                        T.C. Memo. 1997-485



                      UNITED STATES TAX COURT



          GALEDRIGE CONSTRUCTION, INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 21463-94.                    Filed October 28, 1997.



     John P. McDonnell, for petitioner.

     Ronald G. Dong, for respondent.



                        MEMORANDUM OPINION

     PARR, Judge:   This case is before the Court on petitioner's

motion for reasonable litigation costs pursuant to section 74301

     1
          References to sec. 7430 in this opinion are to that
section as amended by sec. 1551 of the Tax Reform Act of 1986,
Pub. L. 99-514, 100 Stat. 2752 (effective for proceedings
commenced after Dec. 31, 1985), and by sec. 6239(a) of the
Technical and Miscellaneous Revenue Act of 1988, Pub. L. 100-647,
102 Stat. 3342, 3743-3747 (effective with respect to proceedings
commenced after Nov. 10, 1988). Sec. 7430 was amended most
                                                   (continued...)
                                -2-

and Rule 231, filed June 24, 1997, and petitioner's amended

motion, filed September 2, 1997.2     Petitioner's motion is for

only the reasonable litigation costs it expended on the issue of

whether it was liable for the addition to tax pursuant to section

6661 (the section 6661 issue) in Galedrige Construction, Inc. v.

Commissioner, T.C. Memo. 1997-240 (Galedrige I).

     The issues for decision are:     (1) Whether respondent's

determination of the section 6661 addition to tax for substantial

understatement of tax was substantially justified within the

meaning of section 7430(c)(4) and the regulations thereunder.      We

hold it was not.   (2) Whether the amount of litigation costs

claimed by petitioner is reasonable within the meaning of section

7430(c)(1).   We hold it is.




     1
      (...continued)
recently by the Taxpayer Bill of Rights 2, Pub. L. 104-168, sec.
701, 110 Stat. 1452, 1463-1464 (1996), effective with respect to
proceedings commenced after July 30, 1996. The amendments to the
section shift to the Commissioner the burden of proving that the
position of the United States was substantially justified, sec.
7430(c)(4)(B), and changed the hourly rate for attorney's fees to
$110, sec. 7430(c)(1)(B)(iii).
     A judicial proceeding is commenced in this Court with the
filing of a petition. Rule 20(a); Maggie Management Co. v.
Commissioner, 108 T.C. 430 (1997). Petitioners filed their
petition on Nov. 21, 1994; thus the 1996 amendments do not apply
here.

     2
        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, unless
otherwise indicated. All dollar amounts are rounded to the
nearest dollar, unless otherwise indicated.
                                 -3-

     The relevant facts are taken from our opinion in Galedrige

I, the parties' submissions, and the existing record.       At the

time the petition in this case was filed, petitioner's principal

place of business was in Alviso, California.    For convenience, we

present a general background section and combine our findings of

fact with our opinion under each separate issue heading.

Background

     Petitioner is a corporation engaged in the business of

asphalt paving and related services.    In performing its

contracts, petitioner took delivery of the materials directly

from the asphalt supplier.    Petitioner's driver picked up the

asphalt and took it directly to the job site.    The asphalt had to

be laid within 2 to 5 hours from the time it was picked up from

the plant, or it would become rock hard and have to be thrown

away.    Petitioner had no way to extend the time that asphalt is

in an emulsified condition.    Once the asphalt hardened, it could

not be melted and reused, nor could it be returned for credit to

the asphalt supplier.

     Petitioner generally worked on only one job at a time,

lasting a week or less.    When the job was finished, petitioner

billed the customer and created an accounts receivable on its

books.    The asphalt company sent petitioner an invoice, usually

due within 30 days, which petitioner paid only after it received

payment from its customer.    Petitioner keeps its books and
                                -4-

records on the cash method, and it files its Federal income tax

return using a fiscal year ending June 30.

