                           113 T.C. No. 26



                    UNITED STATES TAX COURT



OSTEOPATHIC MEDICAL ONCOLOGY AND HEMATOLOGY, P.C., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



    Docket No. 11551-98.                     Filed November 22, 1999.


         P, a professional service corporation, specializes
    in the treatment of cancer through chemotherapy. P
    uses drugs and ancillary pharmaceuticals (collectively,
    the drugs) during its treatment. The chemotherapy
    treatments are prescribed by P’s professional staff,
    and patients do not select the type or quantity of
    drugs used during the treatments. P uses the cash
    method to expense the cost of the drugs. R determined
    that the drugs were "merchandise" under sec. 1.471-1,
    Income Tax Regs., and that P must use an accrual method
    to report all amounts attributable to the drugs.
         Held: The inherent nature of P's business is that
    of a service provider, P’s use of the drugs is
    subordinate to the provision of its services, and P
    uses the drugs as an indispensable and inseparable part
    of the rendering of its services; thus, the drugs are
    not "merchandise" under sec. 1.471-1, Income Tax Regs.,
    and P properly used the cash method to expense the
    drugs’ cost.
                                  - 2 -


     David C. May, for petitioner.

     Grant E. Gabriel, for respondent.


                                 OPINION


     LARO, Judge:    The parties submitted this case to the Court

without trial.   See Rule 122.    Petitioner petitioned the Court to

redetermine respondent's determination of a $50,515 deficiency in

its 1995 Federal income tax.     The sole issue for decision is

whether petitioner, a professional service corporation, may use

the cash receipts and disbursements method (cash method) to

expense the drugs and ancillary pharmaceuticals (collectively,

chemotherapy drugs) used by it while providing chemotherapy

treatments to its patients.    We hold it may.    Unless otherwise

stated, section references are to the Internal Revenue Code as

applicable to 1995, and Rule references are to the Tax Court

Rules of Practice and Procedure.

                              Background

     All facts are stipulated and are so found.      The stipulation

of facts and exhibits submitted therewith are incorporated herein

by this reference.   Petitioner's principal place of business was

in Clinton Township, Michigan, when it petitioned the Court.

     Petitioner is a professional medical corporation that

provides osteopathic services, with a speciality in oncology

(mainly chemotherapy) and hematology.      Petitioner's staff
                                - 3 -


consists of physicians, nurses and nursing assistants, laboratory

technicians, administrative personnel, and office workers.

Petitioner has three offices in the Clinton Township area.   At

each of these offices, petitioner stores chemotherapy drugs and

has the staffing, equipment, and supplies necessary to administer

chemotherapy treatments.

     Chemotherapy drugs are pharmaceutical drugs which under

applicable State (Michigan) law must be prescribed by a doctor

and may be sold only by a licensed pharmacist.   Petitioner is not

a licensed pharmacist, and it is unlawful for petitioner to sell

the drugs.   Petitioner may use the drugs during the performance

of its chemotherapy services.

     Chemotherapy drugs come in ready-to-use form or as powders

or liquids that require mixing.   Petitioner generally maintains

about a 2-week supply of chemotherapy drugs, and it regularly

purchases chemotherapy drugs from suppliers to insure that it has

enough on hand to administer prescribed treatments.    Chemotherapy

drugs, in an unmixed form, have shelf-lives varying from about 6

months to 1 year.

     When an individual first becomes a patient of petitioner,

one of petitioner's physicians examines him or her to prescribe

necessary treatments, and that physician records the

individualized chemotherapy treatment in the patient's file.

After the patient is evaluated and the physician prescribes a
                                - 4 -


chemotherapy regime, the patient begins regular, periodic

treatments.    The patient does not select the type or quantity of

drugs used in the treatments; this selection is within the sole

discretion of petitioner’s professional staff.    In accordance

with standard oncology practice, patients are not examined by a

physician at every chemotherapy treatment but are usually

reexamined by a physician every 4 to 6 weeks during the ongoing

course of treatments.   Any changes in the future course of

treatments are documented in the patient's file at that time.

     Petitioner's personnel mix and otherwise prepare the

chemotherapy drugs that petitioner administers to a patient; the

chemotherapy drugs cannot be self-administered.    One of

petitioner's oncology nurses generally performs the

administration, and a physician is always on site to respond to

emergencies.   The physician is not always in the room during the

administration.

     Petitioner is a participating provider with Medicare1 and

several other private insurance carriers.   Virtually all of

petitioner's patients who receive chemotherapy treatments are

covered by Medicare or private insurance, and those patients are

billed only for the cost of the treatments to the extent of

co-payments, deductibles, and other uncovered charges.      For each

     1
       See Health Insurance for Aged Act, Pub. L. 89-97, 79 Stat.
291 (1965), currently codified at 42 U.S.C. secs. 1395 through
1395ccc (1994).
                                - 5 -


patient visit, petitioner's staff prepares a physician's

statement known as a "charge sheet", which is the document from

which petitioner's billing department generates its bills.   The

charge sheet specifically lists the type, amount, and cost of

chemotherapy and other drugs administered, and the type and cost

of all professional services rendered.   The charge sheets are

specific as to the particulars of chemotherapy treatments so as

to comply with the guidelines of Medicare and the private

insurance industry.   Petitioner submits the charge sheets

directly to Medicare or other responsible party, and petitioner

bills its patients for the copayments or other charges not

covered by insurance.

     Medicare and private insurers analyze on an item-by-item

basis whether to reimburse the charges shown on the charge

sheets.    The dollar amount reimbursed for a drug administered to

a patient is ascertained by reference to the average wholesale

price (AWP) of the units in which the drug is packaged and sold

wholesale, which AWP is published annually with quarterly

updates.   Generally, the reimbursement amount for drugs equals

the AWP times the units used, with rounding up to the next whole

unit of a drug when billing for administration of a partial unit.

     It is common industry practice to charge for all medical

services provided even when the health care provider anticipates

it will not be paid in full for all charges.   The standard charge
                               - 6 -


nationally for chemotherapy drugs is 1.5 times the AWP, and

petitioner bills its patients for the drugs at this rate with the

expectation that the patient will pay the excess over the amount

reimbursed.   With all reimbursement payments from Medicare or

private insurers, petitioner receives an "Explanation of

Benefits" that details the amounts allowed and disallowed as to

each specific charge, and the amounts for each charge which are

due from secondary insurance and/or the patient.

     Petitioner has always used the cash method for purposes of

both financial and tax accounting, and it has never maintained an

inventory of any of the items used in its practice.    Petitioner

expenses as supplies the cost of all chemotherapy drugs purchased

during the year; the actual cost of chemotherapy drugs which it

had on hand at the end of 1995 was $31,887.    Petitioner deducted

on its 1995 tax return $772,522 in "medical supplies" for the

actual cost of the chemotherapy drugs and $66,305 in "laboratory

supplies" for the actual cost of miscellaneous nonpharmaceutical

items.   Petitioner reported on its 1995 tax return $2,938,726 in

gross receipts and no cost of goods sold.

     Respondent determined that petitioner had to inventory its

chemotherapy drugs, and, thus, that petitioner's use of the cash

method did not clearly reflect its income.    Respondent changed

petitioner's method of accounting to a hybrid method, which

hybrid method accounted for the chemotherapy drugs on an accrual
                               - 7 -


method and the balance of petitioner's business on the cash

method.   Respondent's change to the hybrid method increased

petitioner's income by:   (1) $31,887, the actual cost of the

chemotherapy drugs on hand at the end of 1995, and (2) $148,557,

the value of petitioner's accounts receivable relating to

chemotherapy drugs conveyed to patients as of the end of 1995.

                            Discussion

     We decide for the first time whether the furnishing of

pharmaceuticals by a medical treatment facility as an integral,

indispensable, and inseparable part of the rendering of medical

services is the sale of "merchandise" for purposes of section

1.471-1, Income Tax Regs.   In Hospital Corp. of Am. v.

Commissioner, 107 T.C. 116 (1996) (HCA), we held that medical

supplies and pharmaceuticals used by hospitals are so vital to

the furnishing of medical services that income earned therefrom

constitutes income earned from the performance of services for

purposes of the nonaccrual-experience method of section

448(d)(5).   In HCA, we explicitly reserved for another day the

question of whether those supplies and pharmaceuticals were

merchandise that had to be inventoried under section 1.471-1,

Income Tax Regs.   See id. at 143-144 n.18.   That day is here in

the factual setting of a physician’s outpatient chemotherapy

treatment facility.
                                - 8 -


     We decide this issue in the context of whether it was an

abuse of respondent’s discretion to exercise his authority under

section 446 and require petitioner to change from the cash method

to a hybrid method.2    Presented is the question of whether

petitioner should be required to keep inventories for tax

purposes under section 471.    Respondent determined that

petitioner’s chemotherapy drugs were merchandise that was an

income-producing factor, that petitioner therefore was required


     2
         Sec. 446 provides in pertinent part:

     SEC. 446.    GENERAL RULE FOR METHODS OF ACCOUNTING.

          (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.
                                - 9 -


to inventory the drugs, and that petitioner was required to use

an accrual method to account for this inventory in order to

reflect its income clearly.    Petitioner asserts that it is not a

merchandising business but a provider of services; to wit,

chemotherapy treatments for patients stricken with cancer.

Petitioner argues that it need not maintain inventories for the

chemotherapy drugs used in the treatments.

