with respect to such
drugs. But, because other cases under submission to the Court
present similar or analogous issues, and because the issue seems
to be a recurring one, a premonitory attempt to tidy up may not
be amiss.
The relevant authority is section 1.162-3, Income Tax Regs.,
“Cost of materials”, which provides as follows:
Taxpayers carrying materials and supplies on hand
should include in expenses the charges for materials
and supplies only in the amount that they are actually
consumed and used in operation during the taxable year
for which the return is made, provided that the costs
of such materials and supplies have not been deducted
in determining the net income or loss or taxable income
for any previous year. If a taxpayer carries
incidental materials or supplies on hand for which no
record of consumption is kept or of which physical
inventories at the beginning and end of the year are
not taken, it will be permissible for the taxpayer to
include in his expenses and to deduct from gross income
the total cost of such supplies and materials as were
purchased during the taxable year for which the return
is made, provided the taxable income is clearly
reflected by this method.
The accounting authorities are in accord: This regulation
means that “Supplies in and of themselves are not considered
inventory and, thus, will not cause the taxpayer to be required
to use accrual accounting,” Bauernfeind, Income Taxation
Accounting Methods and Periods 3-4 (1991), “supplies are deferred
expenses under Reg. § 1.162-3 and not inventory under § 471”, id.
3-14, n. 61, and “when the taxpayer’s inventories are of supplies
only, use of the cash method is permitted. These items are not
- 32 -
inventories under section 471. They are not held for sale in the
ordinary course of business.” Gertzman, Federal Tax Accounting
3-55 (2d ed. 1993) (Gertzman).
The regulation says that materials and supplies cannot be
currently expensed unless four tests are met: (1) They are
“incidental”; (2) no record of consumption is kept; (3) no
physical inventories are taken at the beginning and end of the
year; and (4) income is clearly reflected. Petitioner in this
case would appear to flunk the first three tests: (1)
Chemotherapy drugs transmitted to patients in the course of
petitioner’s rendering of medical services are a substantial
portion of petitioner’s gross receipts and are a material income
producing factor, as evidenced by the markups shown in
petitioner’s billing records; and (2) and (3) records of
consumption and of supplies on hand at yearend are kept; indeed
such records seem to be required by Medicare. However, as to
(4), respondent has not made a stand-alone clear-reflection-of-
income determination, having chosen to rely solely on the
presence of merchandise requiring inventories as compelling
automatic adoption of the accrual method of accounting, the
position that we have rejected.
In other cases of service providers, such as small
contractors in the construction industry, an adjustment treating
yearend supplies as deferred expense might very well be
- 33 -
appropriate, provided that respondent makes the necessary
determinations. Compare J.P. Sheahan Associates, Inc. v.
Commissioner, T.C. Memo. 1992-239, with Thompson Elec., Inc. v.
Commissioner, T.C. Memo. 1995-292, which present different
findings of fact regarding yearend materials and supplies.
As Gertzman states at 6-30:
The rationale behind this provision [the sec. 162-
3 regulation] seems clear. Many taxpayers do not
maintain financial accounting records of consumption
and do not take physical inventories of the supplies on
hand at the beginning and end of the year for business
purposes. In these cases, it would be inconsistent
with the book conformity requirement of Section 446(a),
impractical, and unduly burdensome to require that they
undertake such record-keeping responsibilities or make
such physical counts solely for tax purposes. However,
to protect the Treasury against taxpayers who might
avoid undertaking these activities solely for the
purpose of obtaining a tax benefit, two protections are
afforded. First, the supplies must be incidental and,
second, the taxable income so computed must be
reflected clearly * * * [citation omitted.]
The regulation appears to be not much more than an
illustration of the rule that expenditures that result in assets
having a life beyond the end of the year must be capitalized.
See sec. 263; INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992).
Without attempting to predict the outcome of a hypothetical, see
Gulf Oil Corp. v. Commissioner, 89 T.C. 1010, 1044 (1987)
(Chabot, J., concurring), affd. on other grounds 914 F.2d 396 (3d
Cir. 1990), it suffices to note that the section 162 regulation
authorizes the Commissioner in appropriate cases to treat
supplies on hand at yearend as deferred expenses.
- 34 -
HALPERN, J., dissenting:
I. Introduction
Respondent determined a deficiency in petitioner’s 1995
Federal income tax liability. That deficiency resulted from
respondent’s rejection of the cash receipts and disbursements
method of accounting (the cash method) used by petitioner to
compute taxable income and his recomputation of petitioner’s 1995
taxable income under a hybrid method of accounting. Under that
method (the hybrid method), petitioner was required to use an
accrual method to account for purchases and sales of merchandise.
Respondent recomputed petitioner’s taxable income pursuant to his
authority to require a taxpayer to use a method of accounting
that clearly reflects income, if the method used by the taxpayer
does not clearly reflect income. See sec. 446(b).
