UNITED STATES TAX COURT

T.C. Memo. 1997-309

UNITED STATES TAX COURT

KAPS WAREHOUSE, INC., Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 5795-95.

Filed July 3, 1997.

D. James Manning, for petitioner.

Virginia L. Hamilton, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

JACOBS,

Judge:

Respondent

determined

deficiencies

in

petitioner's Federal income taxes for its fiscal years ended March

31, 1991 and 1992, in the respective amounts of $82,691 and $94,695

and

accuracy-related

penalties

for

these

years

under

section

6662(b)(2) in the respective amounts of $16,538 and $18,939.

- 2 Following concessions by petitioner, the issues remaining for

decision

are:

(1)

Whether

respondent

properly

reallocated

to

petitioner $176,548 for its fiscal year ended March 31, 1991, and

$155,000 for its fiscal year ended March 31, 1992, from three of

its related entities pursuant to section 482; and (2) whether

petitioner is liable for the accuracy-related penalties pursuant to

section 6662(b)(2) for both of the aforementioned fiscal years.

All section references are to the Internal Revenue Code in

effect for the years at issue.

All Rule references are to the Tax

Court Rules of Practice and Procedure.

FINDINGS OF FACT

Some

of

accordingly.

the

facts

have

been

stipulated

and

are

found

The stipulation of facts and the attached exhibits

are incorporated herein by this reference.

Kaps Warehouse, Inc.

Kaps Warehouse, Inc., an Idaho corporation, had its principal

place of business in Blackfoot, Idaho, at the time it filed its

petition.

Petitioner reports its income on the basis of a fiscal

year ending March 31. It timely filed its corporate income tax

returns for its fiscal years ended March 31, 1991 (fiscal year

1991), and March 31, 1992 (fiscal year 1992).

Petitioner is a wholesaler of automotive parts and supplies.

It was originally founded by O. Reed Kirkham (presently retired) in

- 3 1945 as a "jobber"1 of automotive parts. At all relevant times,

petitioner's operations comprising petitioner, one other related

wholesale warehouse, and 24 related retail stores.

related

entities

to

which

separate

legal

entity.

petitioner

Petitioner

sold

also

Each of the

merchandise

sold

was

merchandise

a

to

unrelated entities.

During the years at issue, petitioner's stockholders and their

respective percentage ownership interests were as follows: Michael

Kirkham (M. Kirkham)--25 percent; James Kirkham (J. Kirkham)--25

percent; Linda Sponenburgh (L. Sponenburgh)--25 percent; and O.

Reed and Ruth Kirkham (O.R. and R. Kirkham)--25 percent.

M.

Kirkham, J. Kirkham, and L. Sponenburgh are the children of O.R.

and R. Kirkham, and William Sponenburgh is the husband of L.

Sponenburgh.

Petitioner's Related Entities

Petitioner's

related

entities

purchased

approximately

95

percent of their merchandise from petitioner.

The Kirkham family formed Kirkham Auto Parts Service Co.

(Kapsco), an S corporation, in the early 1960's.

During the years

at issue, Kapsco's shareholders and their respective percentage

ownership interests were as follows: O.R. Kirkham--23 percent; R.

1

In the terminology of the industry, a jobber of

automotive parts purchases automotive parts from a warehouse

distributor or manufacturer and sells the parts to installers

(such as a service station) or to retail stores which then sell

the parts to the consumer.

- 4 Kirkham--23

percent;

J.

Kirkham--18

percent;

percent; and L. Sponenburgh--18 percent.

M.

Kirkham--18

At all relevant times,

Kapsco was a going concern.

Kapsco operated 10 retail stores in fiscal year 1991 and 9

retail stores in fiscal year 1992.

Kapsco's retail stores during

those years were primarily located in eastern Idaho and included

the

following:

(1)

Blackfoot;

(2)

Driggs;

(3)

Idaho

Falls--

Milligan; (4) Idaho Falls--Park; (5) Montpelier; (6) Pocatello; (7)

Rigby; (8) Shelley; (9) American Falls; and (10) Rexburg.

The

retail stores were not separately incorporated.

In order to expand their sales base, the Kirkham family

organized Kaps Automotive Warehouse, Inc. (KAW), in 1979.

the

years

at

percentage

percent;

issue,

ownership

J.

KAW's

shareholders

interest

Kirkham--25

Sponenburgh--25 percent.

were

percent;

as

M.

and

their

follows:

During

respective

Petitioner--25

Kirkham--25

percent;

L.

At all relevant times, KAW was a going

concern.

In 1979, KAW acquired Nordling Parts Co. of Twin Falls (NPC).

(Although KAW acquired 100 percent of NPC's stock, NPC's original

income tax returns for fiscal years 1991 and 1992 indicate that KAW

owned only 75 percent of NPC's stock.)

retail) store.

NPC was KAW's jobber (or

At all relevant times, NPC was a going concern.

During the years at issue, the officers of petitioner, Kapsco,

NPC,

and

KAW

were:

M.

