# UNITED STATES TAX COURT

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## Record

- **Collection:** Agency decision
- **Document type:** Agency decision

## Text

T.C. Memo. 1999-389

UNITED STATES TAX COURT

RONALD D. AND PAULA J. PITTMAN, ET AL.,1 Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 2396-98, 2397-98,
2464-98.

Filed November 29, 1999.

Frederick O. Plater, for petitioners.
Ann L. Darnold and Bruce K. Meneely, for respondent.

1

Cases of the following petitioners are consolidated
herewith: Paul W. and Nova J. Kemp, docket No. 2397-98; and
Douglas W. and Kelly J. Kemp, docket No. 2464-98.

- 2 MEMORANDUM OPINION
DAWSON, Judge:

These consolidated cases were assigned to

Special Trial Judge Robert N. Armen, Jr., pursuant to Rules 180,
181, and 183.2

The Court agrees with and adopts the opinion of

the Special Trial Judge, which is set forth below.
OPINION OF THE SPECIAL TRIAL JUDGE
ARMEN, Special Trial Judge:

This matter is before the Court

on petitioners' motion, as supplemented, for reasonable
litigation and administrative costs under section 7430 and Rules
230 through 233.
After concessions by respondent,3 the issues for decision
are as follows:
(1) Whether respondent's position in the administrative and
court proceedings was substantially justified.

We hold that it

was.

2

All Rule references are to the Tax Court Rules of
Practice and Procedure. All section references are to the
Internal Revenue Code, as amended.
3

Respondent concedes: (1) Petitioners exhausted their
administrative remedies, see sec. 7430(b)(1); (2) petitioners did
not unreasonably protract the proceedings, see sec. 7430(b)(3);
(3) petitioners substantially prevailed, see sec.
7430(c)(4)(A)(i); and (4) petitioners satisfied the applicable
net worth requirement, see sec. 7430(c)(4)(A)(ii).

- 3 (2) Whether the administrative and litigation costs claimed
by petitioners are reasonable.

In light of our holding as to the

first issue, we need not address this second issue.
Neither party requested an evidentiary hearing, and the
Court concludes that such a hearing is not necessary for the
proper disposition of petitioners' motion.

See Rule 232(a)(2).

We therefore decide the matter before us on the basis of the
record that has been developed to date.
Background
Petitioners resided in Oklahoma at the time that the
petitions were filed with the Court.
Petitioners Ronald D. Pittman (Pittman), Douglas W. Kemp (D.
Kemp), and Paul W. Kemp (P. Kemp) are shareholders of Industrial
Coil, Inc. (IC), an S corporation, and each owns 33.33 percent of
its stock.

IC was founded in 1982 as a partnership of Pittman,

D. Kemp, and P. Kemp.

An election was made on January 1, 1989,

to convert IC into an S corporation.
IC manufactures electric coils according to specifications
provided by its customers.

The specifications include the

dimensions, types of materials to be used, and other requirements
necessary to manufacture the coils.

IC purchases materials

locally for each job depending on customer specification.
Approximately 90 percent of IC's jobs are completed within 3

- 4 days, and all jobs are completed within 5 days.

Completed orders

are immediately shipped to the customer.
IC maintains both its income tax and its financial
accounting records on the cash/hybrid method of accounting and
has used that method since its incorporation.

The cash/hybrid

method of accounting is the standard method of accounting for
this type and size of company.

IC has not attempted to prepay

expenses or defer the recognition of income.
IC timely filed its 1994 income tax return.

On that return,

IC reported gross receipts of $1,176,035 and claimed cost of
goods sold of $822,946, of which $525,861 (or 44.7 percent of
gross receipts) consisted of purchases.
Respondent determined that IC should be required to use the
accrual method of accounting because its cash/hybrid method did
not clearly reflect its income.

Respondent's determination

served to increase IC's ordinary income.