Whether a particular method of accounting clearly reflects
income is a question of fact, and the issue must be decided on a
case-by-case basis. See, e.g., Hamilton Indus., Inc. v.
Commissioner, 97 T.C. 120, 128-129 (1991). Generally, where
respondent has determined that a taxpayer’s method of accounting
does not clearly reflect income, the taxpayer must demonstrate
either that his method of accounting clearly reflects income or
that respondent’s method does not clearly reflect income. See
Asphalt Prods. Co. v. Commissioner, 796 F.2d 843, 847 (6th Cir.
1986), affg. in part and revg. in part T.C. Memo. 1984-208.
- 35 -
Petitioner has demonstrated neither that the cash method
clearly reflected its income nor that the hybrid method does not.
Petitioner has demonstrated to the majority’s satisfaction,
however, that its business is a service business. The majority
holds: “Service income, by definition, does not include income
from the sale of goods.” Majority op. p. 26. Therefore, reasons
the majority, petitioner is not engaged in the sale of
merchandise (a word that the majority equates with the word
“goods”). Id. Since petitioner is not engaged in the sale of
merchandise, the majority concludes that respondent may not
require petitioner to use “an inventory method of accounting”.
Majority op. p. 11; see sec. 1.471-1, Income Tax Regs. Finally,
limiting its consideration to the incompatibility of the cash
method with an inventory method of accounting, see sec. 1.446-
1(c)(2)(i), Income Tax Regs., the majority finds that respondent
abused his discretion in requiring petitioner to use the hybrid
method and that petitioner may continue to report all of its
income and expenses under the cash method.
I dissent from the conclusion that petitioner is not engaged
in the sale of merchandise. I also wish to caution against undue
reliance on the majority’s conclusion that respondent abused his
discretion in requiring petitioner to use the hybrid method. As
will be explained, by his answer to the petition, respondent has
limited the issues before the Court.
- 36 -
II. Facts
The majority has set forth many of the facts stipulated by
the parties, and, for the most part, I shall not repeat those
facts. The following facts relate to petitioner’s return,
respondent’s determination of a deficiency, and the pleadings in
this case.
On its Form 1120, U.S. Corporation Income Tax Return, for
1995, petitioner reported gross receipts of $2,938,726, no amount
of cost of goods sold, and a gross profit equal to its gross
receipts. Among other items, petitioner deducted $772,522 for
“medical supplies” (chemotherapy drugs), $600,328 for
compensation paid to its three physician-shareholder-officers
(officer compensation), and other salaries and wages of $630,381.
Petitioner’s deduction for chemotherapy drugs equaled 26 percent
of its reported gross receipts and gross profits and 129 percent
of its officer compensation.
For 1995, under the hybrid method, respondent disallowed the
deduction for chemotherapy drugs claimed by petitioner and
required petitioner to recompute its gross profit by subtracting
from gross receipts (determined under an accrual method) the cost
of the chemotherapy drugs “conveyed” (sold) by petitioner during
that year. The net adjustment to petitioner’s 1995 taxable
income (the net adjustment) was an increase of $180,344,
resulting from (1) an increase of $148,557 in gross receipts to
- 37 -
reflect accounts receivable with respect to chemotherapy drugs
and (2) an increase in closing inventory for the actual cost,
$31,887, of such drugs on hand at the end of 1995.
In respondent’s notice of deficiency in tax (the notice),
respondent explains the net adjustment as follows:
It is determined that since the cash basis of
accounting does not clearly reflect income as required
by the Internal Revenue Code section 446(b), the
Government is changing the taxpayer’s method of
accounting from the overall cash receipts and
disbursements method of accounting to a hybrid method
by which purchases and sales of merchandise are
accounted for on the accrual method of accounting, with
maintenance of inventories.
In the petition, petitioner avers, among other things, that
it is a qualified personal service corporation within the meaning
of section 448(d)(2), “thus allowing it the use of the cash
method of accounting.” See sec. 448(a) and (b). In the answer,
respondent denies petitioner’s averment that it is allowed to use
the cash method and “[a]lleges that the petitioner is required to
maintain inventories and, therefore, is required to use the
accrual method for the purchase and sale of inventories.”
III. Pertinent Provisions of the Code and Regulations
Gross income is defined in section 61(a), which includes, as
an item of gross income, “[g]ross income derived from business”.
Sec. 61(a)(2). In pertinent part, section 1.61-3(a), Income Tax
Regs., provides: “In a manufacturing, merchandising, or mining
business, ‘gross income’ means the total sales, less the cost of
- 38 -
goods sold, plus any income from investments and from incidental
or outside operations or sources.” The regulations thus
recognize that a necessary step in the calculation of the gross
income from sales (at least in a manufacturing, merchandising, or
mining business) is a determination of the cost of goods sold.