       We agree with petitioner that it is not required to

inventory its chemotherapy drugs.    We are mindful of the broad

discretion accorded the Commissioner in applying sections 446 and

471.    Taxpayers challenging the Commissioner’s authority must

prove that the Commissioner’s determination is “clearly unlawful”

or “plainly arbitrary”.    See Thor Power Tool Co. v. Commissioner,

439 U.S. 522 (1979); see also Wal-Mart Stores, Inc. & Subs. v.

Commissioner, T.C. Memo. 1997-1, affd. 153 F.3d 650 (8th Cir.

1998).    The fact that the Commissioner has broad authority under

section 446(b), however, does not mean that the Commissioner may

change a taxpayer’s method of accounting with impunity.        See,

e.g., Prabel v. Commissioner, 91 T.C. 1101, 1112-1113 (1988),

affd. 882 F.2d 820 (3d Cir. 1989).      The Commissioner, for

example, may not change a taxpayer's method of accounting from

one that clearly reflects income to another one that the

Commissioner believes more clearly reflects income.      See
                              - 10 -


Ansley-Sheppard-Burgess Co. v. Commissioner, 104 T.C. 367 (1995);

see also Wal-Mart Stores, Inc. & Subs. v. Commissioner, supra.

     We focus our inquiry on whether the chemotherapy drugs were

supplies deductible under section 162, or merchandise that must

be inventoried under section 471.   Section 162(a) allows a

deduction for “all the ordinary and necessary expenses paid or

incurred during the taxable year in carrying on any trade or

business”.   The relevant regulations explain that

     Taxpayers carrying materials and supplies on hand
     should include in expenses the charges for materials
     and supplies only in the amount that they are actually
     consumed and used in operation during the taxable year
     for which the return is made, provided that the costs
     of such materials and supplies have not been deducted
     in determining the net income or loss or taxable income
     for any previous year. If a taxpayer carries
     incidental materials or supplies on hand for which no
     record of consumption is kept or of which physical
     inventories at the beginning and end of the year are
     not taken, it will be permissible for the taxpayer to
     include in his expenses and to deduct from gross income
     the total cost of such supplies and materials as were
     purchased during the taxable year for which the return
     is made, provided the taxable income is clearly
     reflected by this method. [Sec. 1.162-3, Income Tax
     Regs.]

Section 471 provides in pertinent part:

     SEC. 471.   GENERAL RULE FOR INVENTORIES.

          (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.
                               - 11 -


The relevant regulations explain that "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."   Sec. 1.471-1, Income Tax Regs.

Jurisprudence provides that a taxpayer with inventories must use

an accrual method, unless the taxpayer shows that use of another

method would produce a substantial identity of results and that

the Commissioner’s determination requiring a change is an abuse

of discretion.   See Knight-Ridder Newspapers, Inc. v. United

States, 743 F.2d 781, 789, 791-793 (11th Cir. 1984);

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

1970), affg. T.C. Memo. 1969-79; Ansley-Sheppard-Burgess Co. v.

Commissioner, 104 T.C. at 377; see also sec. 1.446-1(c)(2)(i),

Income Tax Regs.

     Under the facts at hand, respondent may require petitioner

to utilize an inventory method of accounting only if we find each

of the following as facts:   (1) Petitioner produced, purchased,

or sold merchandise, and (2) petitioner's production, purchase,

or sale of that merchandise was an income-producing factor.     See

Honeywell Inc. v. Commissioner, T.C. Memo. 1992-453, affd.

without published opinion 27 F.3d 571 (8th Cir. 1994).   We need

not reach the second part of this inquiry; i.e., whether the

production, purchase, or sale of merchandise is an

income-producing factor, if we are unable to find first that the
                                - 12 -


chemotherapy drugs are merchandise.      See Wilkinson-Beane, Inc. v.

Commissioner, supra; Honeywell Inc. v. Commissioner, supra; sec.

1.471-1, Income Tax Regs.

        The statute and regulations do not define the words

“merchandise” or “inventory”, nor do they clearly distinguish

between "inventory" and “materials and supplies” that are not

actually consumed and remain on hand.     We have held that

“merchandise”, as used in section 1.471-1, Income Tax Regs., is

an item acquired and held for sale.      See Wilkinson-Beane, Inc. v.

Commissioner, T.C. Memo. 1969-79.     Upon appeal, the Court of

Appeals for the First Circuit agreed, stating:

        A canvassing of authorities in the accounting field
        yields several definitions, such as “goods purchased in
        condition for sale,” “goods awaiting sale,” “articles
        of commerce held for sale,” and “all classes of
        commodities held for sale.” Clearly, the meaning of
        the term must be gathered from the context and the
        subject. * * * The common denominator, however, seems
        to be that the items in question are merchandise if
        held for sale. [Wilkinson-Beane, Inc. v. Commissioner,
        420 F.2d at 354-355; citations omitted.]

        Whether an item is acquired and held for sale is governed by

the substance of the transaction and not its form.     See Honeywell

Inc. v. Commissioner, supra.     We take into account the particular

facts and circumstances of the taxpayer in each case and the

manner and context in which the taxpayer operates the business at

hand.     See Wilkinson-Beane, Inc. v. Commissioner, supra; Thompson

Elec., Inc. v. Commissioner, T.C. Memo. 1995-292; Honeywell Inc.

v. Commissioner, supra; J.P. Sheahan Associates, Inc. v.
                              - 13 -


Commissioner, T.C. Memo. 1992-239.     We have previously examined

service transactions in a variety of industries to determine

whether the transactions in substance involved solely the sale of

a service, or whether the transactions involved the sale of both

a service and merchandise.   Those cases are not readily

reconcilable and underscore the fact-intense nature of this

inquiry.3   We have not, however, explored this issue in the

context of the health care industry and have never had a

situation where, as here, applicable laws would prohibit the

taxpayer from selling the items in issue without provision of the

attendant service.

     We find the instant setting distinguishable from the setting

of those cases in which we have held that goods utilized by a

service provider were merchandise for purposes of the inventory

rules.   We give significance to the uniqueness of the industry in


     3
       See, e.g., Addison Distribution, Inc. v. Commissioner,
T.C. Memo. 1998-289 (electronic materials were merchandise);
Thompson Elec., Inc. v. Commissioner, T.C. Memo. 1995-292
(electrical contractor’s wire, conduit, and electrical panels
were merchandise); Honeywell Inc. v. Commissioner, T.C. Memo.
1992-453 (rotable spare parts used in maintenance service
business were not merchandise; Court rejected argument that
taxpayer’s “consideration” of the parts' cost to set its fixed
fee established that the parts were acquired and held for sale),
affd. without published opinion 27 F.3d 571 (8th Cir. 1994); J.P.
Sheahan Associates, Inc. v. Commissioner, T.C. Memo. 1992-239
(contractor’s roofing materials were merchandise); Surtronics,
Inc. v. Commissioner, T.C. Memo. 1985-277 (electroplating metals
were merchandise); Wilkinson-Beane, Inc. v. Commissioner, T.C.
Memo. 1969-79 (funeral business’ caskets were merchandise), affd.
420 F.2d 352 (1st Cir. 1970).
                              - 14 -


which petitioner operates in relation to the other service

industries we have addressed on this issue and bear in mind the

recent case of Hospital Corp. of Am. v. Commissioner, 107 T.C.

116, 143-145 (1996).   There, as explained in more detail below,

we held that the income attributable to the pharmaceuticals and

various medical supplies frequently used by the personnel of the

taxpayer/hospital while performing medical services was not

income from the sale of goods for purposes of the nonaccrual-

experience method of section 448(d)(5).4   We held that those

items were "inseparably connected" to the taxpayer's services.

See id. at 143.

     Like the taxpayer in HCA, petitioner's business is a

quintessential service business.   It is a health care provider

that administers chemotherapy treatments to patients with cancer.

Although it furnishes chemotherapy drugs to its patients as part

of its service, a person cannot obtain the drugs but for the

chemotherapy treatments, and the treatments require the extensive

and specialized service of petitioner's professional staff.

Petitioner's professional staff, as an integral and indispensable

part of furnishing chemotherapy drugs to a patient, must examine

the patient and prescribe a treatment regime, monitor the length,

     4
       The medical supplies included items such as radiological
dyes, casts, crutches, canes, walkers, bandages, sutures,
splints, skin staples, various implants such as joint
replacements, pacemakers, heart valves, orthopedic devices, and
physical and occupational therapy items.
                              - 15 -


kind, quantity, and frequency of the treatments, and reevaluate

the patient on an ongoing basis.   That these services are

critical and essential to the furnishing of the chemotherapy

drugs by petitioner's staff cannot be denied.

     Petitioner is not a merchandiser.   Although it is true that

petitioner transfers the tangible quality of the chemotherapy

drugs to its patients when it administers the drugs to them,

petitioner does so only as an integral and inseparable part of

its service.   Petitioner is precluded by law from selling the

chemotherapy drugs to any person without providing the medical

service, and the drugs are not susceptible of self-

administration.   In fact, the only way that a person may legally

receive the chemotherapy drugs from petitioner is to agree to

petitioner's overall chemotherapy service, and, when they do

agree to this service, they have no say in the type or quantity

of chemotherapy drugs which petitioner uses in their care.

Usually, they are not even aware of the type or quantity of

chemotherapy drugs used on them as part of their treatment.

Where, as here, the service provider dispenses the drugs as an

indispensable and inseparable part of the rendering of its

services, the service provider is not selling “merchandise”.     The

service provider is using the items as supplies which are

essential to the provision of its services.   A medical practice

such as petitioner’s is inherently a service business, and the
                              - 16 -


drugs administered in the practice are subordinate to the

provision of the medical services.

