                        T.C. Memo. 2001-149



                      UNITED STATES TAX COURT



        ALACARE HOME HEALTH SERVICES, INC., Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 9566-99.                        Filed June 22, 2001.


     Robert C. Walthall, for petitioner.

     Marshall R. Jones, for respondent.




             MEMORANDUM FINDINGS OF FACT AND OPINION


     COLVIN, Judge:   Respondent determined deficiencies in

petitioner’s Federal income tax of $136,895 for 1995 and $58,726

for 1996 and accuracy-related penalties under section 6662(a) of

$27,379 for 1995 and $11,745 for 1996.
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     After concessions,1 the issues for decision are:

     1.   Whether petitioner, an accrual-basis taxpayer, may

expense in 1995 and 1996 the cost of assets that each cost less

than $500 and that have a useful life of more than one year, or

whether petitioner must capitalize the cost of those assets.     We

hold that it must capitalize those costs.

     2.   Whether petitioner is liable for the accuracy-related

penalty for substantial understatement of income under section

6662(a) for 1995 and 1996.   We hold that it is not.

     Section references are to the Internal Revenue Code in

effect during the years in issue, and Rule references are to the

Tax Court Rules of Practice and Procedure.

                        FINDINGS OF FACT

     Some of the facts have been stipulated and are so found.

A.   Petitioner

     Petitioner is a Medicare-certified home health care

agency whose principal place of business was in Birmingham,

Alabama, when it filed the petition in this case.   Petitioner

uses the accrual method of accounting.




     1
        Respondent concedes that the 1996 adjustment for office
expenses should be $247,413 rather than $259,062. Due to a
mathematical error in the notice of deficiency, the 1995 computer
expenses adjustment should be $104,806 rather than $101,806.
                              - 3 -

B.   Medicare Guidelines

     The Federal Health Care Financing Administration (HCFA)

reimburses certified home health care agencies, such as

petitioner, for the reasonable costs of providing home health

care services to Medicare beneficiaries.   About 98-99 percent of

petitioner’s revenues are Medicare reimbursements.

     Petitioner must comply with accounting guidelines contained

in the Medicare Provider Reimbursement Manual (HCFA Publication

15-1) (the manual) and must submit to annual compliance audits of

its books and records by one of Medicare’s fiscal intermediaries.

The manual contains guidelines concerning providers’

capitalization and expensing policies.   Those guidelines state:

     108. GUIDELINES FOR CAPITALIZATION OF HISTORICAL COSTS
          AND IMPROVEMENT COSTS OF DEPRECIABLE ASSETS

     108.1 Acquisitions.–If a depreciable asset has at the
     time of its acquisition an estimated useful life of at
     least 2 years and a historical cost of at least $500,
     its costs must be capitalized, and written off ratably
     over the estimated useful life of the asset, using one
     of the approved methods of depreciation. If a
     depreciable asset has a historical cost of less than
     $500, or if the asset has a useful life of less than 2
     years, its cost is allowable in the year it is acquired
     * * *.

     The provider may, if it desires, establish a:
     capitalization policy with lower minimum criteria, but
     under no circumstances may the above minimum limits be
     exceeded. For example, a provider may elect to
     capitalize all assets with an estimated useful life of
     at least 18 months and a historical cost of at least
     $400. However, it may not elect to only capitalize
     assets with a useful life of at least 3 years and a
     historical cost of more than $600.
                                - 4 -

C.   Medicare Guidelines and Petitioner’s Expensing Policy

     Petitioner was incorporated in 1982.         Since then, petitioner

has expensed all capital items for which it paid less than $500.

Petitioner followed that practice in 1995 and 1996.        Its

expensing policy complies with Medicare guidelines for the

capitalization of depreciable assets described above.

     The following chart shows the number, total cost, and

average cost of office items petitioner bought in 1995 and 1996

which have an expected useful life of one year or longer and

which cost less than $500 (the disputed assets):

                                          1995                   1996

Number of office and computer
items costing less than
$500 each                                 2,632                  2,381

Total cost of office and
computer items                          $467,944              $351,543

Average cost per item                    177.79                  147.65

     Petitioner’s office items included bookcases, chairs,

credenzas, desks, organizers, file cabinets, hutches,

refrigerators, microwaves, serving carts, panels and accessories,

tables, telephones, and typewriters.      Petitioner’s computer items

included modems, CD ROMs, hard drives, keyboards, motherboards,

memory modules, outlets, processors, servers, software, and

terminals.
                                 - 5 -

D.   Petitioner’s Income Tax Returns

     Petitioner hired Pearlman, Nebben & Associates, an

accounting firm that specializes in the health care industry, to

prepare its 1995 and 1996 Federal corporate income tax returns.