That recognition implies the use of inventories, to determine the
cost of goods sold.1 Section 1.162-1(a), Income Tax Regs.,
confirms the role that inventories play in the determination of
1
The determination of cost of goods sold and gross income
from sales for a manufacturer involves the use of inventories
pursuant to the basic accounting equation described below:
Beginning inventory $ XXX
Purchases of inventory XXX
Production costs incurred XXX
Total cost of goods
available for sale XXX
Less: Ending inventory XXX
Cost of goods sold $ XXX
Gross receipts from sales $ XXX
Less: Cost of goods sold XXX
Gross income from sales (sec. 61) $ XXX
It can be seen from the foregoing equation that the amount
of a taxpayer’s ending inventory and cost of goods sold both have
a very direct effect on the amount of the taxpayer’s gross income
from sales; however, those effects are exerted in opposite
directions. All other things being constant, as a taxpayer’s
ending inventory increases in amount, its cost of goods sold
decreases, and its gross income from sales increases. In
contrast, as a taxpayer’s ending inventory decreases in amount,
its cost of goods sold increases, and its gross income from sales
decreases. The foregoing equation and comment appear in
Schneider, Federal Income Taxation of Inventories, sec. 1.01,
pp. 1:4-1:5 (1999).
- 39 -
gross income from sales: “The cost of goods purchased for
resale, with proper adjustment for opening and closing
inventories, is deducted from gross sales in computing gross
income.”
Section 446(a) provides the general rule for methods of
accounting: “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.” In pertinent part,
section 446(b) provides: “[I]f 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.”
Section 471(a) is specific with respect to the use of
inventories:
SEC. 471(a). General Rule.--Whenever in the
opinion of the Secretary the use of inventories is
necessary in order clearly to determine the income of
any taxpayer, inventories shall be taken by such
taxpayer on such basis as the Secretary may prescribe
as conforming as nearly as may be to the best
accounting practice in the trade or business and as
most clearly reflecting the income.
The Secretary has exercised the discretion conferred upon him by
Congress in section 471 by requiring, pursuant to regulations,
that, “[i]n order to reflect taxable income correctly,
inventories at the beginning and end of each taxable year are
necessary in every case in which the production, purchase, or
- 40 -
sale of merchandise is an income-producing factor.” Sec. 1.471-
1, Income Tax Regs.
The determination that a taxpayer must maintain inventories
has two important consequences for the computation of the
taxpayer’s taxable income. First, to the extent that costs
incurred by the taxpayer are reflected in items of inventory
that, at the end of the taxpayer’s taxable year, remain unsold,
such costs will not contribute to the cost of goods sold for that
year and, thus, will result in a correspondingly higher gross
income from sales for the year.2 Second, if a taxpayer is
required to use inventories, then, to reflect its income clearly,
it must use an accrual method of accounting with respect to
purchases and sales of inventory items. See sec. 1.446-
1(c)(2)(i), Income Tax Regs.3 The rationale behind this accrual
requirement is explained in Knight-Ridder Newspapers, Inc. v.
United States, 743 F.2d 781, 789 (11th Cir. 1984) (“According to
accounting wisdom, the income realized from the sale of
2
But cf. sec. 1.471-4, Income Tax Regs. (“Inventories at
cost or market, whichever is lower.”)
3
The taking of inventories does not of itself represent a
separate and distinct method of accounting. As Professor
Chirelstein states: “Rather, it is a component of the over-all
accounting procedure whose essential purpose is to establish the
cost of goods sold as a step towards determination of the
taxpayer’s gross income from business operations.” Chirelstein,
Federal Income Taxation, A Law Student’s Guide to the Leading
Cases and Concepts, par. 12.03 at 269 (8th ed. rev. 1999).
- 41 -
merchandise is most clearly measured by matching the cost of that
merchandise with the revenue derived from its sale.”)
Even if a taxpayer need not maintain inventories, the
recovery of costs associated with the production of income may
not be governed by the taxpayer’s method of accounting. That
treatment is well known with respect to the recovery of certain
capital expenditures by way of the deduction for depreciation.
See sec. 167(a); sec. 1.446-1(a)(4)(ii), Income Tax Regs.
(“Expenditures made during the year shall be properly classified
as between capital and expense.”) More pertinent to our case is
section 1.162-3, Income Tax Regs., which addresses the cost of
materials and supplies (without distinction, supplies) that do
not constitute inventory. Unless the purchase of such supplies
constitutes a capital expenditure, section 1.162-3, Income Tax
Regs., provides:
Taxpayers carrying materials and supplies on hand
should include in expenses the charges for materials
and supplies only in the amount that they are actually
consumed and used in operation during the taxable year
for which the return is made, provided that the costs
of such materials and supplies have not been deducted
in determining the net income or loss or taxable income
for any previous year. If a taxpayer carries
incidental materials or supplies on hand, for which no
record of consumption is kept or of which physical
inventories at the beginning and end of the year are
not taken, it will be permissible for the taxpayer to
include in his expenses and to deduct from gross income
the total cost of such supplies and materials as were
purchased during the taxable year for which the return
is made, provided the taxable income is clearly
reflected by this method.