Kirkham--president;

president; and W. Sponenburgh--secretary.

J.

Kirkham--vice

- 5 Petitioner performed all accounting functions for itself,

Kapsco, NPC, and KAW.

Volume Discounts Petitioner Received From Its Suppliers

Petitioner received volume discounts from its suppliers.

The

record does not indicate the amount of the volume discounts, the

effect the discounts had on petitioner's financial position, or the

sales volume petitioner had to maintain in order to obtain the

volume discounts.

Petitioner's Sales and "Rebates" Extended to Petitioner's Related

Stores

Petitioner sold the same items to related and unrelated stores

at the same price.

However, petitioner gave "rebates" to certain

of its related entities, as follows:

1991

1992

Amount

Kapsco stores

Idaho Falls--Park

Pocatello

Rigby

Rexburg

NPC

Total

$46,000

46,000

14,000

14,000

56,548

176,548

NPC

Amount

$115,000

KAW

Total

40,000

155,000

Petitioner did not give rebates to the unrelated stores.

The effect of the rebates was to lower petitioner's profits

and increase the profits (or lower the losses) of the stores

receiving the rebates.

The taxable income of petitioner and the related entities

before and after the rebates was as follows:

- 6 Taxable Income

Before Rebates

Taxable Income

After Rebates

Fiscal Year 1991

Petitioner

Kapsco

NPC

$292,000

(107,987)

(56,899)

$116,124

12,013

149

Fiscal Year 1992

Petitioner

NPC

KAW

251,323

(113,993)

13,544

96,232

1,009

53,544

Petitioner determined the amount of rebates at the end of each

fiscal year by giving consideration to its own taxable income as

well as that of the related entities.

The rebates were based

neither on volume discounts petitioner received from its suppliers

nor on the volume of sales petitioner made to the related entities.

Indeed,

petitioner

sold

approximately

the

same

quantity

of

merchandise to its related entities each year. Further, there is

nothing in the record to suggest that the rebates were tied to any

benefits that petitioner received from the related stores.

The Related Stores' Financial Condition

a.

Kapsco

Kapsco's fiscal year 1991 financial statements (which included

the financial results of 9-10 individual retail stores) reflected

total shareholders' equity of $419,322 and retained earnings of

$274,868.

In that year, Kapsco received from petitioner $120,000

in rebates. (Had there been no rebates in fiscal year 1991,

Kapsco's total shareholders' equity would have been $299,322 and

retained earnings would have been $154,868.)

- 7 At the end of fiscal year 1991, Kapsco had the following

assets:

Inventory

$943,252

Accounts receivable

239,072

Cash in bank

83,709

Total

1,266,033

At the end of fiscal year 1991, Kapsco's current liabilities

totaled $804,108, of which $794,252 represented accounts payable to

petitioner.

(Had

there

been

no

rebates

in

fiscal

year

1991,

Kapsco's current liabilities would have totaled $924,108.)

Kapsco's

shareholders

reported

the

following

amounts

of

taxable income for 1991 on their respective Forms 1040:

M. Kirkham

$24,709

J. Kirkham

44,285

L. Sponenburgh

33,750

O.R. and R. Kirkham 28,567

The record does not indicate the bases of these shareholders in

their Kapsco stock during the years at issue.

b.

KAW

KAW's fiscal year 1992 financial statement reported total

shareholders' equity of $940,062 and retained earnings of $668,632.

In that year, KAW received $40,000 in rebates.

(Had there been no

rebates in fiscal year 1992, KAW's retained earnings would have

been $628,632, and KAW would have had a $13,544 profit.)

At the end of fiscal year 1992, KAW had the following assets:

Inventory

Accounts receivable

Cash in bank

Total

$746,421

213,299

34,417

994,137

- 8 At the end of fiscal year 1992, KAW's current liabilities totaled

$922,081,

of

which

$911,757

represented

accounts

payable

to

petitioner. (Had there been no rebates, KAW would have had current

liabilities totaling $962,081.)

c.

NPC

NPC's financial statements for fiscal years 1991 and 1992

reported retained earnings of approximately $40,000 for each year.

During those fiscal years, NPC received rebates of $56,548 and

$115,000, respectively.

NPC had the following assets at the end of fiscal year 1991:

Merchandise inventory

Accounts receivable

Cash in bank

Total

$268,860

46,203

11,488

326,551

At the end of fiscal year 1991, NPC had current liabilities

totaling $305,663, of which $304,353 was accounts payable to

petitioner. (Had there been no rebates, NPC would have had current

liabilities totaling $362,211.)

NPC had the following assets at the end of fiscal year 1992:

Merchandise inventory

Accounts receivable

Cash in bank

Total

$269,140

55,134

8,418

332,692

NPC had current liabilities totaling $304,154 at the end of said

year, of which $301,094 was accounts payable to petitioner.

(Had

there been no rebate, NPC would have had current liabilities

totaling $419,154.)