     We disagree with respondent's contention that "The transfer

of the drugs is clearly a commercial transaction" to the extent

he implies a commercial transaction is the conveyance of

merchandise.   Given the nature of the services petitioner

provides and the substance of the service transactions, we are

convinced petitioner is not selling merchandise when it

administers chemotherapy drugs.   The case of Abbott Labs. v.

Portland Retail Druggists Association, Inc., 425 U.S. 1 (1976),

parallels that conviction.   There, the Supreme Court decided

whether drugs purchased by a nonprofit hospital at prices lower

than those charged commercial pharmacists were exempt from the

antiprice discrimination provisions of the Robinson-Patman

Antidiscrimination Act, ch. 592, 49 Stat. 1526 (1936), 15 U.S.C.

sec. 13(a) (1994).   The exemption generally applies where the

nonprofit institution is purchasing the drugs for its "own use"

as opposed to for sale to patients.    In siding with the

hospital's contention that it was exempt, the Court stated:

     it seems to us to be very clear that a hospital's
     purchase of pharmaceutical products that are dispensed
     to and consumed by a patient on the hospital premises,
     whether that patient is bedded, or is seen in the
     emergency facility, or is only an outpatient, is a
     purchase of supplies for the hospital's "own use," * *
     *. In our view, * * * this is so clear that it needs
     no further explication. [Abbot Labs. v. Portland
     Retail Druggists Association, supra at 10-11; emphasis
     added.]
                              - 17 -


This Court has also stated similarly.   See St. Luke's Hosp. v.

Commissioner, 35 T.C. 236, 238 (1960), wherein the Court stated

that the taxpayer hospital was "not a merchandising business, and

* * * has no merchandise inventories which would require the use

of an accrual method in keeping its books or reporting its

income.   Its income is derived from providing hospital and

professional care to the sick."

     Respondent's characterization of the chemotherapy drugs as

merchandise offends the natural and ordinary meaning of the term

"merchandise".   The word "merchandise" denotes commodities or

goods that are bought and sold in business.   See Merriam

Webster's Collegiate Dictionary 727 (10th ed. 1996).   Although

pharmaceuticals could reasonably be construed to be merchandise

in some contexts; e.g., when purchased at a grocery store for

self-administration at home, it does not necessarily follow that

pharmaceuticals are merchandise in all contexts.   The latter

proposition is especially true under the facts at hand where

petitioner's patients generally cannot be understood to consider

themselves as purchasers of "merchandise" during the course of

their medical treatment.   The chemotherapy drugs are administered

by petitioner's trained, licensed, and specialized physicians and

other health-related professionals during the rendition of a

unique medical service, and, when administered, the drugs are not

"goods [that were] purchased in condition for sale," or "articles
                               - 18 -


of commerce held for sale."    Simply put, petitioner is not

peddling products.

     Respondent looks to the value of the chemotherapy drugs and

asserts that petitioner's business is part service, part sale.

We disagree.   The mere fact that the chemotherapy drugs are

expensive is insufficient to transmute the transaction from the

sale of a service to the sale of merchandise and a service.     The

common denominator that the items be held for sale is lacking on

these facts.   Petitioner's chemotherapy treatment business is a

pure service business and not, as respondent asserts, a mixed

service and merchandising business.     See, e.g., Hewlett-Packard

Co. v. United States, 71 F.3d 398 (Fed. Cir. 1995) (taxpayer's

computer maintenance business was a service business, not mixed

service and merchandise business, despite installation of parts);

Honeywell, Inc. v. Commissioner, T.C. Memo. 1992-453 (taxpayer's

computer maintenance business was a service business, not mixed

service and merchandise business, despite installation of parts),

affd. without published opinion 27 F.3d 571 (8th Cir. 1994).

     We find no cases on this issue analogous, much less

controlling.   The reported authorities, including those cases

where the court found that the merchandise at issue there was

sold either with or without a service, are all materially

distinguishable from the facts herein given the uniqueness of the

service provided.    Respondent relies on the seminal case of
                              - 19 -


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

1970), affg. T.C. Memo. 1969-79.   There, the taxpayer was an

undertaker that sold caskets as part of its funeral service.    In

finding that the caskets were merchandise for purposes of section

471, the Court of Appeals for the First Circuit noted that the

taxpayer normally kept an inventory of some 35 caskets, that the

caskets were not necessarily used during the year but were

purchased and occasionally carried for long periods of time, that

the caskets were on display and played a central role in the

"sale" of the taxpayer's service, and that there was a direct

relationship between the magnificence of the caskets and the cost

of the service.   See id.

     Those factors are not present here.   Petitioner kept no more

than a 2-week supply of chemotherapy drugs on hand and used

virtually all the drugs during the taxable year.   The drugs also

were not displayed to patients for selection, and patients played

no role in determining the type or amount of drugs used on them.

Furthermore, unlike the taxpayer’s business in Wilkinson-Beane,

Inc., the type of chemotherapy drugs or the "magnificence"

thereof played no role in whether patients chose to purchase

petitioner's services.   The variable factor in the cost of a

patient's treatment is a factor out of the patient's control;

i.e., the type and severity of the patient's condition.   We also

find it critical that a person is unable to obtain the
                              - 20 -


chemotherapy drugs without purchasing petitioner's service.    We

find nothing in the case of Wilkinson-Beane, Inc. that would

cause us to believe that the taxpayer's services there depended

on the purchase of caskets from it.    Instead, the taxpayer in

Wilkinson-Beane, Inc., by choice, sold the funeral services and

caskets as a package.

     Respondent also relies on Knight-Ridder Newspapers, Inc. v.

United States, 743 F.2d 781 (11th Cir. 1984).    There, the Court

of Appeals for the Eleventh Circuit considered whether the

taxpayer, who produced and sold newspapers, was required to keep

inventories.   The taxpayer argued that it was a service business

in that it provided information for its readership and

advertisement for its clients.   The court found that even though

the taxpayer sold an extremely perishable commodity (a 2-day-old

newspaper is stale) and had no inventory of finished goods, the

taxpayer was required to account for inventories because the

newspapers were merchandise and there was a significant

fluctuation of newsprint and ink on hand.

     The facts of Knight-Ridder Newspapers, Inc. v. United

States, supra, are materially distinguishable from the facts at

hand.   In contrast to the instant case, the taxpayer in Knight-

Ridder, Inc. clearly manufactured a product (newspapers) and used

raw materials (paper and ink) in the manufacturing process.    We,

like the Court of Appeals for the Eleventh Circuit, find
                              - 21 -


unconvincing the taxpayer's argument that the readership was

purchasing a service.

     We also find the facts herein to be markedly different from

the facts presented in the various cases on this issue involving

contractors and subcontractors.   In all of those cases where we

found the taxpayer was selling merchandise, the contractor's

services involved installation of products and the customers came

to the contractors to purchase the products as well as the

installation services.   See, e.g., Thompson Elec., Inc. v.

Commissioner, T.C. Memo. 1995-292 (taxpayer was selling

merchandise in connection with a service when he installed

wiring, conduits, electrical panels, and lighting fixtures); J.P.

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

(contractor's roofing materials were merchandise); Surtronics,

Inc. v. Commissioner, T.C. Memo. 1985-277 (electroplating metals

were merchandise).   The customers of the taxpayers also could

have personally purchased the merchandise elsewhere and either

installed the merchandise themselves, if they had the time and

expertise to do so, or contracted with a third party to install

the merchandise for them.   In the instant case, by contrast,

persons seeking chemotherapy treatment may not buy the drugs

elsewhere, and they may not apply the drugs themselves.

     Respondent unduly focuses on the fact that petitioner listed

on the bills submitted to Medicare and private insurers the type
                               - 22 -


and amount of chemotherapy drugs used on its patients but did not

itemize the less expensive supplies.    While we agree with

respondent that the itemization of the drugs on the bills is a

fact properly considered, see, e.g., Thompson Elec., Inc. v.

Commissioner, supra, we disagree with respondent that it is

dispositive of the issue.    The substance of the transactions at

issue is that a service is provided by and purchased from

petitioner.   Petitioner and other health care providers today

must operate under a myriad of statutory, regulatory, and

contractual mandates the purpose of which is aimed at management

of care and cost containment in the health care industry.      See,

e.g., 42 U.S.C. secs. 1395 through 1395ccc (1994); 42 C.F.R.

secs. 405.201 through 405.2470 (1998); Health Care Finance

Administration, Medicare Provider Reimbursement Manual (Pubs. 15-

1 and 15-2) (Rev. 3-93).    Undoubtedly, as the costs of medical

supplies increase, so do the regulatory and contractual

directives for itemization and justification.    There is no

evidence petitioner provided those itemizations for merchantable

purposes or because it was selling merchandise.    Rather, the

manner and form in which petitioner prepares its bills are

dictated by applicable laws, contracts with private insurers, and

the environment of the industry in which it operates.    We decline

to attach further accounting or other significance thereto.
                              - 23 -


     Our declining to attach accounting significance to the bills

is supported by Federal Medicare statutes and regulations.     As

stipulated by the parties, the chemotherapy treatments and drugs

at issue are covered by Medicare.   Medicare covers only medical

"services" and does not cover prescription drugs that can be

self-administered.   See 42 C.F.R. sec. 410.29 (1998).5   In

creating legislative coverage for medical services, Congress was

astutely aware that health care providers may need to use

supplies or administer drugs incident to and as an integral part

of their services.   As pertinent, the Health Insurance for Aged

Act, Pub. L. 89-97, sec. 1861, 79 Stat. 291, 321 (1965), 42

U.S.C. sec. 1395x(s) (1994), provides as follows:

          The term "medical and other health services" means
     any of the following items or services:

          (1) physicians' services;

          (2)(A) services and supplies (including drugs
          and biologicals which cannot, as determined
          in accordance with regulations, be self-
          administered) furnished as an incident to a
          physician's professional service, of kinds
          which are commonly furnished in physicians'
          offices and are commonly either rendered
          without charge or included in the physicians'
          bills.