- 42 -
Section 1.162-3, Income Tax Regs., provides for the deferred
expense treatment of nonincidental supplies without regard to the
taxpayer’s overall method of accounting.
IV. Discussion
A. Purchases and Sales of Inventory
1. Respondent’s Pleading
Petitioner expended $772,522 for chemotherapy drugs during
1995 and treated that expenditure as an expenditure for
incidental supplies. That was plain error under section 1.162-3,
Income Tax Regs. See concurring opinion of Judge Beghe at 32.
Respondent treated the expenditure as if it constituted the cost
of goods purchased for resale. On the facts of this case, in
terms of accounting for the cost of the chemotherapy drugs, it
makes no difference whether the $772,522 expended for
chemotherapy drugs is treated as the cost of goods held for
resale or as a deferred expense.4
The only issue open to debate is whether respondent can
compel petitioner to account for amounts billed to Medicare (and
to patients) under an accrual method. Although section 1.446-
1(c)(2)(ii), Income Tax Regs., leaves no doubt that the Secretary
can so compel petitioner if purchases and sales of inventory are
involved, nothing in section 446(b) prohibits the Secretary from
4
The notice of deficiency shows a $0.00 sec. 481
adjustment.
- 43 -
so compelling petitioner if purchases and sales of inventory are
not involved. Section 446(c) specifically permits a taxpayer to
compute taxable income under the cash method; nevertheless, that
permission is made subject to the Secretary’s section 446(b)
authority to reject the taxpayer’s method of accounting. See
sec. 446(c). By the pleadings, however, the parties have limited
what petitioner must prove to stay on the cash method.
Above, in section II., I have set forth both respondent’s
explanation of the net adjustment and his allegation, in response
to petitioner’s averment that it is entitled to use the cash
method, that “petitioner is required to maintain inventories and,
therefore, is required to use the accrual method for the purchase
and sale of inventories.” (Emphasis added.) Correctly, the
majority thinks that a fair reading of the issue for trial in
this case, as framed by the pleadings, is whether petitioner is
required to maintain inventories. I agree with the limited scope
of the majority’s inquiry, in this case. I do not agree,
however, that petitioner need not use inventories.
2. Inventories Are Required
As set forth in section III., supra, regulations provide:
(1) Inventories are necessary in every case in which the sale of
merchandise is an income-producing factor, and (2) with limited
exceptions, in any case in which it is necessary to use an
inventory, an accrual method must be used with regard to purchase
- 44 -
and sales. See secs. 1.446-1(c)(2), 1.471-1, Income Tax Regs.
Thus, generally, if the purchase and sale of merchandise is an
income-producing factor, an accrual method must be used with
regard to such purchases and sales.
The nominal focus of the majority’s inquiry is whether the
chemotherapy drugs are merchandise: “We focus our inquiry on
whether the chemotherapy drugs were supplies deductible under
section 162, or merchandise that must be inventoried under
section 471.” Majority op. p. 10. The majority states:
“Respondent’s characterization of the chemotherapy drugs as
merchandise offends the natural and ordinary meaning of the term
‘merchandise’”. Id. at 17. The majority concedes, however:
“Although pharmaceuticals could reasonably be construed to be
merchandise in some contexts; * * * it does not necessarily
follow that pharmaceuticals are merchandise in all contexts.”
Id. The majority reaches the conclusion that the chemotherapy
drugs are not merchandise on the basis that petitioner “is not a
merchandiser”, id. at 15, its business “is inherently a service
business”, id. at 16, or “[s]imply put, petitioner is not
peddling products.” Id. at 18. The majority’s conclusions seem
to be informed by its view: “A medical practice such as
petitioner’s is inherently a service business, and the drugs
administered in the practice are subordinate to the provision of
the medical services.” Id. at 16.
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3. Conclusion of Law
The majority’s conclusion that the chemotherapy drugs are
not merchandise is not a finding of fact. The majority’s
conclusion that the chemotherapy drugs are not merchandise
appears to rely on a number of propositions that, when taken
together, amount to a rule of law (i.e., a rule of general
application). The majority’s view that a medical practice such
as petitioner’s is inherently a service business is dependent on
a number of factors (some of which are conclusory): “the
uniqueness of the industry in which petitioner operates”, the
fact that petitioner’s business is a “quintessential service
business”, the “inseparable connection” of the chemotherapy drugs
to the performance of services, and, finally “[s]ervice income,
by definition, does not include income from the sale of goods”.
From those factors, the majority composes the following rule of
law: Doctors (medical and osteopathic) are not in trade. The
dictionary gives as one definition of trade: “the business of
buying and selling commodities; commerce.” The American Heritage
Dictionary of the English Language 1897 (3d ed. 1992). The
majority believes that doctors are not in trade because they are
members of a learned profession, whose stock in trade is
knowledge, not goods or merchandise. See majority op. p. 16.