- 9 Petitioner's Certified Public Accountant

Philip Lamprecht of Jordan & Co. was petitioner's accountant.

Mr. Lamprecht recommended the amount of the rebates to be given to

each

of

petitioner's

making

his

recommendations, which was done after consulting M. Kirkham,

Mr.

Lamprecht

its

considered

related entities.

operation.

the

related

stores.

profitability

of

In

petitioner

and

He treated all the entities as one business

In addition, Mr. Lamprecht analyzed the liquidity of

each of the related stores and the related stores' ability to pay

their receivables.

He took that ability into consideration in

determining the amount of the rebate to be given to each store.

Petitioner's Bookkeeping

Petitioner and the related entities employed the accrual

method of accounting. Petitioner booked sales to both related and

unrelated entities when the merchandise was delivered, debiting

accounts receivable and crediting sales.

Petitioner's related

stores accounted for the delivery of petitioner's merchandise to

the stores by crediting an account payable to petitioner and

debiting purchases.

Petitioner accounted for the rebates by crediting accounts

receivable and debiting sales, thereby eliminating the amount of

the rebate from accrued sales for Federal income tax purposes.

Petitioner's

related

stores

to

which

the

rebates

were

given

- 10 accounted for the rebates by debiting their accounts payable and

crediting purchases.

Petitioner

kept

track

of

the

aging

of

receivables

from

unrelated stores through monthly computer reports. Ralph Dunn,

petitioner's office manager, reviewed the accounts receivable aging

sheets. Accounts that were not collected were sent to collection

agencies. Mr. Dunn prepared the list of petitioner's accounts

receivable to be written off by each store and recommended the

amount of writeoffs. Petitioner's officers reviewed the list of

proposed writeoffs of accounts, which was sent to Mr. Lamprecht at

the end of each year. Generally, Mr. Dunn's recommendations were

accepted.

After

petitioner

wrote

off

the

delinquent

accounts

from

unrelated entities, petitioner stopped selling merchandise to them.

Petitioner did not keep records to reflect the aging of

accounts

receivable

from

related

stores.

Nor

did

Mr.

Dunn

recommend writeoffs for any of the related stores.

Petitioner's Federal Income Tax Returns

On its Federal income tax returns for fiscal years 1991 and

1992,

petitioner

reported

gross

sales

of

$7,628,708.29

and

$7,736,795, respectively.

Notice of Deficiency

In

the

notice

of

deficiency,

respondent

determined

that

petitioner's gross sales for fiscal years 1991 and 1992 were

- 11 understated by $176,548 and $155,000, respectively, on the basis of

the rebates petitioner gave to its related entities. Respondent

determined that the reduction of petitioner's income on account of

the rebates was improper because the rebates were not at arm's

length.

Respondent also determined that petitioner was liable for

the section 6662(b)(2) accuracy-related penalties for both years at

issue.

OPINION

Issue 1.

Reallocation of Income

We first consider respondent's reallocation of income to

petitioner from three of its related entities pursuant to section

482 for fiscal years 1991 and 1992.

A.

Relevant Section 482 Law

Section

482

grants

the

Commissioner

broad

discretion

to

scrutinize transactions between commonly controlled taxpayers and

to allocate items of income, deductions, and credits between them

where necessary to prevent the evasion of taxes or to ensure the

clear reflection of each taxpayer's income.2

2

See, e.g., Paccar,

Sec. 482 provides, in pertinent part, as follows:

In any case of two or more

organizations, trades, or businesses * * *

owned or controlled directly or indirectly by

the same interests, the Secretary may

distribute, apportion, or allocate gross

income, deductions, credits, or allowances

between or among such organizations, trades,

or businesses, if he determines that such

(continued...)

- 12 Inc. & Subs. v. Commissioner, 849 F.2d 393 (9th Cir. 1988), affg.

85 T.C. 754, 785 (1985); Altama Delta Corp. v. Commissioner, 104

T.C. 424, 456 (1995); Seagate Tech., Inc. & Consol. Subs. v.

Commissioner, 102 T.C. 149, 163 (1994); Sundstrand Corp. & Subs. v.

Commissioner, 96 T.C. 226, 352-353 (1991); Inverworld, Inc. v.

Commissioner, T.C. Memo. 1996-301, supplemented by T.C. Memo. 1997226. Section 482 is designed to prevent artificial distortion of

the true net incomes of commonly controlled entities.

As this

Court has stated:

In order to prevent the artificial shifting of

income from one related business to another,

section 482 places a controlled taxpayer on a

parity with an uncontrolled taxpayer, by

determining according to the standard of an

uncontrolled taxpayer, the true net income of

a controlled taxpayer. Thus, income which has

been artificially diverted to one member of a

controlled group but which in fact was earned

by another member of the group may be

"allocated" by the Commissioner under section

482 * * * [to] the entity which really earned

it. * * * [Citations omitted.]