     5
       This is true for the fee-for-service statutory coverage
under Medicare. The Secretary of Health and Human Services may
contract with private insurers (health maintenance organizations)
to provide benefits to beneficiaries under Medicare. See Health
Insurance for Aged Act, Pub. L. 89-97, 79 Stat. 291 (1965), 42
U.S.C. sec. 1395mm (1994). The beneficiaries that opt for
coverage under a health maintenance organization plan may have
prescription drug coverage under their contract with the insurer.
                               - 24 -


The chemotherapy treatments administered by petitioner, including

the chemotherapy drugs, are considered part of the medical

service under Medicare and are within the scope of Medicare's

coverage.   Congress explicitly provided that charging for the

drugs on the bill does not change the nature of the transaction

from the provision of a covered "service" to the sale of

noncovered prescription drugs.    See 42 U.S.C. sec. 1395x(s)

(1994); see also 42 C.F.R. secs. 410.10, 410.26, 410.27 (1998).

     Respondent is also unduly impressed by the fact that

petitioner's physicians do not administer the treatments and are

generally not present when treatments are administered by

oncology nurses.   This is irrelevant to the inquiry of whether

petitioner is selling a service or a service and merchandise, and

we place no significance on it.    We disagree with respondent's

likening the facts herein to "prescription drugs in a drug store

-- drugs which are clearly merchandise requiring the use of

inventories."   When a drug store sells drugs, there is little if

any specialized and personalized service element attendant to the

sale.   Respondent's analogy is flawed.

     Respondent argues the chemotherapy drugs comprised 26

percent of petitioner's gross receipts, that the drugs are billed

to responsible parties at 1.5 times the AWP, and that the cost of

the chemotherapy drugs was dramatically higher than the cost of

other supplies.    These factors go to whether the sale of the
                               - 25 -


"merchandise" is an income-producing factor.   Without addressing

the merits of these arguments, we do not interpret section

1.471-1, Income Tax Regs., to require that if a material is an

income-producing factor it must, per se, be “merchandise”.    The

section provides that “inventories * * * are necessary in every

case in which the production, purchase, or sale of merchandise is

an income-producing factor”.   See sec. 1.471-1, Income Tax Regs.

Because we conclude that the chemotherapy drugs used in the

administration of the chemotherapy treatments are not

merchandise, we need not and do not reach the question of whether

merchandise is an income-producing factor in petitioner’s

business.

     As mentioned above, our conclusion parallels our holding in

Hospital Corp. of Am. v. Commissioner, 107 T.C. 116 (1996), where

the hospital's professional staff frequently used pharmaceuticals

and medical supplies to provide medical care to patients.

Respondent argued in that case that the income attributable to

the pharmaceuticals and supplies could not be reported using the

nonaccrual-experience method of section 448(d)(5) because the

income was attributable to the sale of “goods”.   Id. at 141.

Under that method, an accrual method taxpayer need not accrue

amounts to be received for the performance of services that, on

the basis of experience, will not be collected.   See sec.

448(d)(5).   The nonaccrual-experience method may not be used to
                               - 26 -


the extent amounts are attributable to a "taxpayer's activities

with respect to * * * selling goods".    Sec. 1.448-2T(d),

Temporary Income Tax Regs., 52 Fed. Reg. 22775 (June 16, 1987).

       We held in HCA that the taxpayer's income attributable to

the pharmaceuticals and medical supplies was service income

because it was "inseparably connected" to the performance of

services.    Hospital Corp. of Am. v. Commissioner, 107 T.C. at

143.    Consistent with that holding, the income that petitioner

earned here from its use of the chemotherapy drugs must also be

considered service income.    Service income, by definition, does

not include income from the sale of goods.    See, e.g., sec.

1.448-2T(d), Temporary Income Tax Regs., 52 Fed. Reg. 22775 (June

16, 1987).    The logical conclusion is that the underlying items

giving rise to service income also are not "merchandise".      As we

discussed above, the meaning of the word “merchandise” is no

broader than the meaning of the word "goods", and, if anything,

the word “merchandise” is a subset of the word “goods”.      As a

matter of fact, not even respondent has argued that an item can

be “merchandise” for one purpose of the Code but not a “good” for

a different purpose.    Nor has respondent argued that an item the

income from which may be reported on the nonaccrual-experience

method may be inventory for purposes of section 471.

       The notice of deficiency is worded broadly as to the

specific basis for respondent's determination that the cash
                              - 27 -


method does not clearly reflect petitioner’s income.    On brief,

however, respondent’s argument as to why petitioner's use of the

cash method does not clearly reflect income articulates that the

chemotherapy drugs are merchandise that must be inventoried.

Respondent does not dispute that petitioner's use of the cash

method clearly reflects income to the extent that the

chemotherapy drugs are not merchandise.   We need not and do not

engage in further analysis of the clear reflection of income

standard of section 446.6   See Concord Consumers Housing v.

Commissioner, 89 T.C. 105, 106 n.3 (1987); Estate of Fusz v.

Commissioner, 46 T.C. 214, 215 n.2 (1966).   Based on the

foregoing, we hold that respondent abused his discretion in

requiring petitioner to use the hybrid method and that petitioner

may report all its income and expenses under the cash method.

     We have considered all arguments in this case for a contrary

holding and, to the extent not discussed above, find those

     6
       We are mindful of Asphalt Prods. Co. v. Commissioner, 796
F.2d 843 (6th Cir. 1986), affg. in part and revg. in part Akers
v. Commissioner, T.C. Memo. 1984-208, revd. on another issue 482
U.S. 117 (1987), wherein the Court of Appeals for the Sixth
Circuit held that the taxpayer’s method of accounting did not
clearly reflect its income. The setting of Asphalt Prods. Co. is
distinguishable from the setting at hand. The issue there was
not the issue before us today; i.e., whether the furnishing of
pharmaceuticals by a medical treatment facility as an integral,
indispensable, and inseparable part of the rendering of medical
services is the sale of "merchandise" for purposes of section
1.471-1, Income Tax Regs. That case also involved primarily a
significant accumulation of accounts receivable at yearend and
neither involved nor addressed whether the disputed items of
inventory (asphalt) were merchandise in the first place.
                             - 28 -

arguments to be without merit or irrelevant.   To reflect the

foregoing,

                                        Decision will be entered

                                   for petitioner.



Reviewed by the Court.

     CHABOT, PARR, WELLS, COLVIN, BEGHE, FOLEY, VASQUEZ, GALE,
and THORNTON, JJ., agree with this majority opinion.

     MARVEL, J., concurs in the result only.

     RUWE, J., dissents.
                              - 29 -

     PARR, J., concurring:   I agree with the majority's opinion,

and write separately merely to emphasize that each case that

comes before this Court presents a unique set of facts and is

decided on its own merits.   Although we now find that the facts

of this case are "markedly different" from the facts of some of

the cases we have decided involving construction contractors, I

believe that the principles enunciated here also apply to

construction cases.   This is true, for example, when a building

material is indispensable and inseparable from the service

provided by the construction contractor.   See, e.g., Galedrige

Constr., Inc. v. Commissioner, T.C. Memo. 1997-240.

     BEGHE, J., agrees with this concurring opinion.
                              - 30 -

     BEGHE, J., concurring:   I write separately to tie up or at

least pick at a loose end left by respondent’s determination and

arguments:   the proper tax treatment of the slightly more than 2-

week supply of chemotherapy drugs costing $31,887 on hand at the

end of the taxable year.1

     Respondent, having tried to put petitioner on the accrual

method with respect to “sales” of chemotherapy drugs, determined

that petitioner’s income should be increased not only by the cost

of such drugs on hand at yearend in the amount of $31,887, but

also by $148,557, the value of petitioner’s accounts receivable

relating to such drugs transmitted to patients during the year.

Rejecting respondent’s “sales” characterization in favor of

treating petitioner’s operations as an overall service business,

we have thereby rejected respondent’s determination putting

petitioner on a hybrid method that would require accrual of its

yearend receivables with respect to transmissions of such drugs.

     Respondent did not assert or argue, as an alternative fall-

back position, that petitioner’s deduction of the cost of drugs

on hand at yearend should be deferred to the following year.   The

Court need not sua sponte make that adjustment, particularly

where the proper result in this case is not clear, in part

because respondent did not make a stand-alone clear-reflection-



     1
       $772,522 ÷ 26 = $29,712.384 (average cost of 2-week
supply) ‹ $31,877 (actual on hand).
                              - 31 -

of-income determination (or even argument) with respect to such

drugs.   But, because other cases under submission to the Court

present similar or analogous issues, and because the issue seems

to be a recurring one, a premonitory attempt to tidy up may not

be amiss.

     The relevant authority is section 1.162-3, Income Tax Regs.,

“Cost of materials”, which provides as follows:

          Taxpayers carrying materials and supplies on hand
     should include in expenses the charges for materials
     and supplies only in the amount that they are actually
     consumed and used in operation during the taxable year
     for which the return is made, provided that the costs
     of such materials and supplies have not been deducted
     in determining the net income or loss or taxable income
     for any previous year. If a taxpayer carries
     incidental materials or supplies on hand for which no
     record of consumption is kept or of which physical
     inventories at the beginning and end of the year are
     not taken, it will be permissible for the taxpayer to
     include in his expenses and to deduct from gross income
     the total cost of such supplies and materials as were
     purchased during the taxable year for which the return
     is made, provided the taxable income is clearly
     reflected by this method.

