                      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,    Filed November 29, 1999.
                2464-98.



    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          $6,019
                      2397-98           3,611
                      2464-98           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.    Sec. 7430(a) and

(b)(1), (3).    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

reasonably.   See Pierce v. Underwood, 487 U.S. 552 (1988); Sher

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

at onset".    Nalle v. Commissioner, 55 F.3d 189, 191 (5th Cir.

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

position.    See Maggie Management Co. v. Commissioner, supra at

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
                               - 10 -
of deficiency.   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 -
IC's income.   Respondent therefore required IC to use the accrual

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.    See Commissioner v. Hansen,

360 U.S. 446, 467 (1959).   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.   See sec. 1.446-1(c)(2)(i), Income

Tax Regs.   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 custom-

fabricated 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.   See Pierce v. Underwood, 487

U.S. 552 (1988).   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.
