                        T.C. Memo. 2000-383



                      UNITED STATES TAX COURT



         MID-DEL THERAPEUTIC CENTER, INC., Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent

           D. RICHARD ISHMAEL, M.D., PC, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 9060-97, 9270-97.       Filed December 19, 2000.



     Bruce A. Moates and LeRoy D. Boyer, for petitioners.

     Elizabeth Downs, for respondent.



                        MEMORANDUM OPINION


     MARVEL, Judge:   These cases are before the Court on

petitioners’ motion for award of litigation and administrative
                               - 2 -


costs1 filed pursuant to section 7430 and Rule 231.2   Petitioners

seek to recover litigation costs of $44,456 incurred in

contesting respondent’s deficiency determinations in docket No.

9060-97 for the taxable year ended April 30, 1995, and in docket

No. 9270-97 for the taxable year 1995.

     The issues for decision are whether respondent’s position at

trial was substantially justified and, if not, whether the

attorney’s fees and other costs that petitioners seek to recover

are reasonable in amount.   Neither petitioners nor respondent

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).

                            Background

     Petitioner Mid-Del Therapeutic Center, Inc. (Mid-Del), and

petitioner D. Richard Ishmael, M.D., PC (PC), are Oklahoma

corporations, each of which operates an oncology clinic in the

Oklahoma City metropolitan area.   On the dates the petitions in

these consolidated cases were filed, Mid-Del’s principal place of

business was in Midwest City, Oklahoma, and PC’s principal place


     1
      Although the title of the motion referred to administrative
costs, petitioners claimed only litigation costs in the motion.
Consequently, our discussion is limited to petitioners’ claim for
litigation costs.
     2
      Unless otherwise indicated, all section references are to
the Internal Revenue Code, and all Rule references are to the Tax
Court Rules of Practice and Procedure.
                               - 3 -


of business was in Oklahoma City, Oklahoma.    Dr. D. Richard

Ishmael, an oncologist, owns 100 percent of the stock of both

Mid-Del and PC.   PC is Dr. Ishmael’s personal service

corporation, and Mid-Del is a subchapter C corporation owned and

managed by Dr. Ishmael.

     During the relevant periods, petitioners operated medical

clinics that purchased and used chemotherapy drugs (drugs) to

treat patients with cancer and other illnesses.   PC maintained an

onsite pharmacy where the drugs purchased by both PC and Mid-Del

were stored and where a pharmacist employed by PC mixed and

prepared chemotherapy treatments for both clinics.    Petitioners

used approximately 85 different drugs to treat patients.

     With the exception of Mid-Del’s Federal income tax return

for the taxable year 1993, both Mid-Del and PC used the cash

method of accounting (cash method) for income tax purposes and

consistently reported the drugs used in patient treatments as

supplies and not as inventory.   Mid-Del’s 1993 return, which

originally was filed using the accrual method of accounting

(accrual method), was amended to report income and expenses on

the cash method after a revenue agent determined on audit that

Mid-Del was required to use the cash method.   It was a customary

and accepted practice in the health care industry for health care

practitioners to use the cash method.
                                - 4 -


     By notices of deficiency dated April 23, 1997, respondent

determined deficiencies of $140,025 and $211,979 in Mid-Del’s and

PC’s Federal income taxes, respectively.   The crux of the

deficiencies was respondent’s determination, made pursuant to

section 446(b), that petitioners must use an accrual method to

compute their taxable income.

     By separate petitions, petitioners commenced their cases in

this Court, and the cases were consolidated for trial.

Respondent argued at trial that the drugs used to treat patients

were merchandise, the purchase and sale of which were income-

producing factors in petitioners’ businesses, and that

petitioners, therefore, were required by section 1.471-1, Income

Tax Regs., to use the accrual method to compute their taxable

income.   Petitioners asserted that the drugs were supplies used

in the course of treating patients and that section 1.471-1,

Income Tax Regs., was inapplicable.