     The accounting authorities are in accord:    This regulation

means that “Supplies in and of themselves are not considered

inventory and, thus, will not cause the taxpayer to be required

to use accrual accounting,” Bauernfeind, Income Taxation

Accounting Methods and Periods 3-4 (1991), “supplies are deferred

expenses under Reg. § 1.162-3 and not inventory under § 471”, id.

3-14, n. 61, and “when the taxpayer’s inventories are of supplies

only, use of the cash method is permitted.   These items are not
                                - 32 -

inventories under section 471.    They are not held for sale in the

ordinary course of business.”    Gertzman, Federal Tax Accounting

3-55 (2d ed. 1993) (Gertzman).

     The regulation says that materials and supplies cannot be

currently expensed unless four tests are met:   (1) They are

“incidental”; (2) no record of consumption is kept; (3) no

physical inventories are taken at the beginning and end of the

year; and (4) income is clearly reflected.   Petitioner in this

case would appear to flunk the first three tests: (1)

Chemotherapy drugs transmitted to patients in the course of

petitioner’s rendering of medical services are a substantial

portion of petitioner’s gross receipts and are a material income

producing factor, as evidenced by the markups shown in

petitioner’s billing records; and (2) and (3) records of

consumption and of supplies on hand at yearend are kept; indeed

such records seem to be required by Medicare.   However, as to

(4), respondent has not made a stand-alone clear-reflection-of-

income determination, having chosen to rely solely on the

presence of merchandise requiring inventories as compelling

automatic adoption of the accrual method of accounting, the

position that we have rejected.

     In other cases of service providers, such as small

contractors in the construction industry, an adjustment treating

yearend supplies as deferred expense might very well be
                              - 33 -

appropriate, provided that respondent makes the necessary

determinations.   Compare J.P. Sheahan Associates, Inc. v.

Commissioner, T.C. Memo. 1992-239, with Thompson Elec., Inc. v.

Commissioner, T.C. Memo. 1995-292, which present different

findings of fact regarding yearend materials and supplies.

     As Gertzman states at 6-30:

          The rationale behind this provision [the sec. 162-
     3 regulation] seems clear. Many taxpayers do not
     maintain financial accounting records of consumption
     and do not take physical inventories of the supplies on
     hand at the beginning and end of the year for business
     purposes. In these cases, it would be inconsistent
     with the book conformity requirement of Section 446(a),
     impractical, and unduly burdensome to require that they
     undertake such record-keeping responsibilities or make
     such physical counts solely for tax purposes. However,
     to protect the Treasury against taxpayers who might
     avoid undertaking these activities solely for the
     purpose of obtaining a tax benefit, two protections are
     afforded. First, the supplies must be incidental and,
     second, the taxable income so computed must be
     reflected clearly * * * [citation omitted.]

     The regulation appears to be not much more than an

illustration of the rule that expenditures that result in assets

having a life beyond the end of the year must be capitalized.

See sec. 263; INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992).

Without attempting to predict the outcome of a hypothetical, see

Gulf Oil Corp. v. Commissioner, 89 T.C. 1010, 1044 (1987)

(Chabot, J., concurring), affd. on other grounds 914 F.2d 396 (3d

Cir. 1990), it suffices to note that the section 162 regulation

authorizes the Commissioner in appropriate cases to treat

supplies on hand at yearend as deferred expenses.
                                - 34 -

     HALPERN, J., dissenting:

I.   Introduction

      Respondent determined a deficiency in petitioner’s 1995

Federal income tax liability.    That deficiency resulted from

respondent’s rejection of the cash receipts and disbursements

method of accounting (the cash method) used by petitioner to

compute taxable income and his recomputation of petitioner’s 1995

taxable income under a hybrid method of accounting.    Under that

method (the hybrid method), petitioner was required to use an

accrual method to account for purchases and sales of merchandise.

Respondent recomputed petitioner’s taxable income pursuant to his

authority to require a taxpayer to use a method of accounting

that clearly reflects income, if the method used by the taxpayer

does not clearly reflect income.    See sec. 446(b).

      Whether a particular method of accounting clearly reflects

income is a question of fact, and the issue must be decided on a

case-by-case basis.   See, e.g., Hamilton Indus., Inc. v.

Commissioner, 97 T.C. 120, 128-129 (1991).    Generally, where

respondent has determined that a taxpayer’s method of accounting

does not clearly reflect income, the taxpayer must demonstrate

either that his method of accounting clearly reflects income or

that respondent’s method does not clearly reflect income.    See

Asphalt Prods. Co. v. Commissioner, 796 F.2d 843, 847 (6th Cir.

1986), affg. in part and revg. in part T.C. Memo. 1984-208.
                               - 35 -

     Petitioner has demonstrated neither that the cash method

clearly reflected its income nor that the hybrid method does not.

Petitioner has demonstrated to the majority’s satisfaction,

however, that its business is a service business.   The majority

holds:   “Service income, by definition, does not include income

from the sale of goods.”   Majority op. p. 26.   Therefore, reasons

the majority, petitioner is not engaged in the sale of

merchandise (a word that the majority equates with the word

“goods”).   Id.   Since petitioner is not engaged in the sale of

merchandise, the majority concludes that respondent may not

require petitioner to use “an inventory method of accounting”.

Majority op. p. 11; see sec. 1.471-1, Income Tax Regs.   Finally,

limiting its consideration to the incompatibility of the cash

method with an inventory method of accounting, see sec. 1.446-

1(c)(2)(i), Income Tax Regs., the majority finds that respondent

abused his discretion in requiring petitioner to use the hybrid

method and that petitioner may continue to report all of its

income and expenses under the cash method.

     I dissent from the conclusion that petitioner is not engaged

in the sale of merchandise.   I also wish to caution against undue

reliance on the majority’s conclusion that respondent abused his

discretion in requiring petitioner to use the hybrid method.    As

will be explained, by his answer to the petition, respondent has

limited the issues before the Court.
                                - 36 -

II.   Facts

      The majority has set forth many of the facts stipulated by

the parties, and, for the most part, I shall not repeat those

facts.   The following facts relate to petitioner’s return,

respondent’s determination of a deficiency, and the pleadings in

this case.

      On its Form 1120, U.S. Corporation Income Tax Return, for

1995, petitioner reported gross receipts of $2,938,726, no amount

of cost of goods sold, and a gross profit equal to its gross

receipts.     Among other items, petitioner deducted $772,522 for

“medical supplies” (chemotherapy drugs), $600,328 for

compensation paid to its three physician-shareholder-officers

(officer compensation), and other salaries and wages of $630,381.

Petitioner’s deduction for chemotherapy drugs equaled 26 percent

of its reported gross receipts and gross profits and 129 percent

of its officer compensation.

      For 1995, under the hybrid method, respondent disallowed the

deduction for chemotherapy drugs claimed by petitioner and

required petitioner to recompute its gross profit by subtracting

from gross receipts (determined under an accrual method) the cost

of the chemotherapy drugs “conveyed” (sold) by petitioner during

that year.     The net adjustment to petitioner’s 1995 taxable

income (the net adjustment) was an increase of $180,344,

resulting from (1) an increase of $148,557 in gross receipts to
                               - 37 -

reflect accounts receivable with respect to chemotherapy drugs

and (2) an increase in closing inventory for the actual cost,

$31,887, of such drugs on hand at the end of 1995.

       In respondent’s notice of deficiency in tax (the notice),

respondent explains the net adjustment as follows:

            It is determined that since the cash basis of
       accounting does not clearly reflect income as required
       by the Internal Revenue Code section 446(b), the
       Government is changing the taxpayer’s method of
       accounting from the overall cash receipts and
       disbursements method of accounting to a hybrid method
       by which purchases and sales of merchandise are
       accounted for on the accrual method of accounting, with
       maintenance of inventories.

       In the petition, petitioner avers, among other things, that

it is a qualified personal service corporation within the meaning

of section 448(d)(2), “thus allowing it the use of the cash

method of accounting.”    See sec. 448(a) and (b).   In the answer,

respondent denies petitioner’s averment that it is allowed to use

the cash method and “[a]lleges that the petitioner is required to

maintain inventories and, therefore, is required to use the

accrual method for the purchase and sale of inventories.”

III.    Pertinent Provisions of the Code and Regulations

       Gross income is defined in section 61(a), which includes, as

an item of gross income, “[g]ross income derived from business”.

Sec. 61(a)(2).    In pertinent part, section 1.61-3(a), Income Tax

Regs., provides:    “In a manufacturing, merchandising, or mining

business, ‘gross income’ means the total sales, less the cost of
                              - 38 -

goods sold, plus any income from investments and from incidental

or outside operations or sources.”     The regulations thus

recognize that a necessary step in the calculation of the gross

income from sales (at least in a manufacturing, merchandising, or

mining business) is a determination of the cost of goods sold.

That recognition implies the use of inventories, to determine the

cost of goods sold.1   Section 1.162-1(a), Income Tax Regs.,

confirms the role that inventories play in the determination of

     1
        The determination of cost of goods sold and gross income
from sales for a manufacturer involves the use of inventories
pursuant to the basic accounting equation described below:

     Beginning inventory                        $    XXX
     Purchases of inventory                          XXX
     Production costs incurred                       XXX

     Total cost of goods
      available for sale                             XXX
     Less: Ending inventory                          XXX
     Cost of goods sold                         $    XXX

     Gross receipts from sales                  $    XXX
     Less: Cost of goods sold                        XXX
     Gross income from sales (sec. 61)          $    XXX

     It can be seen from the foregoing equation that the amount
of a taxpayer’s ending inventory and cost of goods sold both have
a very direct effect on the amount of the taxpayer’s gross income
from sales; however, those effects are exerted in opposite
directions. All other things being constant, as a taxpayer’s
ending inventory increases in amount, its cost of goods sold
decreases, and its gross income from sales increases. In
contrast, as a taxpayer’s ending inventory decreases in amount,
its cost of goods sold increases, and its gross income from sales
decreases. The foregoing equation and comment appear in
Schneider, Federal Income Taxation of Inventories, sec. 1.01,
pp. 1:4-1:5 (1999).
                               - 39 -

gross income from sales:    “The cost of goods purchased for

resale, with proper adjustment for opening and closing

inventories, is deducted from gross sales in computing gross

income.”

