                         T.C. Memo. 2002-297



                      UNITED STATES TAX COURT



              BEST AUTO SALES, INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent

                 ABC AUTOS, INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 10149-97, 10150-97.      Filed December 2, 2002.



     B. Gray Gibbs, for petitioners.

     James F. Kearney, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     SWIFT, Judge:   These cases are consolidated for trial,

briefing, and opinion.   Respondent determined against petitioners

deficiencies in Federal income taxes and accuracy-related
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penalties for tax years ending May 31, 1990, 1991, and 1992 as

follows:


                            Best Auto Sales, Inc.

                                               Accuracy-
                                            Related Penalty
             Year Ending     Deficiency       Sec. 6662(a)
             May 31, 1991      $79,787          $15,957
             May 31, 1992       15,413            –-


                             ABC Autos, Inc.

                                               Accuracy-
                                            Related Penalty
             Year Ending     Deficiency       Sec. 6662(a)
             May 31, 1990      $97,851          $19,570
             May 31, 1991       58,432           11,686
             May 31, 1992       81,560           16,312


     Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.

     The primary issues for decision are:

     (1) Whether petitioners are entitled to bad debt deductions

with respect to certain automobile loans;

     (2) Whether petitioner ABC Autos, Inc., is entitled under

sections 1.471-2(c) and 1.471-4(c), Income Tax Regs., to claimed

write-downs of its used automobile inventory to the lower of cost

or market; and
                               - 3 -

     (3) Whether petitioners are liable for accuracy-related

penalties under section 6662(a).


                         FINDINGS OF FACT

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

     At the time the petitions were filed, the principal place of

business for each petitioner was located in Tampa, Florida.

     During the years in issue, petitioners owned and operated

separate used automobile dealerships.   Petitioners were engaged

in the sale of used automobiles to high credit risk purchasers

and in financing the purchase of the automobiles at high interest

rates (e.g., 32 percent) over short repayment periods (e.g., 1 to

2 years).   Typically, under the automobile loans that petitioners

made, the purchasers (hereafter “debtors”) of the automobiles

were obligated to make installment payments to petitioners on a

weekly, biweekly, semimonthly, or monthly basis.

     When loan payments due on petitioners’ automobile loans

became delinquent, petitioners’ office personnel mailed to the

debtors past due notices and demand letters requesting that the

delinquent amounts due on the loans be paid.

     If the debtors failed to make the delinquent payments due on

the automobile loans within a few days or weeks after

notification, petitioners initiated repossession of the debtors’

automobiles through a third-party automobile repossession agent.

After repossession of the automobiles, petitioners notified the
                               - 4 -

debtors by mail that the automobiles would be sold unless the

debtors within 10 days made the delinquent loan payments or fully

paid off the loans.

     Upon failure of the debtors to make the delinquent loan

payments or to fully pay off the loans, the automobiles would be

repurchased by petitioners at what were essentially private

sales, and the automobiles would be returned to petitioners’ used

automobile inventory for resale to retail customers or to

wholesalers.   In this manner, many of petitioners’ automobiles

were sold, repossessed, placed back into petitioners’ automobile

inventory, and resold a number of times.   Occasionally,

automobiles to be repossessed were not located, and occasionally

automobiles were voluntarily returned by the debtors.

     For the years in issue, petitioners’ books and Federal

corporation income tax returns were prepared using the accrual

method of accounting.

     Generally, with regard to past due or delinquent automobile

loans, upon repossession or return of the automobiles securing

the loans, all but $100 of the outstanding balance due on the

loans would be charged off on petitioners’ corporate Federal

income tax returns as business bad debt deductions.   The $100

amount was arbitrary and reflected the value, for tax purposes,

that was allocated by petitioners to each and every repossessed

or returned automobile, regardless of make, year, and condition.
                              - 5 -

With regard to delinquent loans with respect to which the

automobiles securing the loans were not located by petitioners’

repossession agent, the entire outstanding balance of the loans

would be charged off on petitioners’ corporate Federal income tax

returns as business bad debt deductions.1

     Whether a bad debt tax deduction relating to a particular

loan and repossession was claimed on petitioners’ corporate

Federal income tax return for the current tax year or for the

prior tax year depended on when the loan originated and whether

the repossession of the automobile occurred prior to the filing

of the tax return for the prior tax year.   With respect to a

delinquent loan that had been made in the prior tax year and

where the repossession of the automobile occurred in the current

tax year but prior to the filing of the corporate Federal income

tax return for the prior tax year, the related bad debt deduction

would be claimed by petitioners on the tax return for the prior

tax year.