Huber Homes, Inc. v. Commissioner, 55 T.C. 598, 605 (1971); see

also sec. 1.482-1(b)(1), Income Tax Regs.

An

arm's-length

reallocations

2

between

standard

is

controlled

used

to

entities

determine

are

whether

necessary.

(...continued)

distribution, apportionment, or allocation is

necessary in order to prevent evasion of

taxes or clearly to reflect the income of any

of such organizations, trades, or businesses.

* * *

The

- 13 regulations provide a guide to identifying the "true taxable

income" of each entity on the basis of the taxable income that

would have resulted had the entities been uncontrolled parties

dealing

at

arm's

length.

See

Sundstrand

Corp.

&

Subs.

v.

Commissioner, supra at 353; sec. 1.482-1(b)(1), Income Tax Regs.

The Commissioner's determination as set forth in the notice of

deficiency is presumptively correct.

The taxpayer has the burden

of disproving that determination. Rule 142(a); Welch v. Helvering,

290 U.S. 111 (1933).

In meeting its burden, the taxpayer must

prove that it did not improperly utilize its control to shift

income.

Procter & Gamble Co. v. Commissioner, 95 T.C. 323, 331

(1990), affd. 961 F.2d 1255 (6th Cir. 1992). Furthermore, where the

Commissioner determines that an allocation under section 482 is

necessary to prevent either tax evasion or the distortion of a

taxpayer's income, the determination must stand unless the taxpayer

proves

that

the

determination

is

unreasonable,

arbitrary,

or

capricious. Ballentine Motor Co. v. Commissioner, 321 F.2d 796, 800

(4th Cir. 1963), affg. 39 T.C. 348 (1962); Seagate Tech., Inc. &

Consol. Subs. v. Commissioner, supra at 164; Sundstrand Corp. &

Subs. v. Commissioner, supra at 353.

Absent a showing of abuse of

discretion, the Commissioner's section 482 determination must be

sustained. Sundstrand Corp. & Subs. v. Commissioner, supra; Bausch

& Lomb, Inc. & Consol. Subs. v. Commissioner, 92 T.C. 525, 582

(1989), affd. 933 F.2d 1084 (2d Cir. 1991).

"Whether respondent

- 14 has exceeded his discretion is a question of fact. * * * In

reviewing the reasonableness of respondent's determination, the

Court focuses on the reasonableness of the result, not on the

details of the methodology used."

Sundstrand Corp. & Subs. v.

Commissioner, supra at 353-354.

In addition to proving that the deficiencies herein are

arbitrary, capricious, or unreasonable, petitioner has the burden

of proving satisfaction of the arm's-length standard.

See Eli

Lilly & Co. v. Commissioner, 856 F.2d 855, 860 (7th Cir. 1988),

affg. on this issue, revg. in part and remanding 84 T.C. 996

(1985).

Section 1.482-1(a)(3), Income Tax Regs., provides:

(3) The term "controlled" includes any

kind of control, direct or indirect,

whether legally enforceable, and however

exercisable or exercised.

It is the

reality of the control which is decisive,

not its form or the mode of its exercise.

A presumption of control arises if income

or deductions have been arbitrarily

shifted.

The term "controlled taxpayer" means "any one of two or more

organizations, trades, or businesses owned or controlled directly

or indirectly by the same interests."

Tax Regs.

Sec. 1.482-1(a)(4), Income

The terms "group" and "group of controlled taxpayers"

mean "the organizations, trades, or businesses owned or controlled

by the same interests."

Sec. 1.482-1(a)(5), Income Tax Regs.

- 15 This Court has described the requisite control under section

482 as one of "actual, practical control rather than any particular

percentage of stock ownership."

B. Forman Co. v. Commissioner, 54

T.C. 912, 921 (1970), affd. in part and revd. in part 453 F.2d 1144

(2d Cir. 1972).

"The language of section 482 is broad and

sweeping, and its application depends on a finding of either

ownership or control."

Collins Elec. Co. v. Commissioner, 67 T.C.

911, 918-919 (1977); Ach v. Commissioner, 42 T.C. 114, 125 (1964),

affd. 358 F.2d 342 (6th Cir. 1966).

B.

The Parties' Arguments

Respondent asserts that petitioner's income as reported on its

fiscal

year

1991

and

1992

Federal

income

tax

returns

was

understated because petitioner gave preferential rebates to its

related entities.

On the other hand, petitioner argues that the

rebates were proper primarily because the accounts payable from the

related entities were uncollectible.

For the reasons set forth

below, we agree with respondent.

C.

Petitioner's Controlled Group and the Effect of the

Rebates

Although petitioner, Kapsco, NPC, and KAW were each separate

legal entities, they were related and controlled directly or

indirectly by the same Kirkham family interests during the years at

issue.

Given

the

ownership

and

management

structure

of

the

- 16 entities, petitioner and its related entities clearly made up a

controlled group of taxpayers for purposes of section 482.