Thereafter, respondent

issued separate notices of deficiency, each dated November 7,
1997, to petitioners determining deficiencies in petitioners'
Federal income taxes for 1994 in the following amounts:
Docket No.

Deficiency

2396-98
2397-98
2464-98

$6,019
3,611
5,070

By separate petitions, each filed on February 9, 1998,
petitioners commenced their cases in this Court.

Respondent

- 5 filed answers on April 6, 1998. On December 7, 1998, the Court
consolidated these cases for trial.
On January 14, 1999, the parties executed a stipulation of
facts, which was filed with the Court on February 1, 1999.
Paragraph 15 of the stipulation of facts, e.g., stated as
follows:
Industrial Coil does not maintain an inventory of
materials or completed coils. All necessary materials
are obtained locally after a determination of the
specific materials needed to complete the job is made.
No merchandise is held for sale to customers in the
ordinary course of Industrial Coil's business.
The cases were submitted fully stipulated under Rule 122 on
February 1, 1999.

The Court directed the parties to file opening

briefs on April 19, 1999, and reply briefs 45 days thereafter.
After respondent's District Counsel attorney prepared her
proposed opening brief, she sent it, along with copies of the
stipulation of facts and both parties' trial memoranda, to the
Assistant Chief Counsel (Field Service) for review before filing
with the Court.

The attorney in the Assistant Chief Counsel's

office responsible for the review opined that the use of the term
"merchandise" in paragraph 15 of the stipulation of facts was
hazardous to respondent's position because the term is "a term of
art in the change of accounting method regulations and opinions."
The attorney concluded that the wording of paragraph 15 amounted
to a concession of a key fact in the cases.

- 6 Thereafter, on March 1, 1999, counsel for respondent
contacted petitioners to inquire whether they would agree to join
in a motion requesting that the record be reopened and, pursuant
to Rule 91(e), that paragraph 15 of the stipulation of facts be
modified.

On March 2, 1999, petitioners informed respondent’s

counsel that they would not agree to reopen the record.

Two days

later, on March 4, 1999, respondent conceded the cases and
prepared stipulated decisions reflecting no deficiencies in
petitioners' income taxes for the year in issue.

Decisions to

that effect were entered by this Court on March 31, 1999.
Petitioners thereafter filed their motion for administrative
and litigation costs.

In accordance with section 7430 and Rule

232, the decisions entered on March 31, 1999, were vacated and
set aside.
Discussion
We apply section 7430 as most recently amended by Congress
in the IRS Restructuring and Reform Act of 1998 (RRA 1998), Pub.
L. 105-206, sec. 3101, 112 Stat. 685, 727.

However, certain of

the amendments made by RRA 1998 to section 7430 (regarding the
reasonableness of costs, the type of recoverable costs, and other
provisions not at issue herein) apply only to costs incurred
after January 18, 1999.

To the extent of the portion of the

claimed costs incurred on or before January 18, 1999, we apply

- 7 section 7430 as amended by the Taxpayer Relief Act of 1997 (TRA),
Pub. L. 105-34, secs. 1285, 1453, 111 Stat. 788, 1038, 1055.
A. Requirements for a Judgment Under Section 7430
Under section 7430, a judgment for litigation costs incurred
in connection with a court proceeding may only be awarded only if
a taxpayer:

(1) Is the "prevailing party"; (2) has exhausted his

or her administrative remedies within the IRS; and (3) did not
unreasonably protract the court proceeding.
(b)(1), (3).

Sec. 7430(a) and

Similarly, a judgment for administrative costs

incurred in connection with an administrative proceeding may be
awarded under section 7430 only if a taxpayer:

(1) Is the

"prevailing party"; and (2) did not unreasonably protract the
administrative proceedings.

Sec. 7430(a) and (b)(3).

A taxpayer must satisfy each of the respective requirements
in order to be entitled to an award of litigation or
administrative costs under section 7430.

See Rule 232(e).

Upon

satisfaction of these requirements, a taxpayer may be entitled to
reasonable costs incurred in connection with the administrative
or court proceedings.