     Section 446(a) provides the general rule for methods of

accounting:    “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.”    In pertinent part,

section 446(b) provides:    “[I]f 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.”

     Section 471(a) is specific with respect to the use of

inventories:

          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.

The Secretary has exercised the discretion conferred upon him by

Congress in section 471 by requiring, pursuant to regulations,

that, “[i]n 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
                                - 40 -

sale of merchandise is an income-producing factor.”    Sec. 1.471-

1, Income Tax Regs.

     The determination that a taxpayer must maintain inventories

has two important consequences for the computation of the

taxpayer’s taxable income.   First, to the extent that costs

incurred by the taxpayer are reflected in items of inventory

that, at the end of the taxpayer’s taxable year, remain unsold,

such costs will not contribute to the cost of goods sold for that

year and, thus, will result in a correspondingly higher gross

income from sales for the year.2    Second, if a taxpayer is

required to use inventories, then, to reflect its income clearly,

it must use an accrual method of accounting with respect to

purchases and sales of inventory items.    See sec. 1.446-

1(c)(2)(i), Income Tax Regs.3    The rationale behind this accrual

requirement is explained in Knight-Ridder Newspapers, Inc. v.

United States, 743 F.2d 781, 789 (11th Cir. 1984) (“According to

accounting wisdom, the income realized from the sale of




     2
        But cf. sec. 1.471-4, Income Tax Regs. (“Inventories at
cost or market, whichever is lower.”)
     3
        The taking of inventories does not of itself represent a
separate and distinct method of accounting. As Professor
Chirelstein states: “Rather, it is a component of the over-all
accounting procedure whose essential purpose is to establish the
cost of goods sold as a step towards determination of the
taxpayer’s gross income from business operations.” Chirelstein,
Federal Income Taxation, A Law Student’s Guide to the Leading
Cases and Concepts, par. 12.03 at 269 (8th ed. rev. 1999).
                              - 41 -

merchandise is most clearly measured by matching the cost of that

merchandise with the revenue derived from its sale.”)

     Even if a taxpayer need not maintain inventories, the

recovery of costs associated with the production of income may

not be governed by the taxpayer’s method of accounting.   That

treatment is well known with respect to the recovery of certain

capital expenditures by way of the deduction for depreciation.

See sec. 167(a); sec. 1.446-1(a)(4)(ii), Income Tax Regs.

(“Expenditures made during the year shall be properly classified

as between capital and expense.”)   More pertinent to our case is

section 1.162-3, Income Tax Regs., which addresses the cost of

materials and supplies (without distinction, supplies) that do

not constitute inventory.   Unless the purchase of such supplies

constitutes a capital expenditure, section 1.162-3, Income Tax

Regs., provides:

          Taxpayers carrying materials and supplies on hand
     should include in expenses the charges for materials
     and supplies only in the amount that they are actually
     consumed and used in operation during the taxable year
     for which the return is made, provided that the costs
     of such materials and supplies have not been deducted
     in determining the net income or loss or taxable income
     for any previous year. If a taxpayer carries
     incidental materials or supplies on hand, for which no
     record of consumption is kept or of which physical
     inventories at the beginning and end of the year are
     not taken, it will be permissible for the taxpayer to
     include in his expenses and to deduct from gross income
     the total cost of such supplies and materials as were
     purchased during the taxable year for which the return
     is made, provided the taxable income is clearly
     reflected by this method.
                                - 42 -

Section 1.162-3, Income Tax Regs., provides for the deferred

expense treatment of nonincidental supplies without regard to the

taxpayer’s overall method of accounting.

IV.   Discussion

      A.   Purchases and Sales of Inventory

            1.   Respondent’s Pleading

      Petitioner expended $772,522 for chemotherapy drugs during

1995 and treated that expenditure as an expenditure for

incidental supplies.    That was plain error under section 1.162-3,

Income Tax Regs.    See concurring opinion of Judge Beghe at 32.

Respondent treated the expenditure as if it constituted the cost

of goods purchased for resale.    On the facts of this case, in

terms of accounting for the cost of the chemotherapy drugs, it

makes no difference whether the $772,522 expended for

chemotherapy drugs is treated as the cost of goods held for

resale or as a deferred expense.4

      The only issue open to debate is whether respondent can

compel petitioner to account for amounts billed to Medicare (and

to patients) under an accrual method.    Although section 1.446-

1(c)(2)(ii), Income Tax Regs., leaves no doubt that the Secretary

can so compel petitioner if purchases and sales of inventory are

involved, nothing in section 446(b) prohibits the Secretary from



      4
        The notice of deficiency shows a $0.00 sec. 481
adjustment.
                               - 43 -

so compelling petitioner if purchases and sales of inventory are

not involved.   Section 446(c) specifically permits a taxpayer to

compute taxable income under the cash method; nevertheless, that

permission is made subject to the Secretary’s section 446(b)

authority to reject the taxpayer’s method of accounting.      See

sec. 446(c).    By the pleadings, however, the parties have limited

what petitioner must prove to stay on the cash method.

     Above, in section II., I have set forth both respondent’s

explanation of the net adjustment and his allegation, in response

to petitioner’s averment that it is entitled to use the cash

method, that “petitioner is required to maintain inventories and,

therefore, is required to use the accrual method for the purchase

and sale of inventories.”    (Emphasis added.)   Correctly, the

majority thinks that a fair reading of the issue for trial in

this case, as framed by the pleadings, is whether petitioner is

required to maintain inventories.    I agree with the limited scope

of the majority’s inquiry, in this case.    I do not agree,

however, that petitioner need not use inventories.

          2.    Inventories Are Required

     As set forth in section III., supra, regulations provide:

(1) Inventories are necessary in every case in which the sale of

merchandise is an income-producing factor, and (2) with limited

exceptions, in any case in which it is necessary to use an

inventory, an accrual method must be used with regard to purchase
                               - 44 -

and sales.   See secs. 1.446-1(c)(2), 1.471-1, Income Tax Regs.

Thus, generally, if the purchase and sale of merchandise is an

income-producing factor, an accrual method must be used with

regard to such purchases and sales.

      The nominal focus of the majority’s inquiry is whether the

chemotherapy drugs are merchandise:      “We focus our inquiry on

whether the chemotherapy drugs were supplies deductible under

section 162, or merchandise that must be inventoried under

section 471.”   Majority op. p. 10.     The majority states:

“Respondent’s characterization of the chemotherapy drugs as

merchandise offends the natural and ordinary meaning of the term

‘merchandise’”.   Id. at 17.   The majority concedes, however:

“Although pharmaceuticals could reasonably be construed to be

merchandise in some contexts; * * * it does not necessarily

follow that pharmaceuticals are merchandise in all contexts.”

Id.   The majority reaches the conclusion that the chemotherapy

drugs are not merchandise on the basis that petitioner “is not a

merchandiser”, id. at 15, its business “is inherently a service

business”, id. at 16, or “[s]imply put, petitioner is not

peddling products.”   Id. at 18.      The majority’s conclusions seem

to be informed by its view:    “A medical practice such as

petitioner’s is inherently a service business, and the drugs

administered in the practice are subordinate to the provision of

the medical services.”   Id. at 16.
                                - 45 -

            3.   Conclusion of Law

       The majority’s conclusion that the chemotherapy drugs are

not merchandise is not a finding of fact.     The majority’s

conclusion that the chemotherapy drugs are not merchandise

appears to rely on a number of propositions that, when taken

together, amount to a rule of law (i.e., a rule of general

application).    The majority’s view that a medical practice such

as petitioner’s is inherently a service business is dependent on

a number of factors (some of which are conclusory):     “the

uniqueness of the industry in which petitioner operates”, the

fact that petitioner’s business is a “quintessential service

business”, the “inseparable connection” of the chemotherapy drugs

to the performance of services, and, finally “[s]ervice income,

by definition, does not include income from the sale of goods”.

From those factors, the majority composes the following rule of

law:    Doctors (medical and osteopathic) are not in trade.    The

dictionary gives as one definition of trade:     “the business of

buying and selling commodities; commerce.”     The American Heritage

Dictionary of the English Language 1897 (3d ed. 1992).     The

majority believes that doctors are not in trade because they are

members of a learned profession, whose stock in trade is

knowledge, not goods or merchandise.     See majority op. p. 16.

       The majority relies on Abbott Labs. v. Portland Retail

Druggists Association, Inc., 425 U.S. 1 (1976), to support its
                               - 46 -

conviction that doctors are not in trade (i.e., are not

merchants).   Abbott Labs., however, is an antitrust case, in

which the Supreme Court addressed purchases by nonprofit

hospitals of pharmaceutical products at favored prices from the

manufacturers of those products.    The issue was the proper

construction of the phrase “purchases of their supplies for their

own use,” as it appears in 52 Stat. 446, 15 U.S.C. sec. 13c

(1994) (referred to by the Supreme Court as the “Nonprofit

Institutions Act”).    The precise question was whether the

nonprofit hospitals’ purchases in question were exempt from the

proscription of the Robinson-Patman Antidiscrimination Act, ch.