Petitioner

supplied

95

percent

of

its

related

entities'

inventory. Petitioner's sales to these entities were therefore

"controlled sales" for section 482 purposes.

Petitioner booked sales to both related and unrelated entities

at the time the merchandise was delivered, debiting its accounts

receivable and crediting its sales.

The related stores accounted

for delivery of this merchandise as a purchase by crediting their

accounts payable to petitioner and debiting purchases. All the

accounting was performed by petitioner.

Petitioner sold merchandise to all it customers (both the

related and unrelated stores) at the same price.

However, at the

end of the year, after petitioner reviewed the financial results of

the entire operation of the controlled group, petitioner made

rebates only to its related stores. These rebates had the effect of

lowering the cost of the merchandise sold to the entities receiving

the

rebates,

which

in

turn

reduced

petitioner's

income

and

increased the incomes of the related stores.

Petitioner gave preferential rebates totaling $176,548 and

$155,000 in fiscal years 1991 and 1992, respectively. Petitioner

accounted for these rebates by crediting accounts receivable and

debiting sales, thereby eliminating the rebated sales from accrued

sales for Federal income tax purposes.

For the related entities,

- 17 the rebates were reflected as a debit in accounts payable to

petitioner and a credit to purchases.

Respondent asserts, and we agree, that the price petitioner

charged its related stores for merchandise sold was not at arm's

length because of the rebates.

The overall effect of the rebates

was to shift income from petitioner to its related entities.

Because this shift of income resulted from controlled transactions

that were not at arm's length, petitioner and its related entities

did not report their true taxable incomes. As a consequence,

petitioner was able to reduce the correct amount of taxes it owed.

Losses that could not advantageously be used by related entities in

essence were shifted to benefit petitioner. (Without the rebates,

both Kapsco and NPC would have had losses for Federal income tax

purposes which would have gone unused in the years at issue.)

Mr. Lamprecht claims that he reviewed the accounts receivable

due petitioner from the related entities and determined the amounts

that were uncollectible.

According to Mr. Lamprecht, it was this

uncollectible amount that determined the amount of the rebate.

Further,

Mr.

Lamprecht

claims

the

uncollectibility

of

the

receivables justified petitioner's shifting (reduction) of income.

Mr. Lamprecht testified that in determining the related entity's

ability to pay, he revalued the related entity's assets (at the end

of the fiscal year) on the basis of the amount that could be

received if the entity were to be liquidated.

We believe this

- 18 assumption to be flawed--none of the related entities were in fact

liquidated, and there is no evidence to suggest that a liquidation

was contemplated.

Rather, the record indicates that each of the

related entities was a going concern. Thus, in our opinion, Mr.

Lamprecht's determination as to the financial position of the

related entities does not correctly reflect the entities' ability

to pay their accounts payable to petitioner.

We believe the rebates were made solely to reduce taxes for

the Kirkham family as a whole.

We are mindful that current tax law

provides that in order for losses of an S corporation, such as

Kapsco, to pass through to its shareholders, the shareholders must

have sufficient bases in their stock and debt to absorb the loss.

Sec. 1366(d)(1).

In the instant case, there is no evidence that

Kapsco's shareholders had sufficient bases in 1991 to absorb

Kapsco's losses before the rebates.

It would appear that it was financially advantageous for the

losses that otherwise would have gone to the Kapsco shareholders

(the Kirkham family) to instead be used to reduce petitioner's

income.

Similarly, before the rebates, NPC showed losses of ($56,899)

and ($113,993) in fiscal years 1991 and 1992, respectively. A

review of NPC's original Federal income tax returns for those years

indicates that these losses would have gone unused in the years at

issue.

- 19 (At the time NPC's original returns were filed for fiscal

years 1991 and 1992, it was reported that KAW owned 75 percent of

NPC.

Under these circumstances, KAW could not have filed a

consolidated return with NPC, enabling some of NPC's losses to be

used against KAW's income.

Secs. 1501, 1504.

Thus, NPC's losses

could not have been used to reduce any other taxable liability of

the group. Subsequently, during preparation for trial, petitioner

discovered the error in the original filing of the NPC returns; KAW

in fact owned 100 percent of NPC.)

D.

The Rebated Amounts Were Not Bad Debts

Petitioner contends that the rebates were not an attempt to

avoid income taxation; but rather, because the rebates were given

on

the

basis

of

the

lack

of

collectibility

of

the

accounts

receivable from the related entities, the rebated amounts should be

treated as bad debts.

Section 166(a) provides a deduction for any debt that becomes

worthless during the taxable year. The amount of the deduction for

a bad debt is limited to the taxpayer's adjusted basis in the debt

as provided in section 1011.

Sec. 166(b); Perry v. Commissioner,

92 T.C. 470, 477-478 (1989), affd. without published opinion 912

F.2d 1466 (5th Cir. 1990).

Whether, and when, a debt becomes

worthless is determined by inspecting the facts and circumstances.

Sec. 1.166-2(a), Income Tax Regs.