1
     The record is not completely clear as to how the amount of a
particular loan chargeoff was calculated for purposes of
petitioners’ financial books and records. Some evidence
indicates that upon repossession or return of an automobile
securing a loan, the amount of the chargeoff was calculated in
the same manner as it was calculated for tax purposes (namely,
all but $100 of the outstanding balance due on the related loan
would be charged off). Other evidence indicates that for
financial book purposes upon repossession of an automobile
petitioners determined the wholesale book value of the automobile
and charged off only the difference between the loan balance and
the wholesale book value.
                                - 6 -

     With respect to a delinquent loan that had been made in the

prior tax year and where the repossession of the automobile

occurred in the current tax year but after the filing of the

corporate Federal income tax return for the prior tax year, the

related bad debt deduction would be claimed by petitioners on the

tax return for the current tax year.

     For example, for the tax year ending May 31, 1990,

petitioner ABC Autos, Inc. (ABC), in November of 1990 (before

filing its corporate Federal income tax return for its tax year

ending May 31, 1990), charged off as bad debts $237,795 in

automobile loans that were outstanding as of May 31, 1990, even

though the automobiles securing the loans were repossessed

between June and November of 1990.      In ABC’s journal entry of

November 17, 1990, reflecting the above chargeoff of $237,795, a

written notation is made to the effect that the related loans

“went bad in June-Nov. ‘90’”.

     Also, on ABC’s corporate Federal income tax returns for its

tax years ending May 31, 1990 and 1992, ABC’s yearend total basis

in its used automobile inventory was written down under sections

1.471-2(c) and 1.471-4(c), Income Tax Regs.      No records were

maintained by ABC to substantiate how these inventory write-downs

were calculated.

     After respondent’s audits were completed, on February 28,

1997, respondent issued to each petitioner a separate notice of
                              - 7 -

deficiency for the years in issue in which respondent disallowed

the above claimed bad debt deductions to the extent the

deductions claimed on the tax returns were based on delinquent

loans with respect to which the automobiles securing the loans

were repossessed or returned (or identified as unlocatable) after

the end of the year for which, for Federal income tax purposes,

the related bad debt deductions were claimed.   The total amounts

of petitioners’ claimed bad debt deductions disallowed by

respondent for each year were allowed to petitioners by

respondent as bad debt deductions for the immediately following

year.

     Respondent also, in the notice of deficiency issued to ABC,

disallowed the inventory write-downs claimed by ABC for its 1990

and 1992 tax years.2

     In addition, respondent determined against petitioners

accuracy-related penalties under section 6662(a).




2
     Respondent’s notice of deficiency for 1990 issued to ABC
also reflects a related sec. 481 adjustment that appears to be
mechanical and not in dispute.
                              - 8 -

                             OPINION

Bad Debt Deductions3

     We review for an abuse of discretion respondent’s

determinations under section 166(a)(2) to disallow deductions for

debts claimed to be partially worthless, and respondent’s

determinations in that regard will not be disturbed unless

plainly arbitrary or unreasonable.     Brimberry v. Commissioner,

588 F.2d 975, 977 (5th Cir. 1979), affg. T.C. Memo. 1976-209;

Austin Co. v. Commissioner, 71 T.C. 955, 971 (1979) (citing

Findley v. Commissioner, 25 T.C. 311, 319 (1955), affd. per

curiam 236 F.2d 959 (3d Cir. 1956)).

     Generally, to be entitled to deductions under section

166(a)(2) for debts claimed to be partially worthless, taxpayers

have the burden of proving that, based on all the facts and

circumstances, the portion of the debts with respect to which the

deductions are claimed became unrecoverable by the end of the

year for which the deductions are claimed.     Austin Co. v.

Commissioner, supra at 971; Portland Manufacturing Co. v.

Commissioner, 56 T.C. 58, 73 (1971), affd. without published

opinion 35 AFTR 2d 75-1439, 75-1 USTC par. 9449 (9th Cir. 1975).



3
     The parties treat and brief the issue as to the allowability
of petitioners’ claimed bad debt deductions relating to the
automobile loans under the bad debt provisions of sec. 166. No
claim is made that the claimed deductions should be allowed under
the loss provisions of sec. 165.
                               - 9 -

     The fact that some payments on debts become delinquent,

standing alone, does not establish the worthlessness or

uncollectibility of the debts or of any portion thereof.

Milenbach v. Commissioner, 106 T.C. 184, 204-205 (1996).

     A taxpayer’s business judgment concerning whether debts in a

particular year are partially worthless, if clearly supported by

facts, may be sufficient to prove the partial worthlessness of

the debts for a particular year.   Portland Manufacturing Co. v.