The majority relies on Abbott Labs. v. Portland Retail
Druggists Association, Inc., 425 U.S. 1 (1976), to support its
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conviction that doctors are not in trade (i.e., are not
merchants). Abbott Labs., however, is an antitrust case, in
which the Supreme Court addressed purchases by nonprofit
hospitals of pharmaceutical products at favored prices from the
manufacturers of those products. The issue was the proper
construction of the phrase “purchases of their supplies for their
own use,” as it appears in 52 Stat. 446, 15 U.S.C. sec. 13c
(1994) (referred to by the Supreme Court as the “Nonprofit
Institutions Act”). The precise question was whether the
nonprofit hospitals’ purchases in question were exempt from the
proscription of the Robinson-Patman Antidiscrimination Act, ch.
592, 49 Stat. 1526 (1936), 15 U.S.C. secs. 13, 13a, 13b, and 21a
(1994) because they were for the hospitals’ own use, within the
meaning of the Nonprofit Institutions Act. Abbott Labs. v.
Portland Retail Druggists Association, Inc., supra at 4. The
majority states: “The exemption generally applies where the
nonprofit institution is purchasing the drugs for its ‘own use’
as opposed to for sale to patients.” Majority op. p. 16
(emphasis added). Apparently, since, in Abbott Labs., the
Supreme Court found that at least some of the drugs in question
were purchased by the hospitals for their own use (within the
meaning of 15 U.S.C. sec. 13c), the majority concludes that those
drugs were not purchased for resale (which, I assume, leads to
the conclusion that doctors, like the hospitals, are not
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merchants). The majority mischaracterizes a provision of the
Nonprofit Institutions Act, 15 U.S.C. sec. 13(c) (1994). That
provision provides as follows: “Nothing in the * * * Robinson-
Patman Antidiscrimination Act, shall apply to purchases of their
supplies for their own use by schools, colleges, universities,
public libraries, churches, hospitals, and charitable
institutions not operated for profit.” The provision does not
establish a dichotomy between use and sale, as suggested by the
majority.5 See, e.g., De Modena v. Kaiser Found. Health Plan,
Inc., 743 F.2d 1388, 1393 (9th Cir. 1983) (referring to Abbott
5
In Abbott Labs. v. Portland Retail Druggists Association,
Inc., 425 U.S. 1 (1976), each of the hospitals in question
operated a pharmacy, which was a separate department of the
hospital, and whose operations produced revenue in excess of
cost. The pharmacies dispensed the pharmaceutical products in
question. The Supreme Court used the terms “sales” and
“dispensations” with reference to those products, and without any
clear distinction between the two terms. The Supreme Court
categorized the following dispensations as for the hospitals’
“own use”:
1. To the inpatient, or to the emergency facility patient,
upon his discharge and for his personal use away from the
premises.
2. To the outpatient for personal use away from the
premises.
3. To the hospital’s physicians, employees, or students,
for their personal use or for the use of their dependents.
Clearly the third category, if not all three, constitutes
sales of merchandise by the pharmacies, notwithstanding that such
merchandise was acquired for the hospitals’ own use. Nothing in
the opinion indicates that the pharmacies failed to inventory
their pharmaceuticals.
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Labs. v. Portland Retail Druggists Association, Inc., 425 U.S. 1(1976), and holding: “[D]rugs purchased by an HMO * * * for
resale to its members are purchased for the HMO’s ‘own use’
within the meaning of the Nonprofit Institutions Act and thus
qualify for protection under the Act.”). Abbott Labs. is no
support for the proposition that, as a matter of law, petitioner
is not selling merchandise.
The majority also cites St. Luke’s Hosp., Inc. v.
Commissioner, 35 T.C. 236, 238 (1960), for the proposition that
petitioner is not selling merchandise when it administers
chemotherapy drugs. The principal issue in St. Luke’s Hosp.,
Inc. was whether the taxpayer, having requested and received
permission from the Commissioner to change from an accrual method
to the cash method of accounting for 1953 and thereafter,
properly reported income on the cash method when it continued to
employ primarily an accrual method in keeping its books and
records. We concluded that it did properly report income on the
cash method since, notwithstanding the taxpayer’s retention of an
accrual method, its cash-basis income could readily be
ascertained from its books and records. Our findings of fact
included the following:
Petitioner owns and operates a hospital in Bluefield.
Its business is the customary hospital service
business. It is not a merchandising business, and
petitioner has no merchandise inventories which would
require the use of an accrual method in keeping its
books or reporting its income. Its income is derived
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from providing hospital and professional care to the
sick. [Id. at 238.]
Those are not statements of law but findings of fact. The
findings that the Bluefield hospital is in the customary service
business of hospitals and has no merchandise is not necessarily
applicable to petitioner. Petitioner is not a hospital, but runs
a chemotherapy clinic, where chemotherapy drugs constitute both a
significant cost and a substantial source of revenue. There is
no finding as to how significant drugs and similar items were to
the overall cost of treatment at the Bluefield hospital. In St.
