                         T.C. Memo. 2010-211



                      UNITED STATES TAX COURT



     HEALTH INVESTMENT CORP. AND SUBSIDIARIES, Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 24831-08.              Filed September 30, 2010.



     Steven Ray Mather and Elliott H. Kajan, for petitioner.

     Joyce M. Marr, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     COHEN, Judge:   Respondent determined a Federal income tax

deficiency of $1,829,108 for petitioner’s tax (and fiscal) year

ending April 30, 1997.   After concessions, the issue for decision

is whether petitioner is entitled to the section 481(a)

adjustment resulting from a change in the method of accounting

for bad debts as claimed on the tax return.     Unless otherwise
                               - 2 -

indicated, all section references are to the Internal Revenue

Code in effect for the year in issue, and all Rule references are

to the Tax Court Rules of Practice and Procedure.

                         FINDINGS OF FACT

     Some of the facts have been stipulated, and the stipulated

facts are incorporated in our findings by this reference.

Petitioner is the common parent of an affiliated group of

corporations.   At the time the petition was filed, petitioner’s

principal place of business was in California.    Petitioner filed

consolidated Federal income tax returns for its tax and fiscal

years ending April 30, 1996, 1997, and 1998.    Ernst & Young,

L.L.P., a public accounting firm, prepared petitioner’s tax

returns for fiscal years ending (FYE) in 1997 and 1998.

     Petitioner, through its subsidiaries, operated five

hospitals during its FYE April 30, 1997.    Before this tax year,

petitioner used a reserve method of accounting for bad debts for

both financial and tax accounting.

     In its financial accounting, petitioner maintained combined

contractual and bad debt allowances (sometimes called “bad debt

reserve”) accounts.   A contractual allowance reflects amounts

petitioner is not entitled to collect because of contractual

agreements with healthcare payers.     The bad debt allowance

reflects the amount petitioner is entitled to collect, but does

not collect.
                                 - 3 -

     During the 1990s, Linda Bentley (Bentley) held the position

of controller and then chief financial officer for petitioner.

At Ernst & Young’s request, Bentley prepared a schedule entitled

“Contractual/Bad Debt Exp Analysis” for three of petitioner’s

subsidiaries that she understood would be used for an application

to the Internal Revenue Service (IRS) to request a change in

methods of accounting.    Bentley’s schedule purportedly identified

the bad debt portion in the combined contractual and bad debt

allowance accounts as of April 30, 1996.    Bentley used

petitioner’s accounts receivable aging reports, determined a

reserve percentage for what petitioner termed financial classes

(groupings of similar sources of petitioner’s revenue and

accounts receivable), and then categorized the classes as

contractual, bad debt, or a combination of the two using

petitioner’s files and information obtained from petitioner’s

business office.    Where petitioner had agreed to a payment

amount, Bentley determined what had been paid, what the charges

were, and whether an unpaid portion was a contractual or a bad

debt allowance.    From this historical analysis, Bentley

determined percentages that reflected the general collection

amount for a particular class.    Bentley applied the percentages

to the respective financial classes that had combined contractual

and bad debt amounts to determine the bad debt amount.
                               - 4 -

     Petitioner submitted a Form 3115, Application for Change in

Accounting Method, to the IRS requesting permission to change the

method of accounting for bad debts for the taxable year that

began May 1, 1996, for three of its subsidiaries:    (1) Bay Cities

Medical Center (Bay Cities); (2) Jupiter Bellflower Doctors

Hospital (Jupiter Bellflower); and (3) Los Angeles Doctors

Hospital Corp. (LA Doctors).   Petitioner included documents with

the Form 3115 indicating that if the method of accounting for bad

debts were changed, under section 481(a) an adjustment for the

amount of the reserve for bad debts as of the close of FYE April

30, 1996, would be required as follows:   (1) $310,311 for Bay

Cities; (2) $339,138 for Jupiter Bellflower; and (3) $500,261 for

LA Doctors, for a total section 481(a) adjustment of $1,149,710.