Assuming a debt is recoverable

only in part, the amount of such a debt charged off within the

- 20 taxable year is allowable as a deduction.

A debt will generally be

considered worthless only when it can be reasonably expected that

the debt is without possibility of future payment and legal action

to enforce the debt would not result in satisfaction.

Commissioner, 20 T.C. 1069 (1953).

Hawkins v.

The taxpayer bears the burden

of proving that the debt had value at the beginning of the taxable

year and that it became worthless during and prior to the end of

that year. Millsap v. Commissioner, 46 T.C. 751, 762 (1966), affd.

387 F.2d 420 (8th Cir. 1968). In other words, the taxpayer must

demonstrate

what

part

of

the

3(a)(2)(iii), Income Tax Regs.

of

a

bad

debt,

the

discretion was abused.

question

debt

is

worthless.

Sec.

1.166-

In the case of a partial writeoff

is

whether

the

Commissioner's

Brimberry v. Commissioner, 588 F.2d 975,

977 (5th Cir. 1979), affg. T.C. Memo. 1976-209.

Here, petitioner is claiming a partial worthlessness of the

debts at issue; that is, the accounts payable to petitioner were

worthless to the extent of the rebates.

As discussed hereafter,

petitioner failed to prove that any portion of the accounts payable

to petitioner from its related entities was worthless and thus

uncollectible.

1.

KAW

There is no evidence that KAW's accounts payable to petitioner

were partially worthless.

Petitioner gave a $40,000 rebate to KAW

in fiscal year 1992. In that year, KAW:

(1) Had retained earnings

- 21 of $628,632 before the rebate and $668,632 after the rebate; (2)

was in a profit position both before ($13,544) and after ($53,544)

the rebate; and (3) had sufficient current assets to cover its

current liabilities (i.e., it had sufficient short term liquidity

in fiscal year 1992 to cover the accounts payable written off via

the rebate).

Clearly, KAW's financial statements do not reflect that its

accounts payable to petitioner were uncollectible in the amount of

the rebate.

Rather, in our opinion, petitioner gave the rebate in

order to shift income from itself to KAW, where the income would be

taxed at between 15 to 25 percent compared to petitioner's 34percent tax rate.

2.

There

petitioner

Kapsco

is

no

were

evidence

that

Kapsco's

partially

worthless.

In

accounts

fiscal

payable

year

to

1991,

petitioner gave rebates totaling $120,000 to Kapsco. These rebates

were given to four unincorporated Kapsco units (Idaho Falls--Park,

Pocatello, Rigby, and Rexburg).

Because these particular entities

did not have strong financial conditions, Mr. Lamprecht believed

that the accounts payable were uncollectible, thereby justifying

the rebates to Kapsco.

However, Kapsco's financial statement reflects that it was

capable

of

meeting

its

irrelevant

whether

the

accounts

payable

financial

obligation.

condition

of

the

It

is

four

- 22 unincorporated stores to which the rebates were given had weak

financial conditions; rather, the financial condition of Kapsco is

the financial condition that is pivotal.

In fiscal year 1991,

before the rebates were given, Kapsco had retained earnings of

$154,868, total shareholders' equity of $299,322, and a $107,987

loss.

However, evidence of operating losses, without more, does

not establish worthlessness of a debt.

See Trinco Indus., Inc. v.

Commissioner, 22 T.C. 959, 965 (1954).

The mere fact that losses

exist or that an obligation will be difficult to collect does not

determine worthlessness.

Riss v. Commissioner, 56 T.C. 388, 407

(1971), affd. 478 F.2d 731 (8th Cir. 1973).

We are satisfied that Kapsco had sufficient liquidity at the

end

of

fiscal

year

1991

to

cover

the

written

off

accounts

receivable (Kapsco had a $341,925 cushion of its current assets

over its current liabilities to pay its accounts payable, even

before the rebates at issue).

Accordingly, petitioner has failed

to prove that Kapsco's accounts payable were uncollectible.

3.

NPC

There is no evidence that NPC's accounts payable to petitioner

were partially worthless.

Petitioner gave rebates of $56,548 and

$115,000 in fiscal years 1991 and 1992, respectively, to NPC.

NPC's financial condition was certainly the weakest of the three

entities to which the rebates were given.

However, even here,

- 23 petitioner has failed to provide any evidence that NPC could not

have paid the majority of its accounts payable to petitioner.

Before the rebates, NPC had net losses of $56,899 in fiscal

year 1991 and $113,993 in fiscal year 1992.

Here again, evidence

of an operating loss is not sufficient to prove worthlessness when

there are current assets available to pay current debts.

Even

where a business is shown to be insolvent as its liabilities exceed

its assets, evidence of insolvency based on book figures does not

necessarily establish worthlessness.

Brimberry v. Commissioner,

supra at 976; Trinco Indus., Inc. v. Commissioner, supra.

entity is

still

actively

engaged

in

business

and

Where an

has

assets

sufficient to pay off a greater part of the loan, the debt is not

considered worthless.