592, 49 Stat. 1526 (1936), 15 U.S.C. secs. 13, 13a, 13b, and 21a

(1994) because they were for the hospitals’ own use, within the

meaning of the Nonprofit Institutions Act.    Abbott Labs. v.

Portland Retail Druggists Association, Inc., supra at 4.       The

majority states:    “The exemption generally applies where the

nonprofit institution is purchasing the drugs for its ‘own use’

as opposed to for sale to patients.”    Majority op. p. 16

(emphasis added).    Apparently, since, in Abbott Labs., the

Supreme Court found that at least some of the drugs in question

were purchased by the hospitals for their own use (within the

meaning of 15 U.S.C. sec. 13c), the majority concludes that those

drugs were not purchased for resale (which, I assume, leads to

the conclusion that doctors, like the hospitals, are not
                               - 47 -

merchants).    The majority mischaracterizes a provision of the

Nonprofit Institutions Act, 15 U.S.C. sec. 13(c) (1994).    That

provision provides as follows:    “Nothing in the * * * Robinson-

Patman Antidiscrimination Act, shall apply to purchases of their

supplies for their own use by schools, colleges, universities,

public libraries, churches, hospitals, and charitable

institutions not operated for profit.”    The provision does not

establish a dichotomy between use and sale, as suggested by the

majority.5    See, e.g., De Modena v. Kaiser Found. Health Plan,

Inc., 743 F.2d 1388, 1393 (9th Cir. 1983) (referring to Abbott



     5
        In Abbott Labs. v. Portland Retail Druggists Association,
Inc., 425 U.S. 1 (1976), each of the hospitals in question
operated a pharmacy, which was a separate department of the
hospital, and whose operations produced revenue in excess of
cost. The pharmacies dispensed the pharmaceutical products in
question. The Supreme Court used the terms “sales” and
“dispensations” with reference to those products, and without any
clear distinction between the two terms. The Supreme Court
categorized the following dispensations as for the hospitals’
“own use”:

     1. To the inpatient, or to the emergency facility patient,
upon his discharge and for his personal use away from the
premises.

     2. To the outpatient for personal use away from the
premises.

     3. To the hospital’s physicians, employees, or students,
for their personal use or for the use of their dependents.

     Clearly the third category, if not all three, constitutes
sales of merchandise by the pharmacies, notwithstanding that such
merchandise was acquired for the hospitals’ own use. Nothing in
the opinion indicates that the pharmacies failed to inventory
their pharmaceuticals.
                               - 48 -

Labs. v. Portland Retail Druggists Association, Inc., 425 U.S. 1

(1976), and holding:   “[D]rugs purchased by an HMO * * * for

resale to its members are purchased for the HMO’s ‘own use’

within the meaning of the Nonprofit Institutions Act and thus

qualify for protection under the Act.”).    Abbott Labs. is no

support for the proposition that, as a matter of law, petitioner

is not selling merchandise.

     The majority also cites St. Luke’s Hosp., Inc. v.

Commissioner, 35 T.C. 236, 238 (1960), for the proposition that

petitioner is not selling merchandise when it administers

chemotherapy drugs.    The principal issue in St. Luke’s Hosp.,

Inc. was whether the taxpayer, having requested and received

permission from the Commissioner to change from an accrual method

to the cash method of accounting for 1953 and thereafter,

properly reported income on the cash method when it continued to

employ primarily an accrual method in keeping its books and

records.   We concluded that it did properly report income on the

cash method since, notwithstanding the taxpayer’s retention of an

accrual method, its cash-basis income could readily be

ascertained from its books and records.    Our findings of fact

included the following:

     Petitioner owns and operates a hospital in Bluefield.
     Its business is the customary hospital service
     business. It is not a merchandising business, and
     petitioner has no merchandise inventories which would
     require the use of an accrual method in keeping its
     books or reporting its income. Its income is derived
                              - 49 -

     from providing hospital and professional care to the
     sick. [Id. at 238.]

Those are not statements of law but findings of fact.   The

findings that the Bluefield hospital is in the customary service

business of hospitals and has no merchandise is not necessarily

applicable to petitioner.   Petitioner is not a hospital, but runs

a chemotherapy clinic, where chemotherapy drugs constitute both a

significant cost and a substantial source of revenue.   There is

no finding as to how significant drugs and similar items were to

the overall cost of treatment at the Bluefield hospital.    In St.

Luke’s Hospital, Inc. v. Commissioner, supra, which dealt with

medicine as it was practiced over more than 40 years ago, the

Commissioner did not even suggest that inventories were required.6

It is no authority for any conclusion of law.

     Nor can the majority rely on any rule of law that service

providers need never use inventories:   “We have previously

examined service transactions in a variety of industries to

determine whether the transactions in substance involved solely

the sale of a service, or whether the transactions involved the

sale of both a service and merchandise.”   Majority op. p. 13.



     6
        In Abbott Labs. v. Portland Retail Druggists Association,
Inc., supra at 11, decided in 1976, the Supreme Court stated with
respect to nonprofit hospitals: “we recognize * * * that the
concept of the nonprofit hospital and its appropriate and
necessary activity has vastly changed and developed since the
enactment of the Nonprofit Institutions Act in 1938.” Needless
to say, much more has changed in the last 23 years.
                                 - 50 -

     Finally, the majority’s reliance on Hospital Corp. of Am. v.

Commissioner, 107 T.C. 116 (1996), to support its proposition

that petitioner’s income is attributable solely to services and

not to some combination of services and merchandise is puzzling.

In Hospital Corp. of Am., we did indeed find that, for purposes

of section 448(d)(5), the use of medical supplies is part of the

medical services furnished patients by the hospitals in question.

See id. at 144.   In the same breath, however, we found “the cost

of those supplies is an incidental cost of the health care

services provided by the hospitals.”      Id.   Given that finding,

the fact that Hospital Corp. of Am. involves a different section

of the statute, and our specific reservation in Hospital Corp. of

Am. that we were not deciding the question of whether the

furnishing of medical supplies by the hospitals as a part of the

rendering of services to their patients could be considered to be

a sale of inventory, I do not consider that case as persuasive

with respect to the issue before us today.

     The majority cannot escape an examination of the particular

facts of this case in light of the relevant provisions of law.

          4.   Finding of Fact

          We find the instant setting distinguishable from
     the setting of those cases in which we have held that
     goods utilized by a service provider were merchandise
     for purposes for the inventory rules. We give
     significance to the uniqueness of the industry in which
     petitioner operates in relation to the other service
     industries we have addressed on this issue and bear in
                              - 51 -

     mind the recent case of Hospital Corp. of Am. v.
     Commissioner, 107 T.C. 116, 143-145 (1996).* * *

Majority op. p. 14.

     What facts distinguish this case from those cases in which

we have held that goods utilized by a service provider were

merchandise for purposes of section 1.471-1, Income Tax Regs.?      I

agree with the majority’s observations that medicine is unique,

and that it is inherently a service business.   So what!   Contrary

to the majority’s impression, health care providers do sell

goods.   See, e.g., De Modena v. Kaiser Found. Health Plan, Inc.,

supra (drugs purchased by an HMO for resale to its members are

purchased for the HMO’s own use).   The relevant distinction is

between supplies, for which inventories need not be taken, and

merchandise held for sale (merchandise), for which inventories

must be taken.   Compare section 1.162-3, Income Tax Regs., with

section 1.471-1, Income Tax Regs.   I agree with the majority when

it states:   “The statute and regulations do not define the words

‘merchandise’ or ‘inventory’, nor do they clearly distinguish

between ‘inventory’ and ‘materials and supplies’ that are not

actually consumed and remain on hand.”   Majority op. p. 12.   As

previously discussed, supra section IV.A.1, it was plain error

for petitioner to treat the expenditure for the chemotherapy

drugs as an expenditure for incidental supplies, and, in terms of

properly accounting for that expenditure, it makes no difference

whether the expenditure is treated as being for merchandise or
                              - 52 -

for supplies.   The relevant difference is with respect to the

application of section 1.446-1(c)(2)(i), Income Tax Regs., which,

with an exception not here relevant, and taking into account

section 1.471-1, Income Tax Regs., requires an accrual method

with regard to purchases and sales of merchandise.     The majority

agrees that the distinction between supplies and merchandise does

not turn on the nature of the underlying commodity:

“pharmaceuticals could reasonably be construed to be merchandise

in some contexts”.   Majority op. p. 17.     In Wilkinson-Beane, Inc.

v. Commissioner, 420 F.2d 352, 354 (1st Cir. 1970), affg. T.C.

Memo. 1969-79, the Court of Appeals for the First Circuit

determined that the meaning of the term “merchandise”, as used in

section 1.471-1, Income Tax Regs., “must be gathered from the

context and the subject.”   The context and the subject are the

explicit requirement that a taxpayer’s method of accounting

clearly reflect income.   See sec. 446(b).    Income realized from

the sale of merchandise is most clearly measured by matching the

cost of that merchandise with the revenue derived from its sale.

Knight-Ridder Newspapers, Inc. v. United States, 743 F.2d at 789.

Given the lack of any clearly pertinent distinction between the

term “supplies” and the term “merchandise”, where the facts raise

some question (as they do here), we should inquire which

classification results in a clearer reflection of the taxpayer’s

income.
                               - 53 -

     The majority describes as seminal the opinion of the Court

of Appeals for the First Circuit in Wilkinson-Beane, Inc. v.