See sec. 7430(a)(1) and (2), (c)(1) and

(2).
To be a prevailing party, the taxpayer must substantially
prevail with respect to either the amount in controversy or the
most significant issue or set of issues presented and satisfy the
applicable net worth requirement.

See sec. 7430(c)(4)(A).

- 8 Respondent concedes that petitioners have satisfied the
requirements of section 7430(c)(4)(A).

Petitioners will

nevertheless fail to qualify as the prevailing party if
respondent can establish that his position in the court and
administrative proceedings was substantially justified.

See sec.

7430(c)(4)(B).
B.

Substantial Justification

The Commissioner's position is substantially justified if,
on the basis of all of the facts and circumstances and the legal
precedents relating to the case, the Commissioner acted
See Pierce v. Underwood, 487 U.S. 552 (1988); Sher

reasonably.

v. Commissioner, 89 T.C. 79, 84 (1987), affd. 861 F.2d 131 (5th
Cir. 1988).

In other words, to be substantially justified, the

Commissioner's position must have a reasonable basis in both law
and fact.

See Pierce v. Underwood, supra; Rickel v.

Commissioner, 900 F.2d 655, 665 (3d Cir.1990), affg. in part and
revg. in part on other grounds 92 T.C. 510 (1989).

A position is

substantially justified if the position is "justified to a degree
that could satisfy a reasonable person."

Pierce v. Underwood,

supra at 565 (construing similar language in the Equal Access to
Justice Act).

Thus, the Commissioner's position may be incorrect

but nevertheless be substantially justified "'if a reasonable
person could think it correct'".

Maggie Management Co. v.

- 9 Commissioner, 108 T.C. 430, 443 (1997) (quoting Pierce v.
Underwood, supra at 566 n.2).
The relevant inquiry is "whether * * * [the Commissioner]
knew or should have known that * * * [his] position was invalid
Nalle v. Commissioner, 55 F.3d 189, 191 (5th Cir.

at onset".

1995), affg. T.C. Memo. 1994-182.

We look to whether the

Commissioner's position was reasonable given the available facts
and circumstances at the time that the Commissioner took his
See Maggie Management Co. v. Commissioner, supra at

position.

443; DeVenney v. Commissioner, 85 T.C. 927, 930 (1985).
The fact that the Commissioner eventually concedes, or even
loses, a case does not establish that his position was
unreasonable.

See Bouterie v. Commissioner, 36 F.3d 1361, 1367

(5th Cir. 1994), revg. on other grounds T.C. Memo. 1993-510;
Estate of Perry v. Commissioner, 931 F.2d 1044, 1046 (5th Cir.
1991); Sokol v. Commissioner, 92 T.C. 760, 767 (1989).

However,

the Commissioner's concession does remain a factor to be
considered.

See Powers v. Commissioner, 100 T.C. 457, 471

(1993), affd. in part, revd. in part and remanded on another
issue 43 F.3d 172 (5th Cir. 1995).
As relevant herein, the position of the United States that
must be examined against the substantial justification standard
with respect to the recovery of administrative costs is the
position taken by the Commissioner as of the date of the notice

of deficiency.

- 10 See sec. 7430(c)(7)(B).

The position of the

United States that must be examined against the substantial
justification standard with respect to the recovery of litigation
costs is the position taken by the Commissioner in the answer to
the petition.

See Bertolino v. Commissioner, 930 F.2d 759, 761

(9th Cir. 1991); Sher v. Commissioner, supra at 134-135.
Ordinarily, we consider the reasonableness of each of these
positions separately.

See Huffman v. Commissioner, 978 F.2d

1139, 1144-1147 (9th Cir. 1992), affg. in part, revg. in part and
remanding on other issues T.C. Memo. 1991-144.

In the present

cases, however, we need not consider two separate positions
because there is no indication that respondent's position changed
or that respondent became aware of any additional facts that
rendered his position any more or less justified between the
issuance of the notices of deficiency and the filing of the
answers to the petitions.
We now turn to petitioners' contention that respondent's
position was not substantially justified.