Trinco Indus., Inc. v. Commissioner, supra.

In NPC's case, it was still actively engaged in business.

It appears that NPC had sufficient current assets to cover 90

percent of total current payables to petitioner in fiscal year 1991

and 79 percent of total current payables in fiscal year 1992.

Any

arm's-length creditor of NPC would not have been content to write

off NPC's accounts payable owed to the creditor.

Petitioner again

has failed to provide sufficient evidence that its rebates to NPC

during the years at issue were based on bad debts.

4.

Other Evidence

The record contains other evidence contradicting petitioner's

argument that the writeoffs were worthless. First, petitioner kept

- 24 detailed and monthly updated computer records of the aging of the

unrelated entities' accounts receivable.

Mr. Dunn, petitioner's

office manager, ultimately recommended to petitioner's accountant

the accounts to be written off.

records

for

the

aging

of

In contrast, petitioner kept no

accounts

receivable

of

its

related

entities and had no comparable procedure with respect to these

debts.

Petitioner did not consider the aging of its related

entities' receivables to be a "problem".

Next, the evidence of petitioner's sales to the related

entities in

the

years

petitioner's

claims

following

that

the

the

rebates

receivables

at

were

issue

belies

uncollectible.

Petitioner admitted that if it wrote off an account of an unrelated

party, it would not continue to sell to that party in the next

year.

But this has not been the case with petitioner's related

entities.

Petitioner continued selling to the related entities,

and in some instances, it actually increased its sales to the

related entities following the year of the rebate. Accordingly, it

would not appear that petitioner took seriously the uncollectible

accounts from its related entities.

Finally,

through

the

testimony

of

its

accountant,

Mr.

Lamprecht, petitioner stated its belief that its income was too

high during both years at issue. Petitioner therefore attempted to

reduce its taxable income by extending the rebates.

- 25 In sum, we hold that petitioner has failed to establish that

the receivables at issue were bad debts pursuant to section 166.

E. Petitioner Was Required To Accrue Sales Income When All

Events Had Occurred That Fixed the Right To Earn the Income

and the Amount Was Determinable With Reasonable Accuracy

Petitioner further contends that it should not have to book

each sale as income in the year the sale took place because the

accounts receivable (from the related entities) were uncollectible.

Respondent argues that petitioner was required to accrue the sales

income in the year of sale and that the accounts were collectible.

We agree with respondent.

The general rule for the taxable years of inclusion of income

appears in section 451.

Section 451(a) requires:

The amount of any item of gross income shall

be included in the gross income for the

taxable year in which received by the

taxpayer,

unless,

under

the

method

of

accounting used in computing taxable income,

such amount is to be properly accounted for as

of a different period.

Section 1.451-1(a), Income Tax Regs., provides that if the taxpayer

is on the accrual basis, the income must be included in income when

all events have occurred that fix the right to receive such income

and the amount thereof can be determined with reasonable accuracy

(the "all-events test"). Section 446(a) provides: "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." The accrual method of accounting is one permissible method

- 26 of computing taxable income. Sec. 446(c)(2).

Section 1.446-

1(c)(ii), Income Tax Regs., provides:

Accrual method. Generally, under an accrual

method, income is to be included for the

taxable year when all the events have occurred

which fix the right to receive such income and

the amount thereof can be determined with

reasonable accuracy. * * *

The accrual method does not focus on the time of payment or

receipt, but rather upon the time there is an obligation to pay or

a right to receive.

See United States v. Hughes Properties, Inc.,

476 U.S. 593, 599 (1986); Spring City Foundry Co. v. Commissioner,

292 U.S. 182, 184-185 (1934).

Petitioner, an accrual method taxpayer, booked all its sales

at the time the merchandise was shipped.

had

a

legally

enforceable

right

to

At that time, petitioner

receive

payment

for

the

merchandise. At the end of the year, petitioner decided the amount

of rebates it would extend and reversed the sales entries, thereby

not accruing the sales income previously booked. Under the allevents test, petitioner was required to accrue the income in the

year the sales were made to its related entities.

Petitioner

collectible

failed

during

the

to

prove

years

at

that

the

issue.

amounts

were

not

Furthermore,

any

uncertainty as to collection that would justify nonaccrual of

income must be substantial and not simply technical.

See Stephens

Marine, Inc. v. Commissioner, 430 F.2d 679, 685 (9th Cir. 1970),

- 27 affg. T.C. Memo. 1969-39. We thus conclude that petitioner has

failed to prove any substantial uncertainty as to collection.

F.

Conclusion

The income petitioner reported on its Federal income tax

returns for fiscal years 1991 and 1992 did not clearly reflect its

income.

itself

Petitioner was not justified in shifting income between

and

its

related

entities.