Commissioner, supra.    The taxpayer in Wilkinson-Beane, Inc. was

an undertaking establishment, which argued the primacy of the

services that it provided to its customers.   The Court of Appeals

affirmed the finding of the Tax Court that the taxpayer was

selling merchandise.   The Court of Appeals stated:

     We fully recognize that petitioner was in the business
     or providing valuable services. But we think it would
     be anomalous to hold that a taxpayer in a service
     business can have no merchandise even though he derives
     a substantial portion of his income from the regular
     purchase and sale of tangible personal property. We
     certainly have no basis for so restricting the
     application of the word 'merchandise’. * * * Since the
     caskets play a central role in the 'sale' of taxpayer's
     service, to use its term, we see no error in the
     determination that the caskets were merchandise.

Id. at 355.   The Court of Appeals’ inquiry into the centrality of

the property to the sale and the substantiality of the income

attributable to the property has been followed in subsequent

cases.   For example, in J.P. Sheahan Associates, Inc. v.

Commissioner, T.C. Memo. 1992-239, we determined whether roofing

materials constituted merchandise, and we looked to whether the

materials were shown separately on the customer’s bill, they

represented a substantial amount of the total bill, and they were

marked up.    In Thompson Elec., Inc. v. Commissioner, T.C. Memo.

1995-292, which involved an electrical contractor, we said:    “If

the cost of material a taxpayer uses to provide a service is
                             - 54 -

substantial compared to its receipts, the material is a

substantial income-producing factor even if the taxpayer does not

markup the prices charged to its customers for the material.”

What I distill from the Wilkinson-Beane, Inc. line of cases is

that, where the question is whether a provider of services is

using supplies or selling merchandise, the answer turns on

whether the commodity in question is a substantial and

identifiable source of revenue.   If so, and if the merchandise is

an income-producing factor, than such merchandise must be

inventoried and an accrual method is appropriate (and may be

required) to match costs and revenue.   On the facts before us, I

would require inventories because petitioner is selling

merchandise that is an income-producing factor.

     The majority’s finding that the chemotherapy drugs are

subordinate to the services rendered ignores the substantiality

and centrality of the income attributable to the chemotherapy

drugs and involves conclusions that have no basis in the record.

The only facts stipulated with respect to the medical aspects of

petitioner’s business are set forth in the margin.7   Petitioner is

     7
        When an individual first becomes a patient of petitioner,
one of petitioner’s physicians examines the patient in order to
determine the proper chemotherapy treatment for that patient.

     When a patient has been evaluated and a chemotherapy regime
has been prescribed, the patient begins regular, periodic
treatments.

                                                      (continued...)
                             - 55 -

a corporation, operating clinics and employing physicians,

nurses, nursing assistants, laboratory technicians,

administrative personnel, and office workers.   The parties have

not stipulated how individuals came to be petitioner’s patients.

Given petitioner’s apparent specialization, it is likely that

patients were referred for chemotherapy drug treatment.   Nothing

in the record establishes the majority’s findings that “patients

played no role in determining the type or amount of drugs used on

them”, majority op. p. 19, or that patients must “agree to

petitioner’s overall chemotherapy service, and, when they do

agree to this service, they have no say in the type or quantity


     7
      (...continued)
     Petitioner’s physicians prescribed the chemotherapy regime
but, with rare exception, did not actually administer the
chemotherapy drugs to patients during taxable year 1995 to
present.

     Chemotherapy drugs were administered by oncology nurses
during taxable year 1995.

     Prior to the initiation of each course of chemotherapy, the
patients were seen and evaluated by the attending physician.

     The patients were not examined at the time of every
chemotherapy administration pursuant to the standard practice of
medical oncology.

     Once a patient has begun a chemotherapy regime, that patient
will see one of petitioner’s physicians approximately every 4- to
6-weeks, between treatments.

     While a physician must be available to respond to
emergencies, a physician is not required to be in every room with
a patient while chemotherapy treatment is being administered.
                                - 56 -

of chemotherapy drugs which petitioner uses in their care.”

Majority op. p. 15.    Nor does anything in the record establish:

“Usually, they [patients] are not even aware of the type or

quantity of chemotherapy drugs used on them as part of their

treatment.”   Id.    Contrary to the inference in the majority’s

opinion, petitioner’s physician-employees do not choose or decide

that a patient shall receive chemotherapy drugs.     Common

experience tells us that, although petitioner’s physician-

employees may recommend such treatment, the patients are the ones

who must make the decision to receive the drugs.     Moreover, if

those patients decide to receive chemotherapy drugs, they want

the drugs and nothing in the record (or in common sense) leads me

to believe that the drugs are necessarily subordinate to the

physician’s services.     I cannot agree with the majority’s

conclusion that, with respect to petitioner’s business, the

provision of chemotherapy drugs was subordinate to the provision

of medical services.

     B.   Clear Reflection of Income

     If a taxpayer’s method of accounting does not clearly

reflect income, section 446(b) accords the Secretary the

authority to require the taxpayer to compute taxable income under

such method as, in the opinion of the Secretary, does clearly

reflect income.     We have interpreted respondent’s position in

this case as requiring petitioner to use an accrual method (the
                              - 57 -

hybrid method) only because purchases and sales of inventory were

involved.   Having concluded that petitioner did not purchase and

sell inventory, the majority has determined that respondent

abused his discretion in requiring petitioner to use the hybrid

method.   Taxpayers should not read too much into that

determination.

     As stated, although section 1.446-1(c)(2)(ii), Income Tax

Regs., leaves no doubt that respondent can so compel petitioner

if purchases and sales of inventory are involved, nothing in

section 446(b) prohibits the Secretary from so compelling

petitioner if purchases and sales of inventory are not involved.

Moreover, although section 446(c) specifically permits a taxpayer

to compute taxable income under the cash method, that permission

is made subject to the Secretary’s section 446(b) authority to

reject the taxpayer’s method of accounting.   See sec. 446(c).

The legislative endorsement of the cash method undoubtedly means

that wages and salaries can be reported on the cash method.    The

taxpayer in this case, however, is not a wage earner.    Petitioner

is a corporation, with three physician-shareholder-employees,

three other physician-employees, numerous other employees, and,

for 1995, just shy of $3 million in receipts.   For that year, it

paid officer compensation of $600,328 and other salaries and

wages of $630,381, for a total of just over $1.2 million.   If the

value of the services provided by all six physicians employed by
                               - 58 -

petitioner is measured by their compensation, then that value is

somewhere in the neighborhood of $1 million (given that there

were numerous employees other than physician employees).

Petitioner, thus, had receipts of about $2 million attributable

to something other than the negotiated value (to the corporation)

of physician’s services, including chemotherapy drugs costing

$772,522.    Petitioner’s receivables at the end of 1995 were

$148,557.    I know of no rule of law that forecloses an inquiry

into whether, to reflect clearly petitioner’s income, the

receivables attributable to the chemotherapy drugs used during

the year should not be reported on an accrual method, as would be

the case under the hybrid method.    Recently, in Oakcross

Vineyards, Ltd. v. Commissioner, T.C. Memo. 1996-433, affd. 142

F.3d 444 (9th Cir. 1998), we sustained the Commissioner’s

determinations that (1) the cash method did not clearly reflect a

farmer’s receipts from the sale of grapes and (2) an accrual

method was required.    We surveyed many of the cases dealing with

a challenge by the Commissioner to the cash method, including

cases involving the Commissioner’s rejection of the cash method

for reporting receipts.    Among the cases we surveyed were the

following:    American Fletcher Corp. v. United States, 832 F.2d

436 (7th Cir. 1987) (credit card charge account service required

to change from cash method to an accrual method); Applied

Communications, Inc. v. Commissioner, T.C. Memo. 1989-469
                              - 59 -

(concerning sales of computer software by the developer of the

software and taking into account that “cash method of accounting

is not appropriate for petitioner because it generates

substantial amounts of receivables or deferrals of revenue as

evidenced by the difference between its software income for tax

and financial purposes.”); Silberman v. Commissioner, T.C. Memo.

1983-782 (cash receipts and disbursements method of accounting

could not be used by a movie production partnership because the

predicted delay between expenditures and receipts created a

mismatching of funds and a distortion of income), affd. without

published opinions sub nom. Appeal of David Whin, Inc., Appeal of

Giordano, Appeal of Malanka, Stamato v. Commissioner, 770 F.2d

1068, 1069, 1072, 1075 (3d Cir. 1985).    In Oakcross Vineyards

Ltd., we also pointed out that the question of whether a

taxpayer’s method of accounting materially distorts or clearly

reflects income is one of fact and is to be resolved on a

case-by-case basis.

     As previously stated, where the Commissioner has determined

that a taxpayer’s method of accounting does not clearly reflect

income, the taxpayer must demonstrate either that his method of

accounting clearly reflects income or that the Commissioner’s

method does not clearly reflect income.   Respondent’s explanation

of the net adjustment in the notice is broader than the ground he

relies on in the answer.   That narrowing of his ground in the
                             - 60 -

answer may not have been intended.    Taxpayers similarly situated

to petitioner should be prepared to demonstrate that the cash

method clearly reflects their income or that the hybrid method

does not.8

V.   Conclusion

     For the foregoing reasons, I dissent from the majority’s

opinion.

     COHEN, WHALEN, and CHIECHI, JJ., agree with this dissent.




     8
        Taxpayers may have difficulty in proving that a method of
accounting such as the hybrid method does not clearly reflect
income. In Hospital Corp. of Am. v. Commissioner, T.C. Memo.
1996-105, we concluded that certain hospitals’ use of a hybrid
method of accounting that reported on an accrual method revenue
allocable to charges for supplies and pharmaceuticals clearly
reflected the hospitals’ income