These reported figures correspond to the amounts on the schedules

Bentley prepared for the three subsidiaries.

     The parties entered into a consent agreement in November

1997, with the IRS granting permission for the three subsidiaries

to change their method of accounting for bad debts from the

reserve method to the specific chargeoff method.    (The three

subsidiaries continued to use the reserve method of accounting

for bad debts for financial accounting purposes.)    According to

the executed consent agreement:

          The information [petitioner furnished] * * *
     indicates that as of the beginning of the year of
     change the adjustment required under section 481(a)
     * * * is computed as follows:
                                - 5 -

            Bay Cities Medical Center               $310,311
            Jupiter Bellflower Doctors Hospital      339,138
            Los Angeles Doctors Hospital Corporation 500,261

     Total adjustment (increase in computing
          consolidated taxable income)            $1,149,710

          The taxpayers’ request has been determined to be a
     change from a Category A method of accounting as
     defined in section 3.06 of Rev. Proc. 92-20, 1992-1
     C.B. 685. Section 3.06 of Rev. Proc. 92-20 defines a
     Category A method of accounting as a method of
     accounting that the taxpayer is specifically not
     permitted to use under the Internal Revenue Code, the
     Income Tax Regulations, or a decision of the Supreme
     Court of the United States. A Category A method is
     also a method of accounting that differs from a method
     the taxpayer is specifically required to use under the
     Code, the regulations, or a decision of the Supreme
     Court of the United States.

          Section 5.03(1)(a) of Rev. Proc. 92-20 provides
     that when there is a change in method of accounting
     from a Category A method of accounting (as defined in
     section 3.06) that results in a net positive section
     481(a) adjustment, the taxpayer must, beginning with
     the year of change, take the net section 481(a)
     adjustment into account ratably over 3 tax years in
     computing taxable income.

          The amount of the adjustment, which is to be taken
     into account over a three-year period (adjustment
     period), is subject to verification by the district
     director upon examination of the consolidated income
     tax return.

        *        *       *       *       *       *       *

          An examining agent may not propose that the
     taxpayers change the same method of accounting as that
     changed by the taxpayers under this ruling for a year
     prior to the year of change. * * *

     Petitioner reported the ratable portion of the claimed

section 481(a) adjustment on Form 1120, U.S. Corporation Income

Tax Return, dated January 15, 1998 (9704 Form 1120), as follows:
                                 - 6 -

           Bay Cities            $310,311/3   =    $103,437
           Jupiter Bellflower     339,138/3   =     113,046
           LA Doctors             500,261/3   =     166,754
             Total                                  383,237

     On the 9704 Form 1120, petitioner claimed current year

deductions for bad debts of $366,033 for Bay Cities, $729,246 for

Jupiter Bellflower, and $518,099 for LA Doctors.      On the attached

Schedule M-1, Reconciliation of Income (Loss) per Books With

Income per Return, petitioner reported the deductions on the

return not charged against book income for this year for the

three subsidiaries.   To calculate these book-to-tax adjustments,

petitioner used the figures Bentley calculated as the bad debt

reserve account balances as of FYE April 30, 1996 (and hence the

beginning of the next fiscal year, May 1, 1996), and subtracted

the bad debt allowance amounts as of FYE April 30, 1997, as

follows:

                       Bad Debt Allowance Amounts     1997 Form 1120
                      May 1, 1996   Apr. 30, 1997      Schedule M-11

Bay Cities            $310,311           $37,018         $273,293
Jupiter Bellflower     339,138           122,736          216,402
LA Doctors             500,261            16,227          484,034
     1
      Line 8, Deductions on this return not charged against book
income this year.