     In Galedrige I, respondent determined that during the years

in issue petitioner's asphalt was merchandise that was an income-

producing factor, that petitioner therefore had inventories, and

thus, that it must use the accrual method of accounting in order

to clearly reflect taxable income.    Accordingly, respondent

determined deficiencies in petitioner's Federal income tax for

taxable years ended June 30, 1989 and 1990, of $111,613 and $775,

respectively.   Respondent also determined a $27,903 section 6661

addition to petitioner's tax for taxable year 1989.3

     In Galedrige I, we found that emulsified asphalt, which

becomes useless in less than 5 hours, is not merchandise held for

sale by petitioner.   Furthermore, as petitioner had no

inventories, we held that it was not required to use an inventory

method of accounting, that its method of accounting clearly

reflected income, and that under these facts it was an abuse of

discretion for respondent to require petitioner to change its

method of accounting.   Due to our holding, we did not need to

address the issue of whether petitioner was liable for an


     3
        Sec. 6661 was repealed applicable for returns the due
date for which (determined without regard to extensions) is after
Dec. 31, 1989. Omnibus Budget Reconciliation Act of 1989, Pub.
L. 101-239, sec. 7721(c)(2), 103 Stat. 2399. Petitioner’s 1989
fiscal year ended June 30, 1989; thus, its return was due
(without regard to extensions) on Sept. 15, 1989. See sec.
6072(b). Therefore, sec. 6661 is applicable.
                                -5-

addition to tax pursuant to section 6661 for substantial

understatement of tax.

Discussion

     A taxpayer who substantially prevails in an administrative

or court proceeding may be awarded a judgment for reasonable

costs incurred in such proceedings.    Sec. 7430(a)(1) and (2).    A

taxpayer has the burden of proving that it meets each requirement

before we may order an award of costs under section 7430.      Rule

232(e); Gantner v. Commissioner, 92 T.C. 192, 197 (1989), affd.

905 F.2d 241 (8th Cir. 1990).

     For this Court to award reasonable litigation costs under

section 7430, several requirements must be met.    The record must

show that:   (1) The moving party did not unreasonably protract

the administrative proceeding or the proceeding in this Court.

Sec. 7430(b)(4).   (2) The moving party exhausted any

administrative remedies available to him or her in the Internal

Revenue Service.   Sec. 7430(b)(1).   Respondent concedes that

petitioner satisfies these first two requirements.    (3) The

moving party was the prevailing party.    Sec. 7430(a).   As

discussed below, we find that petitioner has met this

requirement.

     Whether Petitioner Is the Prevailing Party

     A taxpayer must satisfy several conjunctive requirements to

be deemed a prevailing party.   Sec. 7430(c).   The taxpayer must

establish:   (1) The position of the United States in the civil
                                 -6-

proceeding was not substantially justified.   Sec.

7430(c)(4)(A)(i).    (2) The taxpayer substantially prevailed with

respect to the amount in controversy or with respect to the most

significant issue or set of issues presented.   Sec.

7430(c)(4)(A)(ii).   (3) The taxpayer is either an individual

whose net worth does not exceed $2 million, or an owner of an

unincorporated business, or any partnership, corporation, etc.,

the net worth of which does not exceed $7 million at the time the

petition is filed.   Sec. 7430(c)(4)(A)(iii); 28 U.S.C. sec.

2412(d)(2)(B) (1988).

      Respondent concedes that petitioner substantially prevailed

in Galedrige I.   In addition, we are satisfied, based upon

petitioner's submissions to this Court, that petitioner's net

worth was less than $7 million when its petition was filed.     Rule

231(b)(5).   Thus, the only issue remaining for decision is

whether the position of the United States in the Court proceeding

was not substantially justified.

     Position of the United States Not Substantially Justified

     A position is not substantially justified in law if legal

precedent does not substantially support the Commissioner's

position given the facts available to the Commissioner.    Coastal

Petroleum Refiners, Inc. v. Commissioner, 94 T.C. 685, 688

(1990).   In deciding this issue, we must identify the point at

which the United States is first considered to have taken a
                                -7-

position, and then decide whether the position taken from that

point forward was not substantially justified.

     The position taken by the United States, for purposes of

litigation costs, refers to the position of the United States in

a judicial proceeding.   Sec. 7430(c)(7)(A).   Respondent's

position in the judicial proceeding herein was taken on December

27, 1994, the date respondent's answer was filed.    Huffman v.