In order to decide

whether respondent's position was substantially justified we must
review the substantive merits of these cases.
Respondent determined that IC's cash/hybrid method of
accounting did not clearly reflect its income because merchandise
was an income-producing factor in IC's business and, therefore,
that the use of inventories was necessary to clearly determine

- 11 Respondent therefore required IC to use the accrual

IC's income.

method of accounting.

Thus, the substantive issue for decision

was whether respondent abused his discretion in requiring IC to
change from the cash/hybrid method of accounting to the accrual
method.

"Subsumed in this issue is the question whether * * *

[the taxpayer] should be required to use the inventory method for
tax purposes."

J.P. Sheahan Associates, Inc. v. Commissioner,

T.C. Memo. 1992-239.

Accordingly, we turn to the applicable Code

provision and case law dealing with this matter.
We begin with section 446.

That section provides in

pertinent part as follows:
SEC. 446(a). General Rule.--Taxable income shall be
computed under the method of accounting on the basis of
which the taxpayer regularly computes his income in keeping
his books.
(b) Exceptions.--If no method of accounting has been
regularly used by the taxpayer, or if the method used does
not clearly reflect income, the computation of taxable
income shall be made under such method as, in the opinion of
the Secretary, does clearly reflect income.
(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.

- 12 In administering section 446, the Commissioner has broad
powers to determine whether an accounting method used by a
taxpayer clearly reflects income.
360 U.S. 446, 467 (1959).

See Commissioner v. Hansen,

Generally, courts do not interfere

with the Commissioner's determination unless it is an abuse of
discretion.

See Thor Power Tool Co. v. Commissioner, 439 U.S.

522, 532 (1979); Lucas v. American Code Co., 280 U.S. 445, 449
(1930); Ford Motor Co. v. Commissioner, 102 T.C. 87, 92 (1994),
affd. 71 F.3d 209 (6th Cir. 1995).

Whether an abuse of

discretion exists is a question of fact.

See Rodebaugh v.

Commissioner, 518 F.2d 73, 75 (6th Cir. 1975), affg. T.C. Memo.
1974-36.

The taxpayer bears the burden of proving an abuse of

discretion by the Commissioner.

See Asphalt Prods. Co. v.

Commissioner, 796 F.2d 843, 848 (6th Cir. 1986), affg. on this
issue and revg. on another issue Akers v. Commissioner, T.C.
Memo. 1984-208, revd. on another issue 482 U.S. 117 (1987).
However, the Commissioner cannot require a taxpayer to change
from an accounting method that clearly reflects income to an
alternative method of accounting merely because the Commissioner
considers the alternative method to more clearly reflect the
taxpayer's income.

See Ansley-Sheppard-Burgess Co. v.

Commissioner, 104 T.C. 367, 371 (1995).
If a taxpayer must use inventories, the Commissioner has
broad latitude pursuant to section 471 and the regulations

- 13 thereunder to determine that the cash method of accounting does
not clearly reflect the taxpayer's income.
Section 471 provides in pertinent part:
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.
Section 1.471-1, Income Tax Regs., in turn provides in
pertinent part:
Need for inventories.-- In 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 sale of merchandise is an
income-producing factor. * * *
Thus, a taxpayer must use inventories if the production,
purchase, or sale of merchandise is an income-producing factor.
See id.

Whether the production, purchase, or sale of merchandise

is an income-producing factor is decided under the facts and
circumstances of each case.

See Thompson Elec., Inc. v.

Commissioner, T.C. Memo. 1995-292; Honeywell & Subs., Inc. v.
Commissioner, T.C. Memo. 1992-453, affd. without published
opinion 27 F.3d 571 (8th Cir. 1994).
A taxpayer that uses inventories must also generally use the
accrual method of accounting.
Tax Regs.