     For the Form 1120 petitioner filed for FYE April 30, 1998,

petitioner used this same method to calculate the bad debt

reserve amounts for these subsidiaries and used the following

fiscal year beginning and ending amounts for the bad debt

allowance amounts:
                                - 7 -

                      Bad Debt Allowance Amounts    1998 Form 1120
                     May 1, 1997   Apr. 30, 1998     Schedule M-1
                                          1            2
Bay Cities            $37,018              -0-           $37,018
                                                       3
Jupiter Bellflower    122,736           $222,172         (99,436)
                                                      4
LA Doctors             16,227            173,624        (157,397)
     1
       Bay Cities was temporarily closed at the end of FYE Apr.
30, 1998.
     2
       Line 8, Deductions on this return not charged against book
income this year.
     3
       Line 5, Expenses recorded on books this year not deducted
on this return.
     4
       Line 5.

     Upon review of documents that petitioner supplied for each

of the three subsidiaries during the IRS examination of

petitioner’s Federal income tax return, an IRS revenue agent

prepared a worksheet on or before January 22, 2001, noting that

those documents identified two different amounts for petitioner’s

bad debt reserve as of April 30, 1996.    One amount was

petitioner’s reported section 481(a) adjustment on the Form 3115,

as reported ratably on the 9704 Form 1120.    The revenue agent

identified a different amount on worksheets prepared by Ernst &

Young.

     The Ernst & Young worksheet amounts were calculated for each

subsidiary by multiplying the subsidiary’s combined contractual

allowance and bad debt allowance account amount by an allowance

percentage to determine the bad debt allowance amount, with the

remainder allocated to the contractual allowance.    The bad debt

allowance amounts Ernst & Young calculated for the subsidiaries

as of April 30, 1996, are as follows:    (1) $23,615 for Bay
                               - 8 -

Cities; (2) $146,547 for Jupiter Bellflower; and (3) $54,889 for

LA Doctors.   Using these figures, the ratable portion of the

section 481(a) adjustment is $75,017.

     The revenue agent requested documentation to verify

petitioner’s determination of the bad debt reserve amounts as of

April 30, 1996, for the three subsidiaries as claimed on the tax

return.   In response, an Ernst & Young accountant acting as

petitioner’s representative during the examination provided for

each subsidiary the calculation used to derive the bad debt

reserve amount.   The documents provided showed each subsidiary’s

bad debt reserve equal to the gross accounts receivable

multiplied by a bad debt percentage “(per client)”.   The revenue

agent concluded that the percentages could not be explained or

verified and thus the bad debt reserve amounts were not proper.

     The revenue agent did not question petitioner’s calculated

balances of the bad debt reserves as of April 30, 1997, used to

compute the corresponding Schedule M-1 adjustments for each of

the three subsidiaries, according to the Ernst & Young worksheets

supplied:   (1) $37,018 for Bay Cities; (2) $122,736 for Jupiter

Bellflower; and (3) $16,227 for LA Doctors.   To calculate these

amounts, the same method was used as that used for FYE April 30,

1996.

     The revenue agent concluded that the amounts of the bad debt

reserves as of April 30, 1996, on the Ernst & Young worksheets
                                - 9 -

were the correct figures--not the amounts that Bentley calculated

that were reported on the consent agreement and tax return.

Using the Ernst & Young worksheet amounts, the revenue agent

determined that:    (1) Petitioner’s section 481(a) adjustment

should be reduced by $308,220 because petitioner included an

adjustment in income of $383,237 that should have been $75,017

and (2) petitioner should have reported aggregate Schedule M-1

adjustments decreasing taxable income by $62,473 and a Schedule

M-1 adjustment decreasing taxable income by $13,403, rather than

aggregate Schedule M-1 adjustments of $973,729, thus decreasing

the section 166 bad debt deduction by $924,659.    The revenue

agent’s calculations resulted in a net increase to taxable income

of $616,439 ($924,659 less $308,220) for FYE April 30, 1997.