By

granting

the

rebates,

petitioner essentially sold merchandise at non-arm's-length prices

to its related entities, and arbitrarily shifted income between

itself and its related entities.3

Petitioner has failed to prove

that: (1) Respondent's determination was arbitrary, capricious or

unreasonable; and (2) petitioner sold goods at arm's-length prices

to

its

related

entities.

Accordingly,

respondent

properly

reallocated income between petitioner and its related entities

under section 482, and we hold for respondent on this issue.

Issue 2.

Section 6662(b)(2) Accuracy-Related Penalties

The second issue is whether petitioner is liable for the

section 6662(b)(2) accuracy-related penalties for fiscal years

ended March 31, 1991 and 1992. Respondent contends that petitioner

is liable for the penalties in connection with both petitioner's

3

Petitioner claims that it was forced to shift income

among its related entities because it was a victim of competitive

forces over which it had no control. We are unpersuaded by

petitioner's argument. Petitioner chose to operate its business

under the existing market conditions. Petitioner cannot ignore

the reality of the businesses it selected. It was bound by the

structure it chose.

- 28 improper

extension

of

rebates

to

its

related

entities

and

petitioner's improper writedown of ending inventory for the years

at issue. Although petitioner conceded the ending inventory issue,

petitioner argues that these penalties are inapplicable to both

issues.

Section 6662(b)(2) imposes a penalty equal to 20 percent of

the portion of an underpayment of tax that is attributable to any

substantial understatement of tax.

Sec. 6662(a) and (b)(2).

An

understatement of tax is substantial in the case of a corporation

when it exceeds the greater of 10 percent of the tax required to be

shown on the return or $10,000.

Sec. 6662(d)(1)(B).

The amount of

an understatement will be reduced if a taxpayer has substantial

authority for the way an item was treated, or if the facts that

affect the item's tax treatment are adequately disclosed in the

return.

Sec. 6662(d)(2)(B).

A taxpayer has the burden of proving

that the Commissioner's determination of an addition to tax is in

error.

Luman v. Commissioner, 79 T.C. 846, 860-861 (1982).

The accuracy-related penalty does not apply to any portion of

an underpayment if there was reasonable cause for such portion and

the taxpayer acted in good faith.

determination

is

made

by

taking

Sec. 6664(c)(1).

into

account

all

Such a

facts

and

circumstances, including the experience, knowledge, and education

of the taxpayer and reliance on a professional tax adviser.

1.6664-4(b)(1), Income Tax Regs.

Sec.

- 29 Petitioner's income taxes for fiscal years 1991 and 1992 were

substantially understated as a result of (1) giving rebates to its

related entities for which it has shown no economic justification

other than to avoid taxation, and (2) writing down its ending

inventory in the respective amounts of $160,000 and $415,000 in

fiscal years 1991 and 1992.

Our discussion in Issue 1 leaves no

doubt that petitioner had no reasonable basis or substantial

authority

for

its

position

of

giving

the

rebates.

We

will

hereinafter discuss whether petitioner was justified in writing

down its ending inventory.

Petitioner maintained a perpetual inventory system.

daily

basis,

purchase

invoice

amounts

were

plugged

On a

into

petitioner's computer and sales were taken off on a daily sales

sheet, leaving an inventory balance.

Each month, if amounts sold

were greater than purchases, ending inventory would be lower than

the previous month.

If amounts sold were less than purchases,

ending inventory would be higher than the previous month.

At

yearend, petitioner relied on its perpetual inventory system and

took no physical inventory of goods on hand.

As new inventory was

purchased, petitioner updated its book inventory cost per unit on

the

basis

of

the

most

recent

invoice

price

from

suppliers.

Petitioner had no significant amounts of obsolete inventory in

stock in the years at issue.

If inventory became obsolete,

petitioner's suppliers would normally accept the inventory in

- 30 exchange for different inventory.

Petitioner's ending inventory

was not written down because of obsolescence.

By writing down its ending inventory at the end of fiscal

years

1991

and

1992

by

$160,000

and

$115,000,

respectively,

petitioner reduced taxable income by these amounts. Petitioner has

failed to provide a valid reason for the writedowns.

Mr. Dunn

provided no reason to believe that the inventory balances on record

as a result of the perpetual inventory system were inaccurate.

Moreover, Mr. Lamprecht testified that one factor he relied

upon to determine the ending inventory writedown was petitioner's

high gross profit percentage compared to prior years. However,

petitioner

provided

no

evidence

of

how

the

established or the computations petitioner used.

writedown

was

Petitioner was

simply unable to demonstrate to us that ending inventory was

understated on its books.

In sum, there was no reasonable basis or substantial authority

for petitioner's positions with regard to the rebates or the

inventory writedown.

There was also no disclosure on the returns

of the relevant facts affecting the tax treatment of these items.

Accordingly, we hold that petitioner is liable for the section

6662(b) penalties for substantial understatements of taxable income

in connection with the rebates to its related entities and the

writedown of ending inventory for fiscal years 1991 and 1992.

- 31 To reflect the foregoing and petitioner's concessions,

Decision will be

entered for respondent.