Commissioner, 978 F.2d 1139, 1148 (9th Cir. 1992), affg. in part

and revg. in part T.C. Memo. 1991-144.   More specifically,

respondent's position in Galedrige I was that petitioner's use of

the cash method of accounting did not clearly reflect its income

(the method of accounting issue), and that it was therefore

subject to the addition to tax pursuant to section 6661(a) for

the substantial understatement of tax (the section 6661 issue).

     Whether respondent's position was not substantially

justified turns on a finding of reasonableness, based upon all

the facts and circumstances, as well as legal precedents relating

to the case.   Pierce v. Underwood, 487 U.S. 552 (1988); Coastal

Petroleum Refiners, Inc. v. Commissioner, supra at 694-695; Sher

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

Cir. 1988); DeVenney v. Commissioner, 85 T.C. 927, 930 (1985).      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; Powers v. Commissioner, 100 T.C. 457,

470-471 (1993).   A position that merely has enough merit to avoid
                                 -8-

sanctions for frivolousness will not satisfy this standard;

rather, it must have a "reasonable basis both in law and fact."

Pierce v. Underwood, supra at 564-565.     A position is not

substantially justified in law if legal precedent does not

substantially support the Commissioner's position given the facts

available to the Commissioner.    Coastal Petroleum Refiners, Inc.

v. Commissioner, supra at 688.    The Commissioner cannot escape an

award for costs pursuant to section 7430 simply because a case

presents a question of fact.     Minahan v. Commissioner, 88 T.C.

492, 500-502 (1987).

     The fact that the Commissioner eventually loses or concedes

the case is not determinative as to whether the taxpayer is

entitled to an award of administrative or litigation costs.

Sokol v. Commissioner, 92 T.C. 760, 767 (1989); Wasie v.

Commissioner, 86 T.C. 962, 968-969 (1986).     It remains, however,

a relevant factor to consider in determining the degree of the

Commissioner's justification.    Estate of Perry v. Commissioner,

931 F.2d 1044, 1046 (5th Cir. 1991); Powers v. Commissioner,

supra at 470, 472.

     Petitioner has the burden of establishing that respondent's

position was not substantially justified.    Rule 232(e); Dixson

Intl. Serv. Corp. v. Commissioner, 94 T.C. 708, 715 (1990).     For

petitioner to prevail, it must show that respondent's position,

in fact as well as in law, was not justified to a degree that

could satisfy a reasonable person.     Determining the
                                 -9-

reasonableness of respondent's position and conduct necessarily

requires considering what respondent knew at the time.      Cf.

Rutana v. Commissioner, 88 T.C. 1329, 1334 (1987); DeVenney v.

Commissioner, supra.    Thus, in determining whether respondent

acted reasonably, this Court must "consider the basis for

respondent's legal position and the manner in which the position

was maintained."    Wasie v. Commissioner, supra at 969.

     Petitioner concedes that respondent's position with respect

to the method of accounting issue was not unreasonable; however,

it asserts that respondent's position was not substantially

justified with respect to the section 6661 issue.     In some cases

courts have adopted an issue-by-issue approach to section 7430,

apportioning the requested awards between those issues for which

the Commissioner was, and those issues for which the Commissioner

was not, substantially justified.      See Powers v. Commissioner, 51

F.3d 34, 35 (5th Cir. 1995); Swanson v. Commissioner, 106 T.C.

76, 102 (1996).    We follow that approach here and separately

discuss whether respondent's position on the section 6661 issue

was substantially justified.

Issue 1. Whether Respondent's Determination of the Section 6661
Addition to Tax Was Substantially Justified

     Section 6661(a) imposes an addition to tax if there is a

substantial understatement of income tax.     There is an

understatement where the amount of tax shown on the return is

less than the amount required to be shown on the return.      A
                                 -10-

substantial understatement occurs in the case of a corporation

where the understatement exceeds the greater of 10 percent of the

amount of the tax required to be shown on the return or $10,000.