       The Form 886-A, Explanation of Adjustments, attached to the

July 17, 2008, notice of deficiency sent to petitioner, stated

that

       It is determined that the deductions for bad debts,
       resulting from an authorized change in accounting
       method for taxable year ending April 30, 1997, is
       disallowed to the extent of $616,439.00 because the IRC
       Section 481(a) adjustment was computed incorrectly.
       Accordingly, your taxable income for the taxable year
       ending April 30, 1997 is increased $616,439.00.

                               OPINION

       Petitioner argues that respondent’s redetermination of the

April 30, 1996, bad debt reserve amount is barred by the consent

agreement and is not properly raised in the notice of deficiency.
                              - 10 -

Petitioner further asserts that respondent bears the burden of

proof regarding the redetermination of the bad debt reserve

amount because this is a “new matter” according to Rule 142(a).

     Petitioner argues that respondent violated the consent

agreement term that prohibits respondent from proposing that

petitioner change the method of accounting for a year before the

year of change.   Petitioner asserts that respondent applied an

“improper” accounting method to determine the bad debt reserve

amount that resulted in a taxable income increase.

     Respondent’s revenue agent explained at trial that he did

not adjust the April 30, 1996, bad debt reserve amounts using an

accounting method that petitioner began using in FYE April 30,

1997.   He analyzed documents that petitioner supplied and

determined that the Ernst & Young bad debt reserve amounts for

FYE April 30, 1996, and hence for the fiscal year that began May

1, 1996, were the figures that should be used for the section

481(a) adjustment and not those reported on the Form 3115 and tax

return that Bentley calculated.   No change in method of

accounting was proposed for FYE April 30, 1996, and the consent

agreement, subject to verification by the district director upon

examination of petitioner’s consolidated tax return, was not

violated.

     We also reject petitioner’s argument that the notice of

deficiency did not provide notice that the basis for respondent’s
                                - 11 -

adjustment to the bad debt deduction included a determination of

bad debt allowance amounts as of April 30, 1996.       Section 7522(a)

provides that a notice of deficiency “shall describe the basis

for, and identify the amounts (if any) of, the tax due, interest,

additional amounts, additions to the tax, and assessable

penalties included in such notice.       An inadequate description

* * * shall not invalidate such notice.”       The purpose of section

7522 is to give the taxpayer notice of the Commissioner’s basis

for determining a deficiency.    See Shea v. Commissioner, 112 T.C.

183, 196 (1999).   The objective language in the notice of

deficiency remains the controlling factor.       Id. at 192.

     The notice sent to petitioner stated that the section 481(a)

adjustment was “computed incorrectly”.       Petitioner supplied the

figures for the section 481(a) adjustment with the application

for the accounting method change and subsequently used them for

the filed 9704 Form 1120.   Bentley’s schedules for the three

subsidiaries identified these figures as the bad debt allowance

amounts as of April 30, 1996.    These computed amounts were

different from those respondent contends are correct, as

identified on the Ernst & Young worksheets, and resulted in

respondent’s income adjustments.    During the examination, the

revenue agent identified the issue and requested that petitioner

verify the amounts petitioner reported.       Nothing in the notice is
                              - 12 -

inconsistent with respondent’s position in this case (unlike Shea

v. Commissioner, supra).

     Petitioner objects to our consideration of how respondent’s

adjustments occurred as “going behind” the statutory notice.    The

events of the audit, however, are relevant to petitioner’s claims

regarding the adequacy of the notice.   See generally id.    They

are also relevant to petitioner’s claims that the Court should

excuse petitioner’s belated production at trial of additional

schedules used by Bentley because petitioner was surprised by

respondent’s position.   We conclude that the notice apprised

petitioner of the basis for respondent’s adjustment and that

petitioner was neither surprised nor prejudiced regarding

respondent’s position that the amounts of the bad debt reserves

as of April 30, 1996, are in dispute.