Commissioner, supra at 73.

     Petitioners argue that the alleged “sound business judgment”

of petitioners has been established by the loan delinquencies,

the automobile repossessions, and the inherent nature of the

loans made to high credit risk customers.    We disagree.

     We perceive little “sound business judgment” in petitioners’

method of charging off the loans in issue.    Rather, petitioners’

method was arbitrary and unrelated to the exercise of any

meaningful discretion with respect to particular loans.

Essentially, because petitioners’ automobile loans were made to

high risk customers, petitioners would have us treat all of their

automobile loans to customers whose cars were repossessed as

inherently worthless from the day the loans originated.     We

reject that treatment.   The facts of loan delinquency and

automobile repossession in a year, combined with high risk

debtors, do not automatically establish the full or partial
                              - 10 -

worthlessness of a loan for the year prior to the year in which

the repossession occurred.

     No facts extant at the end of May 1990, 1991, and 1992, have

been established by petitioners that would support the disputed

claimed bad debt deductions for those years.


Inventory Write-Downs

     Section 471 provides that a taxpayer should use a method of

accounting for inventory as prescribed by the Secretary that

clearly reflects the taxpayer’s income.

     Inventory should be recorded in a legible manner, properly

computed, summarized, and kept as part of the accounting records

of the taxpayer.   Sec. 1.471-2(e), Income Tax Regs.

     When respondent determines that a taxpayer’s method of

accounting for inventory under section 471 is improper, the

taxpayer has a heavy burden of proving that respondent’s

determination is plainly arbitrary and constitutes an abuse of

discretion.   Thor Power Tool Co. v. Commissioner, 439 U.S. 522,

532-533 (1979).

     The Secretary’s regulations provide that the lower of cost

or market is an acceptable method of accounting for inventory.

Sec. 1.471-2(c), Income Tax Regs.

     Under the lower of cost or market method, as of the end of

an inventory period (e.g., as of yearend) the cost of each item

of inventory is compared to its market value, and the lower of
                              - 11 -

the two is recorded as the basis of that item of inventory for

tax purposes.   Sec. 1.471-4(c), Income Tax Regs.   If as of

yearend the market value of inventory is lower than its cost, the

taxpayer “writes down” the basis of the inventory to the lower

market value, thereby reducing gross income.    See, e.g., Thor

Power Tool Co. v. Commissioner, supra at 530.

     The write-down of inventory from cost to market value based

on mere estimates is not allowable.    Sec. 1.471-2(f)(1), Income

Tax Regs.

     An official guide for used automobiles may be used to

ascertain the market value of used automobile inventory for

purposes of determining the lower of cost or market value.

Brooks-Massey Dodge, Inc. v. Commissioner, 60 T.C. 884, 895

(1973) (citing Rev. Rul. 67-107, 1967-1 C.B. 115).

     Without objective evidence such as books and records to

substantiate that item-by-item comparisons of cost to market

value were conducted by ABC in the calculation of its yearend

inventory write-downs, we will not disturb respondent’s

determination to disallow ABC’s claimed inventory write-downs.

See Thor Power Tool Co. v. Commissioner, supra at 536; Import

Specialties, Inc. v. Commissioner, T.C. Memo. 1982-41.    The

testimony of ABC’s president that at yearend he made estimates of

the value of the automobiles does not provide a basis on which

the claimed inventory write-downs can be allowed in this case.
                               - 12 -

Accuracy-Related Penalties

     Under section 6662, accuracy-related penalties of 20 percent

are imposed on underpayments of tax attributable to negligence or

to a disregard of Federal rules or regulations.   Sec. 6662(a) and

(b)(1).

     For purposes of section 6662, the term “negligence”

constitutes a failure to make a reasonable attempt to comply with

the Internal Revenue Code, and the term “disregard” includes

carelessness, recklessness, and intentional disregard.   Sec.

6662(c).    “Negligence” also includes a failure by a taxpayer to

keep adequate books and records or to properly substantiate

items.    Sec. 1.6662-3(b)(1), Income Tax Regs.

     Petitioners did not make a good faith attempt to ascertain

which loans were worthless at yearend.

     Also, ABC’s failure to maintain records to substantiate its

inventory write-downs constitutes negligence under section

6662(a).    See secs. 1.471-2(e) and (f)(1), 1.6662-3(b)(1), Income

Tax Regs.    We sustain respondent’s determination of the section

6662 penalties.
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To reflect the foregoing,



                                       Decisions will be

                             entered under Rule 155.