     The amount of the addition to tax under section 6661(a) is

equal to 25 percent of any underpayment attributable to the

understatement.    Where an item is not attributable to a tax

shelter,4 the understatement may be reduced by the amount

attributable to that item, and the addition to tax accordingly

reduced, if the taxpayer's treatment of the item was based on

substantial authority.    Sec. 6661(b)(2)(B)(i).5   Petitioner

     4
        See sec. 6661(b)(2)(C)(i). Petitioner's asphalt paving
activity does not constitute a "tax shelter" as defined for
purposes of sec. 6661. See sec. 6661(b)(2)(C)(ii).
     5
         Sec. 6661 provides in pertinent part as follows:

          SEC. 6661(a). Addition To Tax.--If there is a
     substantial understatement of income tax for any
     taxable year, there shall be added to the tax an amount
     equal to 25 percent of the amount of any underpayment
     attributable to such understatement.

           (b) Definition And Special Rule.--

               (1) Substantial Understatement.--

               (A) In general.--For purposes of this section,
           there is a substantial understatement of income tax
           for any taxable year if the amount of the
           understatement exceeds the greater of--

                  (i) 10 percent of the tax required
                  to be shown on the return for the
                  taxable year, or

                  (ii) $5,000.

                                                       (continued...)
                              -11-

asserts that at the time it filed its return for its taxable year

ended June 30, 1989, its use of the cash method in its asphalt

paving business was based upon substantial authority.

     The standard of substantial authority requires that, when

the facts and authorities are analyzed with respect to the

taxpayer's case, the weight of the authorities that support the

taxpayer's position should be substantial when compared with

those supporting the contrary position.   Sec. 1.6661-3(b)(1),

     5
      (...continued)
              (B) Special rule for corporations.--In the case of
          a corporation other than an S corporation or a personal
          holding company (as defined in section 542),
          paragraph (1) shall be applied by substituting
          "$10,000" for "$5,000".

              (2) Understatement.--

              (A) In general.--For purposes of
          paragraph    (1), the term, "Understatement"
          means the excess    of--

               (i) the amount of the tax required
               to be shown on the return for the
               taxable year, over

               (ii) the amount of tax imposed
               which is shown on the return,
               reduced by any rebate(within the
               meaning of section 6211(b)(2)).

              (B) Reduction for understatement due to
          position of taxpayer or disclosed item.--The
          amount of the understatement under subparagraph
          (A) shall be reduced by that portion of the
          understatement which is attributable to--

               (i) the tax treatment of any item
               by the taxpayer if there is or was
               substantial authority for such
               treatment, * * *
                                -12-

Income Tax Regs.    Section 1.6661-3(a)(2), Income Tax Regs.,

provides in part:

     The substantial authority standard is less stringent
     than a "more likely than not" standard (that is, a
     greater than 50-percent likelihood of being upheld in
     litigation) but stricter than a reasonable basis
     standard (the standard which, in general, will prevent
     imposition of the penalty under section 6653(a),
     relating to negligence or intentional disregard of
     rules and regulations). Thus, a position with respect
     to the tax treatment of an item that is arguable but
     fairly unlikely to prevail in court would satisfy a
     reasonable basis standard, but not the substantial
     authority standard.

     In determining whether there is substantial authority, only

certain sources will be considered authority, including court

cases, temporary and final regulations construing the Code and

other statutory provisions, and administrative pronouncements

(including revenue rulings and procedures).   Sec. 1.6661-3(b)(2),

Income Tax Regs.

     In support of its reporting position in Galedrige I,

petitioner cites as substantial authority Rev. Rul. 86-149, 1986-

2 C.B. 67, and Rev. Rul. 59-329, 1959-2 C.B. 138, certain

sections of the Code and the regulations, and several court

cases.   The weight of the authorities cited by petitioner depends

on their persuasiveness and relevance as well as their source.

See sec. 1.6661-3(b)(3), Income Tax Regs.

     Rev. Rul. 86-149, supra, is not substantial authority for

petitioner's position.   Rev. Rul. 86-149 addresses the issue of

whether a taxpayer engaged in the business of developing real
                                -13-

estate may use an inventory method of accounting for its

development costs.   The revenue ruling and the cases cited

therein make the situation that the ruling addresses very clear.

Petitioner is not in the business of developing and selling real

estate; thus, this ruling is materially distinguishable on its

facts and not relevant to petitioner's situation.    See sec.

1.6661-3(b)(3), Income Tax Regs.