     Section 446(b) vests the Commissioner with broad discretion

to determine whether a particular method of accounting clearly

reflects income.   See Knight-Ridder Newspapers, Inc. v. United

States, 743 F.2d 781, 788 (11th Cir. 1984); Ansley-Sheppard-

Burgess Co. v. Commissioner, 104 T.C. 367, 370 (1995).   In

reviewing the Commissioner’s determination that a taxpayer’s

method of accounting does not clearly reflect income, the

function of the Court is to decide whether the Commissioner
                               - 5 -


abused his discretion in making that determination under section

446(b).   See RCA Corp. v. United States, 664 F.2d 881, 886 (2d

Cir. 1981).   Consequently, at trial, petitioners had the burden

of proving that respondent’s determination was arbitrary,

capricious, or without sound basis in fact or law.   See Knight-

Ridder Newspapers, Inc. v. United States, supra.

     After these cases were tried but before the opinion was

issued, the Court’s opinion was filed in Osteopathic Med.

Oncology & Hematology, P.C. v. Commissioner, 113 T.C. 376 (1999),

which presented facts strikingly similar to those involved in the

present cases.   In Osteopathic Med. Oncology & Hematology, P.C.,

a taxpayer, specializing in the treatment of cancer through

chemotherapy, used the cash method to expense the cost of drugs

used during treatments.   The Commissioner argued that the drugs

were merchandise under section 1.471-1, Income Tax Regs., and,

therefore, the taxpayer had to use the accrual method to report

income and costs attributable to the drugs.   This Court held that

the drugs were not merchandise and that the taxpayer properly

used the cash method to expense the cost of the drugs and report

income.   Osteopathic Med. Oncology & Hematology, P.C., was not

appealed, and the decision became final on April 7, 2000.   See

secs. 7481(a)(1), 7483; cf. Fed. R. App. P. 13(a).

     In Mid-Del Therapeutic Ctr., Inc. v. Commissioner, T.C.

Memo. 2000-130 (Mid-Del I), we held that respondent’s
                                 - 6 -


determination, requiring petitioners to change from the cash

method to the accrual method, was arbitrary, capricious, or

without sound basis in fact or law.      In so doing, we relied

heavily on Osteopathic Med. Oncology & Hematology, P.C.

Petitioners thereafter filed their motion seeking to recover

litigation costs.

                           Discussion

     In general, section 74303 provides for the award of

reasonable litigation costs to a taxpayer who: (1) Is the

prevailing party in a court proceeding brought against the United

States involving the determination of any tax, interest or

penalty pursuant to the Internal Revenue Code; (2) has exhausted

his or her administrative remedies within the IRS; and (3) did

not unreasonably delay or protract the court proceedings.

Respondent concedes that petitioners exhausted their

administrative remedies and that they did not unreasonably delay

or protract these proceedings.

     To be a prevailing party, a taxpayer must satisfy the

applicable net worth requirement and must substantially prevail


     3
      Sec. 7430 as most recently amended by Congress in the IRS
Restructuring and Reform Act of 1998, Pub. L. 105-206, sec. 3101,
112 Stat. 685, 727, applies to that portion of the claimed costs
incurred after Jan. 18, 1999. Sec. 7430 as amended by the
Taxpayer Relief Act of 1997, Pub. L. 105-34, secs. 1285, 1453,
111 Stat. 788, 1038, 1055, applies to that portion of the claimed
costs incurred on or before Jan. 18, 1999.
                               - 7 -


with respect to either the amount in controversy or the most

significant issue or set of issues presented.   See sec.

7430(c)(4)(A).   Respondent concedes that petitioners have

substantially prevailed and that they meet the applicable net

worth limitation but argues that his litigating position was

substantially justified.   If respondent can establish that the

position taken in Mid-Del I was substantially justified, then

petitioners fail to qualify as prevailing parties.   See sec.

7430(c)(4)(B).   In deciding whether to award reasonable costs,

therefore, we address only the issue of whether respondent’s

position was substantially justified.