Luke’s Hospital, Inc. v. Commissioner, supra, which dealt with
medicine as it was practiced over more than 40 years ago, the
Commissioner did not even suggest that inventories were required.6
It is no authority for any conclusion of law.
Nor can the majority rely on any rule of law that service
providers need never use inventories: “We have previously
examined service transactions in a variety of industries to
determine whether the transactions in substance involved solely
the sale of a service, or whether the transactions involved the
sale of both a service and merchandise.” Majority op. p. 13.
6
In Abbott Labs. v. Portland Retail Druggists Association,
Inc., supra at 11, decided in 1976, the Supreme Court stated with
respect to nonprofit hospitals: “we recognize * * * that the
concept of the nonprofit hospital and its appropriate and
necessary activity has vastly changed and developed since the
enactment of the Nonprofit Institutions Act in 1938.” Needless
to say, much more has changed in the last 23 years.
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Finally, the majority’s reliance on Hospital Corp. of Am. v.
Commissioner, 107 T.C. 116 (1996), to support its proposition
that petitioner’s income is attributable solely to services and
not to some combination of services and merchandise is puzzling.
In Hospital Corp. of Am., we did indeed find that, for purposes
of section 448(d)(5), the use of medical supplies is part of the
medical services furnished patients by the hospitals in question.
See id. at 144. In the same breath, however, we found “the cost
of those supplies is an incidental cost of the health care
services provided by the hospitals.” Id. Given that finding,
the fact that Hospital Corp. of Am. involves a different section
of the statute, and our specific reservation in Hospital Corp. of
Am. that we were not deciding the question of whether the
furnishing of medical supplies by the hospitals as a part of the
rendering of services to their patients could be considered to be
a sale of inventory, I do not consider that case as persuasive
with respect to the issue before us today.
The majority cannot escape an examination of the particular
facts of this case in light of the relevant provisions of law.
4. Finding of Fact
We find the instant setting distinguishable from
the setting of those cases in which we have held that
goods utilized by a service provider were merchandise
for purposes for the inventory rules. We give
significance to the uniqueness of the industry in which
petitioner operates in relation to the other service
industries we have addressed on this issue and bear in
- 51 -
mind the recent case of Hospital Corp. of Am. v.
Commissioner, 107 T.C. 116, 143-145 (1996).* * *
Majority op. p. 14.
What facts distinguish this case from those cases in which
we have held that goods utilized by a service provider were
merchandise for purposes of section 1.471-1, Income Tax Regs.? I
agree with the majority’s observations that medicine is unique,
and that it is inherently a service business. So what! Contrary
to the majority’s impression, health care providers do sell
goods. See, e.g., De Modena v. Kaiser Found. Health Plan, Inc.,
supra (drugs purchased by an HMO for resale to its members are
purchased for the HMO’s own use). The relevant distinction is
between supplies, for which inventories need not be taken, and
merchandise held for sale (merchandise), for which inventories
must be taken. Compare section 1.162-3, Income Tax Regs., with
section 1.471-1, Income Tax Regs. I agree with the majority when
it states: “The statute and regulations do not define the words
‘merchandise’ or ‘inventory’, nor do they clearly distinguish
between ‘inventory’ and ‘materials and supplies’ that are not
actually consumed and remain on hand.” Majority op. p. 12. As
previously discussed, supra section IV.A.1, it was plain error
for petitioner to treat the expenditure for the chemotherapy
drugs as an expenditure for incidental supplies, and, in terms of
properly accounting for that expenditure, it makes no difference
whether the expenditure is treated as being for merchandise or
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for supplies. The relevant difference is with respect to the
application of section 1.446-1(c)(2)(i), Income Tax Regs., which,
with an exception not here relevant, and taking into account
section 1.471-1, Income Tax Regs., requires an accrual method
with regard to purchases and sales of merchandise. The majority
agrees that the distinction between supplies and merchandise does
not turn on the nature of the underlying commodity:
“pharmaceuticals could reasonably be construed to be merchandise
in some contexts”. Majority op. p. 17. In Wilkinson-Beane, Inc.
v. Commissioner, 420 F.2d 352, 354 (1st Cir. 1970), affg. T.C.
Memo. 1969-79, the Court of Appeals for the First Circuit
determined that the meaning of the term “merchandise”, as used in
section 1.471-1, Income Tax Regs., “must be gathered from the
context and the subject.” The context and the subject are the
explicit requirement that a taxpayer’s method of accounting
clearly reflect income. See sec. 446(b). Income realized from
the sale of merchandise is most clearly measured by matching the
cost of that merchandise with the revenue derived from its sale.
Knight-Ridder Newspapers, Inc. v. United States, 743 F.2d at 789.