See sec. 1.446-1(c)(2)(i), Income

As we stated in Ansley-Sheppard-Burgess Co. v.

Commissioner, supra at 377, a taxpayer who is required to use

- 14 inventories may use the cash method of accounting only in limited
circumstances:
a taxpayer that is required to use the inventory method of
accounting must meet the substantial-identity-of-results
test in order to show that the Commissioner's determination
requiring a change in its method of accounting was an abuse
of discretion. * * *
The substantial-identity-of-results test requires the
taxpayer to establish substantial identity of result between the
method of accounting used by the taxpayer and the method of
accounting the Commissioner has determined clearly reflects the
taxpayer's income.

See id.

Respondent's position in these cases was that petitioners
were required to use the accrual method of accounting because
merchandise was an income-producing factor in IC's business.
Respondent relied on the fact that IC purchased raw
materials used to manufacture its custom-made electric coils and
that the raw material then became a part of these electric coils.
Respondent determined that at a minimum, IC had title to the
electric coils it manufactured before sale to its customers.
Finally, respondent concluded that since raw materials purchased
by IC represented about 45 percent of its gross receipts during
1994, materials were in fact an income-producing factor in IC's
business.
In this regard, respondent relied on Epic Metals Corp. &
Subs. v. Commissioner, T.C. Memo. 1984-322, affd. without

- 15 published opinion 770 F.2d 1069 (3d Cir. 1985).

Therein, we held

that the Commissioner did not abuse his discretion in requiring a
taxpayer to use the accrual method of accounting where the
taxpayer ordered materials for each job and sold customfabricated metal decking.

We reasoned that the taxpayer's

possession, even momentarily, of title to the metal decking was
sufficient to require the use of inventories and the use of the
accrual method of accounting.
Further, respondent relied upon our holding in Thompson
Elec., Inc. v. Commissioner, supra, and Wilkinson-Beane, Inc. v.
Commissioner, T.C. Memo. 1969-79, affd. 420 F.2d 352 (1st Cir.
1970), where we held that if the cost of material that a taxpayer
uses to provide a service is substantial compared to the
taxpayer's receipts, the material is an income-producing factor.
Although we need not decide the substantive issue in these
cases, we think that respondent's position was sufficiently
supported by the facts and circumstances in petitioners' cases
and the existing legal precedent.
U.S. 552 (1988).

See Pierce v. Underwood, 487

Respondent's position was reasonable in fact

because respondent reasonably inferred that IC "held" goods for
sale and that such goods were an income-producing factor in IC's
business.

Respondent's position was reasonable in law because

respondent reasonably relied upon existing legal precedent that,

- 16 under the facts of petitioners' cases, IC should be required to
use the accrual method of accounting.
Thus, in these cases, the fact that respondent eventually
conceded does not establish that his position was unreasonable.
See Bouterie v. Commissioner, 36 F.3d at 1367; Estate of Perry v.
Commissioner, 931 F.2d at 1046; Sokol v. Commissioner, 92 T.C. at
767.
Moreover, respondent has never conceded that IC should not
be required to use the accrual method of accounting.

Rather, as

described by the attorney in the Assistant Chief Counsel's
office, respondent's concession was based on "a poor choice of
words" in the stipulation of facts that amounted to "the
concession of a key fact".

After discovering the error,

respondent promptly conceded his position.

It was reasonable for

respondent to take the position that IC should be required to use
the accrual method of accounting until the time as respondent
committed what he regarded as a litigation error.

Shortly after

discovering the error respondent conceded the cases.
Therefore, we hold that respondent has established that his
position in the administrative and litigation proceedings was
substantially justified because he acted reasonably given the
legal precedent and the circumstances surrounding petitioners'
cases.

Accordingly, petitioners are not entitled to recover

administrative or litigation costs.

- 17 On the basis of the foregoing, we need not decide whether
petitioners' claimed costs are reasonable.
To reflect the foregoing,

Appropriate orders and
decisions will be entered.

---

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