     The Commissioner’s position is substantially justified if

the Commissioner acted reasonably in pursuing his litigating

position on the basis of all of the facts and circumstances and

the applicable legal precedents.   See Pierce v. Underwood, 487

U.S. 552, 564 (1988); Sher v. Commissioner, 89 T.C. 79, 84

(1987), affd. 861 F.2d 131 (5th Cir. 1988).   Although the

Commissioner’s litigating position may have been incorrect in

hindsight, it is substantially justified “if a reasonable person

could think it correct”.   Pierce v. Underwood, supra at 566 n.2.

The fact that the Commissioner eventually loses a case does not

establish that the position was unreasonable.   See Anthony v.

United States, 987 F.2d 670, 674 (10th Cir. 1993); Sokol v.

Commissioner, 92 T.C. 760, 767 (1989).   We decide whether the
                                - 8 -


Commissioner’s position was reasonable by examining applicable

facts and circumstances at the time he asserted his position in

the answer and during the trial.   See Maggie Management Co. v.

Commissioner, 108 T.C. 430, 443 (1997).

     Petitioners contend that the decision of this Court in

Mid-Del I, which held that respondent’s determination was

arbitrary, capricious, or without sound basis in fact or law,

necessarily leads to a conclusion that respondent’s position at

trial was unreasonable.   In support of this assertion,

petitioners rely on Mauerman v. Commissioner, T.C. Memo. 1995-237

(Mauerman II), which held that a failure by the Commissioner to

waive an addition to tax was unreasonable.   Respondent argues

that Mauerman II does not stand for the proposition for which it

is cited by petitioners and that respondent’s litigating position

was reasonable.

     In Mauerman v. Commissioner, T.C. Memo. 1993-23, revd. 22

F.3d 1001 (10th Cir. 1994) (Mauerman I), the issue that was

litigated was whether the taxpayer should be subject to additions

to tax under section 6661(a).   At trial, the taxpayer had the

burden of proving that the Commissioner’s imposition of the

additions to tax was arbitrary, capricious, or without sound

basis in fact or law.   This Court upheld the additions to tax and

decided that the Commissioner had not abused his discretion.     The

Court of Appeals for the Tenth Circuit reversed the decision of
                              - 9 -


this Court, holding that the Commissioner’s determination to

impose the additions to tax was arbitrary, capricious, or without

sound basis in fact or law and remanded for further proceedings.

On remand, the taxpayer filed a motion for litigation costs.

     In Mauerman II, the taxpayer contended that the

determination of the Court of Appeals that the Commissioner’s

failure to waive the addition to tax was an abuse of his

discretion necessarily led to a conclusion that the

Commissioner’s position was unreasonable and urged us to grant

the taxpayer’s motion for reasonable litigation costs.    Although

we agreed with the taxpayer’s conclusion that the Commissioner’s

litigating position in Mauerman I was unreasonable under the

circumstances involved there, we recognized the possibility that

a different conclusion might be reached in other cases.    We

explained our position as follows:

          In Mauerman I, we stated that, in order to prevail
     on the addition to tax issue, “petitioner must show
     * * * that respondent’s refusal to waive is an abuse of
     discretion.” In reversing our decision, the Court of
     Appeals agreed with petitioner * * * that the
     Commissioner should have waived the addition to tax.
     The question before us, then, is whether respondent was
     substantially justified in defending, in the instant
     litigation, an administrative determination that was
     held by the Court of Appeals to be an abuse of
     discretion; i.e., arbitrary, capricious, or without
     sound basis in fact. While there may be other
     situations where such a holding would not necessarily
     determine that respondent was not substantially
     justified, our review of the record in the instant case
     persuades us that petitioner has carried his burden in
     that respect.
                              - 10 -


          Accordingly, on the basis of the record in the
     instant case, we conclude that respondent’s position
     was not substantially justified. [Mauerman v.
     Commissioner, T.C. Memo. 1995-237; emphasis added.]