Given the lack of any clearly pertinent distinction between the
term “supplies” and the term “merchandise”, where the facts raise
some question (as they do here), we should inquire which
classification results in a clearer reflection of the taxpayer’s
income.
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The majority describes as seminal the opinion of the Court
of Appeals for the First Circuit in Wilkinson-Beane, Inc. v.
Commissioner, supra. The taxpayer in Wilkinson-Beane, Inc. was
an undertaking establishment, which argued the primacy of the
services that it provided to its customers. The Court of Appeals
affirmed the finding of the Tax Court that the taxpayer was
selling merchandise. The Court of Appeals stated:
We fully recognize that petitioner was in the business
or providing valuable services. But we think it would
be anomalous to hold that a taxpayer in a service
business can have no merchandise even though he derives
a substantial portion of his income from the regular
purchase and sale of tangible personal property. We
certainly have no basis for so restricting the
application of the word 'merchandise’. * * * Since the
caskets play a central role in the 'sale' of taxpayer's
service, to use its term, we see no error in the
determination that the caskets were merchandise.
Id. at 355. The Court of Appeals’ inquiry into the centrality of
the property to the sale and the substantiality of the income
attributable to the property has been followed in subsequent
cases. For example, in J.P. Sheahan Associates, Inc. v.
Commissioner, T.C. Memo. 1992-239, we determined whether roofing
materials constituted merchandise, and we looked to whether the
materials were shown separately on the customer’s bill, they
represented a substantial amount of the total bill, and they were
marked up. In Thompson Elec., Inc. v. Commissioner, T.C. Memo.
1995-292, which involved an electrical contractor, we said: “If
the cost of material a taxpayer uses to provide a service is
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substantial compared to its receipts, the material is a
substantial income-producing factor even if the taxpayer does not
markup the prices charged to its customers for the material.”
What I distill from the Wilkinson-Beane, Inc. line of cases is
that, where the question is whether a provider of services is
using supplies or selling merchandise, the answer turns on
whether the commodity in question is a substantial and
identifiable source of revenue. If so, and if the merchandise is
an income-producing factor, than such merchandise must be
inventoried and an accrual method is appropriate (and may be
required) to match costs and revenue. On the facts before us, I
would require inventories because petitioner is selling
merchandise that is an income-producing factor.
The majority’s finding that the chemotherapy drugs are
subordinate to the services rendered ignores the substantiality
and centrality of the income attributable to the chemotherapy
drugs and involves conclusions that have no basis in the record.
The only facts stipulated with respect to the medical aspects of
petitioner’s business are set forth in the margin.7 Petitioner is
7
When an individual first becomes a patient of petitioner,
one of petitioner’s physicians examines the patient in order to
determine the proper chemotherapy treatment for that patient.
When a patient has been evaluated and a chemotherapy regime
has been prescribed, the patient begins regular, periodic
treatments.
(continued...)
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a corporation, operating clinics and employing physicians,
nurses, nursing assistants, laboratory technicians,
administrative personnel, and office workers. The parties have
not stipulated how individuals came to be petitioner’s patients.
Given petitioner’s apparent specialization, it is likely that
patients were referred for chemotherapy drug treatment. Nothing
in the record establishes the majority’s findings that “patients
played no role in determining the type or amount of drugs used on
them”, majority op. p. 19, or that patients must “agree to
petitioner’s overall chemotherapy service, and, when they do
agree to this service, they have no say in the type or quantity
7
(...continued)
Petitioner’s physicians prescribed the chemotherapy regime
but, with rare exception, did not actually administer the
chemotherapy drugs to patients during taxable year 1995 to
present.
Chemotherapy drugs were administered by oncology nurses
during taxable year 1995.
Prior to the initiation of each course of chemotherapy, the
patients were seen and evaluated by the attending physician.
The patients were not examined at the time of every
chemotherapy administration pursuant to the standard practice of
medical oncology.
Once a patient has begun a chemotherapy regime, that patient
will see one of petitioner’s physicians approximately every 4- to
6-weeks, between treatments.
While a physician must be available to respond to
emergencies, a physician is not required to be in every room with
a patient while chemotherapy treatment is being administered.
- 56 -
of chemotherapy drugs which petitioner uses in their care.”
Majority op. p. 15. Nor does anything in the record establish:
“Usually, they [patients] are not even aware of the type or
quantity of chemotherapy drugs used on them as part of their
treatment.” Id. Contrary to the inference in the majority’s
opinion, petitioner’s physician-employees do not choose or decide
that a patient shall receive chemotherapy drugs. Common
experience tells us that, although petitioner’s physician-
employees may recommend such treatment, the patients are the ones
who must make the decision to receive the drugs. Moreover, if
those patients decide to receive chemotherapy drugs, they want
the drugs and nothing in the record (or in common sense) leads me
to believe that the drugs are necessarily subordinate to the
physician’s services. I cannot agree with the majority’s
conclusion that, with respect to petitioner’s business, the
provision of chemotherapy drugs was subordinate to the provision
of medical services.