     Petitioner next asserts that respondent raised a “new

matter” regarding the redetermination of the bad debt allowance

amounts and thus the burden of proof shifts to respondent.    See

Rule 142(a).   Respondent acknowledges that the recomputation of

the amounts of petitioner’s bad debt reserves as of April 30,

1996, was not expressly mentioned in the notice but asserts that

it is implicit in respondent’s explanation that the section

481(a) adjustment was computed incorrectly.

     If the Commissioner advances a new theory that either alters

the original deficiency or requires presentation of new evidence,
                               - 13 -

the Commissioner bears the burden of proof as to this new matter.

Shea v. Commissioner, supra at 191-197; Wayne Bolt & Nut Co. v.

Commissioner, 93 T.C. 500, 507 (1989).      We conclude that

respondent has not advanced a new theory by redetermining the

amounts of the bad debt reserves as of April 30, 1996, because

these amounts are a direct component of the section 481(a)

adjustment.   See sec. 481(a); Bird Mgmt., Inc. v. Commissioner,

48 T.C. 586 (1967).    Thus, the burden of proof remains with

petitioner.   See Shea v. Commissioner, supra at 197.

     Respondent argues that petitioner overstated the ratable

portion of the section 481(a) adjustment for the year in issue by

$308,220 (aggregate bad debt reserve amount for three

subsidiaries as of April 30, 1996:      $383,237 (as identified by

Bentley and reported by petitioner) less $75,017 (as identified

on the Ernst & Young worksheets and determined as the correct

amount by respondent)).    This difference results in a decrease of

petitioner’s claimed deduction for bad debts under section 166

and an increase in income.    Respondent asserts that petitioner

has not established that the amounts it claimed as the balances

of the bad debt reserves for the three subsidiaries as of April

30, 1996, equaled the deductions previously claimed for Federal

income tax purposes.    Petitioner counters that petitioner’s

determination of the bad debt allowances as of April 30, 1996, is

“vastly more reliable and accurate than respondent’s
                              - 14 -

determination” and that respondent “used the wrong concept, the

wrong accounting method and the wrong schedules” to redetermine

the bad debt allowances as of April 30, 1996, for the three

subsidiaries.   Despite petitioner’s rhetoric, neither the Ernst &

Young calculations nor respondent’s reliance on them has been

shown to result in an erroneous adjustment.

     Section 166(a) provides that taxpayers are allowed a

deduction for “any debt which becomes worthless within the

taxable year” (the specific chargeoff method).   Before being

repealed by the Tax Reform Act of 1986, Pub. L. 99-514, sec. 805,

100 Stat. 2361, section 166(c) provided that, alternatively,

accrual basis taxpayers could use the reserve method to deduct “a

reasonable addition to a reserve for bad debts.”   See Thor Power

Tool Co. v. Commissioner, 439 U.S. 522, 546 (1979).   As we

explained in Bird Mgmt., Inc. v. Commissioner, supra at 595-596:

          Essentially a bad debt reserve constitutes an
     estimate of the loss which can reasonably be expected
     to result from worthlessness of debts outstanding at
     the close of the taxable year. Under the reserve
     method when specific debts become worthless they are
     charged against the reserve and serve to reduce the
     credit balance therein. Then, if any amount which has
     been charged against the reserve is subsequently
     collected the collection does not result in the receipt
     of income but the amount collected is credited to the
     reserve. If the credit balance in the reserve at the
     end of the year is not adequate to cover the reasonably
     expected loss with respect to the debts outstanding at
     the end of the year, then an addition is made to the
     reserve to bring the credit balance to the appropriate
     amount, and such addition is deductible. * * * And the
     general rule is well established that any balance in a
     reserve for bad debts existing when the reserve becomes
                              - 15 -

     no longer necessary must be included in taxable income,
     since the amount of such balance represents amounts
     which have been previously deducted. * * *