     Mauerman II does not stand for the blanket proposition,

asserted by petitioners, that, if this Court finds that the

Commissioner’s determination is arbitrary, capricious, or without

sound basis in fact or law, it necessarily follows that his

litigating position cannot be substantially justified.     Rather,

Mauerman II acknowledges that there may be situations in which

the Commissioner’s litigating position in support of a

determination is substantially justified even though the

determination ultimately is held to be arbitrary, capricious, or

without sound basis in fact or law.    We must decide whether this

is one of those situations.

     Respondent contends that this case presents one of the

“other situations” contemplated in Mauerman II.    In respondent’s

objection to petitioners’ motion for award of litigation and

administrative costs filed June 13, 2000, respondent summarizes

his position as follows:

     Whenever respondent determines a taxpayer’s method of
     accounting does not clearly reflect income, the
     standard of review is abuse of discretion. Thor Power
     Tool Co. v. Commissioner, 439 U.S. 522, 532 (1979);
     Cole v. Commissioner, 586 F.2d 747, 749 (9th Cir.
     1978), affg. 64 T.C. 1091 (1975). The Court’s
     conclusion that a change in accounting method was
     unwarranted requires a finding that the Commissioner
     abused his discretion; however, the record does not
     support a finding that respondent had no factual or
                              - 11 -


     legal basis for his position. Moreover, it is clear
     that there was no existing legal authority that would
     have made respondent’s arguments under sections 446 and
     471 unreasonable since, at least until the issuance of
     Osteopathic Medical, the pivotal issue in this case,
     whether oncology drugs administered by health care
     providers constituted merchandise, was an issue of
     first impression. Accordingly, unlike Mauerman, the
     record in this case does not warrant a determination
     that respondent’s position was not substantially
     justified.

     Respondent urges us, as we did in Stieha v. Commissioner, 89

T.C. 784, 790-791 (1987), to allow respondent a reasonable amount

of time following adverse litigation on an issue of first

impression to adjust his litigating position before we determine

that his litigating position warrants an award of costs under

section 7430.   Respondent points out that the decision in

Osteopathic Med. Oncology & Hematology, P.C. v. Commissioner, 113

T.C. 376 (1999), became final on April 7, 2000, just 4 days

before the opinion in the instant case was rendered.   Twenty-one

days after the decision in Osteopathic Med. Oncology &

Hematology, P.C. became final, the Commissioner issued an action

on decision acquiescing in that case as to result only.   See

Action on Decision 2000-005 (Apr. 28, 2000).

     Respondent’s litigating position at trial in Mid-Del I

flowed from his conclusion that the drugs purchased and used by

petitioners were merchandise and an income-producing factor in

their businesses.   In support of this position, respondent argued

that the drugs were tangible products that were purchased by
                                - 12 -


petitioners and consumed by the patients, that the cost of the

drugs was significant, and that the permissible charges for the

drugs were listed separately on bills submitted by petitioners to

third-party insurers.     Respondent relied on the seminal case of

Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d 352 (1st Cir.

1970), affg. T.C. Memo. 1969-79,4 for the proposition that the

drugs were merchandise.    See also Tebarco Mechanical Corp. v.

Commissioner, T.C. Memo. 1997-311; Thompson Elec., Inc. v.

Commissioner, T.C. Memo. 1995-292; J.P. Sheahan Associates., Inc.

v. Commissioner, T.C. Memo. 1992-239; Surtronics, Inc. v.

Commissioner, T.C. Memo. 1985-277; Epic Metals Corp. & Subs. v.

Commissioner, T.C. Memo. 1984-322, affd. without published

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

     Our evaluation of the facts and circumstances presented by

Mid-Del I, as well as the legal environment from which

respondent’s litigating position evolved, leads us to the

conclusion that respondent’s litigating position in Mid-Del I was

substantially justified.    See Stieha v. Commissioner, supra at

790-791.   The issue of whether drugs used in treating patients



     4
      In Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d 352 (1st
Cir. 1970), affg. T.C. Memo. 1969-79, the Court of Appeals for
the First Circuit held that caskets sold by service-oriented
businesses were merchandise even though the caskets were not held
for sale in the traditional retail context. The taxpayer was a
funeral home that sold caskets as part of the funeral services it
provided to customers.
                                - 13 -


constituted merchandise in the context of whether the accrual

method must be used was an issue of first impression on which no

court had ruled until we filed our opinion in Osteopathic Med.