B. Clear Reflection of Income
If a taxpayer’s method of accounting does not clearly
reflect income, section 446(b) accords the Secretary the
authority to require the taxpayer to compute taxable income under
such method as, in the opinion of the Secretary, does clearly
reflect income. We have interpreted respondent’s position in
this case as requiring petitioner to use an accrual method (the
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hybrid method) only because purchases and sales of inventory were
involved. Having concluded that petitioner did not purchase and
sell inventory, the majority has determined that respondent
abused his discretion in requiring petitioner to use the hybrid
method. Taxpayers should not read too much into that
determination.
As stated, although section 1.446-1(c)(2)(ii), Income Tax
Regs., leaves no doubt that respondent can so compel petitioner
if purchases and sales of inventory are involved, nothing in
section 446(b) prohibits the Secretary from so compelling
petitioner if purchases and sales of inventory are not involved.
Moreover, although section 446(c) specifically permits a taxpayer
to compute taxable income under the cash method, that permission
is made subject to the Secretary’s section 446(b) authority to
reject the taxpayer’s method of accounting. See sec. 446(c).
The legislative endorsement of the cash method undoubtedly means
that wages and salaries can be reported on the cash method. The
taxpayer in this case, however, is not a wage earner. Petitioner
is a corporation, with three physician-shareholder-employees,
three other physician-employees, numerous other employees, and,
for 1995, just shy of $3 million in receipts. For that year, it
paid officer compensation of $600,328 and other salaries and
wages of $630,381, for a total of just over $1.2 million. If the
value of the services provided by all six physicians employed by
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petitioner is measured by their compensation, then that value is
somewhere in the neighborhood of $1 million (given that there
were numerous employees other than physician employees).
Petitioner, thus, had receipts of about $2 million attributable
to something other than the negotiated value (to the corporation)
of physician’s services, including chemotherapy drugs costing
$772,522. Petitioner’s receivables at the end of 1995 were
$148,557. I know of no rule of law that forecloses an inquiry
into whether, to reflect clearly petitioner’s income, the
receivables attributable to the chemotherapy drugs used during
the year should not be reported on an accrual method, as would be
the case under the hybrid method. Recently, in Oakcross
Vineyards, Ltd. v. Commissioner, T.C. Memo. 1996-433, affd. 142
F.3d 444 (9th Cir. 1998), we sustained the Commissioner’s
determinations that (1) the cash method did not clearly reflect a
farmer’s receipts from the sale of grapes and (2) an accrual
method was required. We surveyed many of the cases dealing with
a challenge by the Commissioner to the cash method, including
cases involving the Commissioner’s rejection of the cash method
for reporting receipts. Among the cases we surveyed were the
following: American Fletcher Corp. v. United States, 832 F.2d
436 (7th Cir. 1987) (credit card charge account service required
to change from cash method to an accrual method); Applied
Communications, Inc. v. Commissioner, T.C. Memo. 1989-469- 59 -
(concerning sales of computer software by the developer of the
software and taking into account that “cash method of accounting
is not appropriate for petitioner because it generates
substantial amounts of receivables or deferrals of revenue as
evidenced by the difference between its software income for tax
and financial purposes.”); Silberman v. Commissioner, T.C. Memo.
1983-782 (cash receipts and disbursements method of accounting
could not be used by a movie production partnership because the
predicted delay between expenditures and receipts created a
mismatching of funds and a distortion of income), affd. without
published opinions sub nom. Appeal of David Whin, Inc., Appeal of
Giordano, Appeal of Malanka, Stamato v. Commissioner, 770 F.2d
1068, 1069, 1072, 1075 (3d Cir. 1985). In Oakcross Vineyards
Ltd., we also pointed out that the question of whether a
taxpayer’s method of accounting materially distorts or clearly
reflects income is one of fact and is to be resolved on a
case-by-case basis.
As previously stated, where the Commissioner has determined
that a taxpayer’s method of accounting does not clearly reflect
income, the taxpayer must demonstrate either that his method of
accounting clearly reflects income or that the Commissioner’s
method does not clearly reflect income. Respondent’s explanation
of the net adjustment in the notice is broader than the ground he
relies on in the answer. That narrowing of his ground in the
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answer may not have been intended. Taxpayers similarly situated
to petitioner should be prepared to demonstrate that the cash
method clearly reflects their income or that the hybrid method
does not.8
V. Conclusion
For the foregoing reasons, I dissent from the majority’s
opinion.
COHEN, WHALEN, and CHIECHI, JJ., agree with this dissent.
8
Taxpayers may have difficulty in proving that a method of
accounting such as the hybrid method does not clearly reflect
income. In Hospital Corp. of Am. v. Commissioner, T.C. Memo.
1996-105, we concluded that certain hospitals’ use of a hybrid
method of accounting that reported on an accrual method revenue
allocable to charges for supplies and pharmaceuticals clearly
reflected the hospitals’ income