     Similarly, we accord no weight to petitioner's reliance on

Rev. Rul. 59-329, supra, as substantial authority.    Rev. Rul. 59-

329 addresses the issue of whether a taxpayer who, under section

1.451-3, Income Tax Regs., accounts for its long-term contracts

on the completed contract method, or who has accounted for both

its long-term and its short-term contracts on the completed

contract method for several years, may consider as inventory the

costs of materials, labor, supplies, depreciation, etc., with

respect to such contracts.   Under the facts of Galedrige I, it is

evident that petitioner has no long-term contracts; thus this

ruling is not substantial authority for the position it took on

reporting its income.

     We noted in Galedrige I that "The statute and regulations do

not define 'merchandise' or 'inventory', nor do they clearly

distinguish between 'materials and supplies' that are not

actually consumed and remain on hand, and inventory."

Furthermore, we acknowledged that "the authorities in this area

are not easily reconcilable."   However, we stated that
                               -14-

          Petitioner’s position has commonsense appeal and
     some support in law and in industry practice. See
     Ansley-Sheppard-Burgess Co. v. Commissioner, supra
     (Commissioner agreed that taxpayer/contractor did not
     have inventory). Furthermore, until the early 1990's,
     the Commissioner generally permitted construction
     contractors to account for construction materials and
     supplies as supplies, rather than as inventory. See,
     e.g., id. at 375 ("The cash method of accounting has
     been widely used throughout the contracting industry
     and accepted by respondent since time immemorial.");
     Hunt Engg. Co. v. Commissioner, T.C. Memo. 1956-248
     (construction contractor purchasing materials for
     various jobs as they were needed maintained no
     inventories; cash method clearly reflected income).

          Beginning in the early 1990's, the Commissioner
     began to require contractors to account for the
     materials used in construction as merchandise
     inventory. [Fn. ref. omitted.]

     Therefore, notwithstanding the difficulty in reconciling the

authorities on this issue, there was substantial authority as

defined in section 1.6661-3(a)(2), Income Tax Regs., for

petitioner's position at the time it filed its return for taxable

year 1989.

     In his objection to petitioner's motion for reasonable

litigation costs, respondent asserts that respondent's position

on the section 6661 issue was substantially justified, and

petitioner, to meet its burden of proof, must show that

"respondent was not substantially justified in including the

substantial understatement penalty in the statutory notice of

deficiency, and in maintaining that position after District

Counsel received the case."   Thus, respondent contends that "the
                                -15-

fact that there was authority at the time of filing does not mean

the taxpayer was correct."

     As support for its argument that its position was

substantially justified, respondent relies on J.P. Sheahan

Associates, Inc. v. Commissioner, T.C. Memo. 1992-239, a case

that was decided several years after petitioner filed its return

for taxable year 1989.

     Respondent's understanding of when substantial authority is

determined is incorrect because petitioner is entitled to rely on

the law that existed at the time its return was filed.   See sec.

1.6661-3(b)(4)(iii), Income Tax Regs.

     We conclude that respondent's position with regard to the

section 6661 issue was not substantially justified.

Issue 2.   Reasonable Costs

     Petitioner seeks recovery of litigation fees and costs that

it incurred after its petition was filed.   Petitioner seeks

recovery of only the fees and costs related to the section 6661

issue and for its motion for litigation costs.   In Huffman v.

Commissioner, 978 F.2d at 1149, the Court of Appeals for

the Ninth Circuit, the Court of Appeals to which an

appeal in this case lies, stated that "So long as the

government's position justifies recovery of fees, any reasonable

fees to recover such fees are recoverable."   Thus, the fees

incurred by petitioner for its motion for reasonable attorney's

fees are recoverable.    We must decide whether the number of hours
                                -16-

billed, the rate at which those hours were billed, and the

miscellaneous costs are reasonable as claimed by petitioner.

     A.   Attorney's Fees

     Petitioner submitted an itemized statement from its

attorney, Mr. John P. McDonnell (McDonnell), for the hours that

were spent, reflecting costs incurred from September 26, 1995,

through August 29, 1997.    McDonnell billed his time at an hourly

rate of either $195 or $220.