Oncology & Hematology, P.C. v. Commissioner, supra.       The

Commissioner generally is not subject to an award of litigation

costs under section 7430 where the underlying issue presents a

question of first impression.    See TKB Intl., Inc. v. United

States, 995 F.2d 1460, 1468 (9th Cir. 1993); Estate of Wall v.

Commissioner, 102 T.C. 391 (1994).       Moreover, the Commissioner

has been granted considerable discretion, by statute, to

determine whether a method of accounting clearly reflects income.

See sec. 446; Don Casey Co. v. Commissioner, 87 T.C. 847, 862

(1986).   Before our decision in Osteopathic Med. Oncology &

Hematology, P.C., Wilkinson-Beane, Inc. v. Commissioner, supra,

and its progeny provided at least a colorable factual and legal

basis for the Commissioner’s conclusion that drugs used in

treating patients constituted merchandise, thereby requiring

petitioners to use the accrual method.5


     5
      The earlier determination made by a revenue agent, that the
cash method should have been used by Mid-Del on its 1993 Federal
income tax return, has no bearing on the decision that the
position taken by respondent at trial was substantially
justified. Although a presumption of unreasonableness exists if
the Commissioner argues a position in the administrative
proceeding that is contrary to any applicable published guidance
of the Commissioner, an initial determination by a revenue agent
does not qualify as guidance that leads to such a presumption.
                                                   (continued...)
                              - 14 -


     Petitioners argue in the alternative that respondent was not

substantially justified with regard to other issues that we did

not find necessary to address in Mid-Del I.   On brief, in Mid-Del

I, petitioners argued that even if the drugs were merchandise

petitioners could continue to use the cash method.   We need not

address the substantive issue involved in this argument but only

whether the position taken by respondent at trial in response to

it was substantially justified.

     Respondent’s position at trial was that section 1.471-1,

Income Tax Regs., mandates that if petitioners maintain

inventories, then petitioners may not use the cash method unless

petitioners demonstrate that the cash method produces a

substantially identical result to that produced by the accrual

method.   In support of this argument, respondent relied on

Asphalt Prods. Co. v. Commissioner, 796 F.2d 843, 848 (6th Cir.

1986), affg. in part and revg. in part Akers v. Commissioner,

T.C. Memo. 1984-208, revd. in part on other grounds 482 U.S. 117

(1987); Ansley-Sheppard-Burgess Co. v. Commissioner, 104 T.C. at



     5
      (...continued)
See sec. 7430(c)(4)(B)(ii); sec. 301.7430-5, Proced. & Admin.
Regs. Furthermore, the Commissioner is not estopped from
attempting to change a method of accounting approved in earlier
years if, in later years, the Commissioner concludes that method
does not clearly reflect income. See Thomas v. Commissioner, 92
T.C. 206, 225-226 (1989); Ezo Prods. Co. v. Commissioner, 37 T.C.
385, 391 (1961).
                               - 15 -


377; and Addison Distribution, Inc. v. Commissioner, T.C. Memo.

1998-289.   Respondent’s litigating position was substantially

justified under the circumstances.

     We hold, therefore, that respondent has established that his

litigating position challenging petitioners’ method of accounting

in Mid-Del I was substantially justified because respondent’s

challenge was reasonable given the facts and circumstances of

petitioners’ cases and the applicable law.   Accordingly,

petitioners are not entitled to recover litigation costs.   In

light of our ruling, we need not decide whether the costs claimed

by petitioners are reasonable.

     We have considered carefully all remaining arguments made by

petitioners for a result contrary to that expressed herein, and,

to the extent not discussed above, we consider them to be

irrelevant or without merit.

     To reflect the foregoing,

                                          Appropriate orders and

                                     decisions will be entered.