     When a taxpayer changes from the reserve method of bad debt

accounting to the specific chargeoff method, the credit balance

in the reserve account is returned to income in the year of

change.   See Arcadia Sav. & Loan Association v. Commissioner, 300

F.2d 247, 250 (9th Cir. 1962), affg. 34 T.C. 679 (1960).     Section

481(a) requires that the adjustments necessary to prevent amounts

from being duplicated or omitted be taken into account when the

taxpayer’s taxable income is computed under a method of

accounting that is different from the method used to compute

taxable income the preceding year.     Section 481(c) and section

1.481-4, Income Tax Regs., provide that the adjustment required

may be taken into account in determining taxable income in the

manner and subject to the conditions agreed to by the

Commissioner and the taxpayer or prescribed by regulations.     The

taxpayer has the burden of proof as to the proper section 481(a)

adjustment.   See Hitachi Sales Corp. of Am. v. Commissioner, T.C.

Memo. 1994-159, supplemented by T.C. Memo. 1995-84.

     Because of the change in accounting method for bad debts

from the reserve method to the specific chargeoff method,

petitioner was required to report the credit balance remaining in

the bad debt reserve accounts as of April 30, 1996.     See sec.

481(a); Arcadia Sav. & Loan Association v. Commissioner, supra.
                              - 16 -

     Whether a taxpayer is on the specific chargeoff or the

reserve method of treating bad debts, there must be an annual

review of doubtful accounts receivable to ascertain whether

certain accounts are either uncollectible or that there is

reasonable probability that they are not collectible.     Rogan v.

Commercial Disc. Co., 149 F.2d 585, 587-588 (9th Cir. 1945).

Accordingly, Ernst & Young prepared worksheets for each

subsidiary that identified the bad debt reserve account amounts,

including fiscal years 1996-98.   (Petitioner used the reserve

method of accounting for financial purposes during all relevant

years.)   Respondent contends that it is these amounts that

petitioner should have used to calculate the section 481(a)

adjustment--not the figures that Bentley calculated and

petitioner used.

     Although Bentley conducted an extensive exercise to analyze

the combined contractual and bad debt allowance accounts as of

April 30, 1996, we are not persuaded that the ascertained bad

debt allowance amounts are more accurate than those of the Ernst

& Young worksheets for purposes of determining petitioner’s

section 481(a) adjustment.   Petitioner did not call anyone from

Ernst & Young to explain those worksheets or to reconcile

discrepancies.   According to Bentley’s prepared schedule and

explanation, it appears her determination regarding each

outstanding receivable supports an analysis of bad debts for
                               - 17 -

partial or total worthlessness.    A determination of partial and

total worthlessness of bad debts is important for the specific

chargeoff method because a taxpayer may claim a deduction when a

business debt becomes either partially or wholly worthless.      Sec.

166.

       As respondent notes, Bentley’s calculations do not purport

to reconcile the amounts that she determined to be the balances

of the bad debt reserve accounts as of April 30, 1996, to the

amounts deducted on petitioner’s Federal income tax returns for

bad debt expenses in earlier years (and before the accounting

method change).    The bad debt credit balance remaining in

petitioner’s allowance account as of April 30, 1996, is reported

for tax purposes under section 481(a).    See Arcadia Sav. & Loan

v. Commissioner, supra at 250.     We sustain respondent’s

determination that the bad debt reserve account amounts

calculated by Ernst & Young should be used for purposes of the

section 481(a) adjustment because petitioner has not established

that those amounts are incorrect.

       Petitioner argues that respondent’s position causes

petitioner to be taxed twice on the same income.    The testimony

of Bentley is inconclusive about whether a protective claim for

refund protects petitioner in this regard.    In any event, we

address only the year before us.
                                - 18 -

     In reaching our decision, we have considered all arguments

made by the parties.   To the extent not mentioned or addressed,

they are irrelevant or without merit.    To reflect concessions and

our conclusions stated above,


                                          Decision will be entered

                                     under Rule 155.