     Section 7430(c)(1) defines reasonable litigation costs in

part as reasonable fees paid or incurred for the services of

attorneys in connection with the court proceeding.   Section

7430(c)(1)(B)(iii) limits the hourly rate for attorney's fees to

$75, with allowances for increase in the cost of living and other

special factors.   An issue exists as to whether the cost of

living adjustment (COLA), which applies to an award of attorney's

fees under section 7430, should be computed from October 1, 1981,

or from January 1, 1986.

     Our position on this issue was stated in Bayer v.

Commissioner, 98 T.C. 19, 23 (1992), where we concluded that

Congress, in providing for cost of living adjustments in section

7430, intended the computation to start on the same date the

COLA's were started under the Equal Access to Justice Act, 5

U.S.C. sec. 504 (1982).    Citing Lawrence v. Commissioner, 27 T.C.

713 (1957), revd. on other grounds 258 F.2d 562 (9th Cir. 1958),

we stated that we would continue to use 1981 as the base year for
                                  -17-

making the COLA calculation, unless the Court of Appeals to which

an appeal would lie had held otherwise.      Golsen v. Commissioner,

54 T.C. 742, 756-757 (1970), affd. 445 F.2d 985 (10th Cir. 1971).

     This case is appealable to the Court of Appeals for the

Ninth Circuit, which has decided that January 1, 1986, is the

correct date for purposes of calculating the COLA adjustment

under section 7430.      Huffman v. Commissioner, supra at 1151.

Accordingly, we find January 1, 1986, to be the applicable date

from which to make the adjustment in this case.      Id.

     We use the Consumer Price Index of All Urban Consumers (CPI-

U) published by the U.S. Department of Labor, Bureau of Labor

Statistics, to adjust the $75 hourly limit for increases in the

cost of living.     We award petitioner attorney's fees at an hourly

rate not to exceed $102.44 for 1994, $104.29 for 1995, $107.37

for 1996, and $109.83 for 1997.6

             1.   1994

         Petitioner's attorney billed 2.6 hours for the time

incurred in connection with preparing and drafting the Tax Court

petition in the instant proceeding.      We find this amount of time


     6
          The index for the 1982-84 CPI-U is 100; for Jan. 1,
1986 it is 109.6. The CPI-U index is 149.7 for December 1994,
the average index is 152.4 for 1995, 156.9 for 1996, and for July
1997 the index is 160.5. At the time of this decision, the
average index for 1997 is not available. Thus, we must use the
index for July, which is a midyear index. Accordingly, the
maximum hourly rate is $102.44 (149.7/109.6 x $75) for 1994,
$104.29 (152.4/109.6 x $75) for 1995, $107.37 (156.9/109.6 x $75)
for 1996, and $109.83 (160.5/109.6 x $75) for 1997.
                                 -18-

is reasonable and therefore shall award fees for 25 percent of

these hours allocable to the section 6661 issue.    Sec.

7430(c)(1)(A).

     2.   1995

     Petitioner's attorney billed 60.1 hours for 1995, 15 hours

of which were related to the section 6661 issue.   We find this

amount of time is reasonable and therefore shall award fees for

these hours.

     3.   1996

     Petitioner's attorney billed 67.2 hours for 1996, 16.8 hours

of which were related to the section 6661 issue.   We find this

amount of time is reasonable and therefore shall award fees for

these hours.

     4.   1997

     Petitioner's attorney billed 19.2 hours for the time

incurred in researching, preparing, and filing petitioner's

motion for reasonable litigation costs.    We find this amount of

time is reasonable and therefore shall award fees for these

hours.

     B.   Miscellaneous Litigation Costs

     The itemized billing shows $20 of miscellaneous costs for

photocopying and the apportioned filing fee.   We find this amount

to be reasonable.

     C.   Legal Research Costs

     Petitioner submitted an itemized statement for legal

research he performed on Westlaw from April 19, 1995, through
                               -19-

March 3, 1996.   This Court has awarded costs for computer

research.   Powers v. Commissioner, 100 T.C. at 493.   Accordingly,

we allow $108.92 for legal research costs.

     Accordingly, we award petitioner attorney's fees in the

amount of $5,476.90, miscellaneous litigation costs of $20, and

research costs of $108.92.

                               An appropriate order and decision

                          will be entered.