Petitioner’s director of accounting and chief financial officer

reviewed those returns for accuracy.

     Petitioner reported gross receipts of $55,128,001 and

$49,184,394, and taxable income of $284,062 and $420,950 on its

1995 and 1996 returns, respectively.

E.   The Notice of Deficiency

     Respondent determined that petitioner’s policy of expensing

assets that cost less than $500 was not a proper method of

accounting, and that petitioner must capitalize the cost of the

disputed assets over their useful lives.2

                                OPINION

A.   Whether Petitioner Must Capitalize the Cost of the Disputed
     Assets

     We must decide whether petitioner, an accrual basis

taxpayer, must capitalize the cost of items that cost less than

$500 and that have a useful life of more than one year.

     1.   Section 263 and Section 446

     In general, amounts paid to acquire machinery and equipment,

furniture and fixtures, and similar property having a useful life


     2
        Respondent allowed depreciation for the disputed assets
of $72,802 for 1995 and $178,819 for 1996.
                                - 6 -

substantially beyond the taxable year must be capitalized.    See

sec. 263(a)(1); Otis v. Commissioner, 73 T.C. 671, 674 (1980),

affd. without published opinion 665 F.2d 1053 (9th Cir. 1981);

sec. 1.263(a)-2(a), Income Tax Regs.

     Section 446 provides in pertinent part:

          SEC. 446(a). General Rule.--Taxable income shall
     be computed under the method of accounting on the basis
     of which the taxpayer regularly computes his income in
     keeping his books.

          (b) Exceptions.--If no method of accounting has
     been regularly used by the taxpayer, or if the method
     used does not clearly reflect income, the computation
     of taxable income shall be made under such method as,
     in the opinion of the Secretary, does clearly reflect
     income.

     2.   Petitioner’s Position

     Petitioner relies on Cincinnati, New Orleans & Tex. Pac. Ry.

Co. v. United States, 191 Ct. Cl. 572, 424 F.2d 563, 569 (1970);

and Union Pac. R.R. Co. v. United States, 208 Ct. Cl. 1, 524 F.2d

1343 (1975).   The taxpayers in Cincinnati and Union Pacific were

required by the Interstate Commerce Commission (ICC) to expense

purchases of certain property costing less than $500 (i.e., the

minimum rule expenses).   See Cincinnati, New Orleans & Tex. Pac.

Ry. Co. v. United States, supra at 565; Union Pac. R.R. Co. v.

United States, supra at 1347.     The Court of Claims held in both

cases that the taxpayer may deduct a de minimis amount of

expenses for low-cost capital assets having a useful life greater

than 1 year if the accounting method established by the ICC
                                 - 7 -

clearly reflects income.   See Cincinnati, New Orleans & Tex. Pac.

Ry. Co. v. United States, supra at 567-578; Union Pac. R.R. Co.

v. United States, supra at 1347-1348.     The Court of Claims in

Cincinnati relied on our prior rejection of the Commissioner’s

contention that section 263 is dispositive without considering

section 446:

          We reject as without merit respondent’s contention
     that section 263 of the Code is in and of itself
     dispositive of the issue before us. By requiring the
     capitalization of amounts “paid out for new buildings
     or for permanent improvements or betterments made to
     increase the value of any property,” such section begs
     the very question we are asked to answer. We are
     satisfied that, under the circumstances involved
     herein, sections 263 and 446 are inextricably
     intertwined.

Cincinnati, New Orleans & Tex. Pac. Ry. Co. v. United States,

supra at 568-569 (quoting Fort Howard Paper Co. v. Commissioner,

49 T.C. 275, 283-284 (1967)).    The Court of Claims in Cincinnati

also said that “The determinative question, therefore, is not

what is the useful life of the asset in question, although that

inquiry is relevant, but does the method of accounting employed

clearly reflect income.”   Id. at 568.    The court noted that the

disputed items were a minute fraction of the taxpayer’s net

income, yearly operating expenses, and yearly depreciation

deduction.   See id. at 571.    The court concluded that the ICC’s

minimum expensing rule was in accordance with generally accepted

accounting principles, see id. at 569-570, and that the

taxpayer’s financial statements clearly reflected income, see id.
                                   - 8 -

at 572-573.     In Union Pac. R.R. Co. v. United States, supra at

1347-1348, the Court of Claims rejected the Commissioner’s

attempt to distinguish Cincinnati.

      Petitioner contends that, like the taxpayers in Cincinnati

and Union Pacific, its method of accounting clearly reflected its

income within the meaning of section 446, and that respondent’s

attempt to change petitioner’s accounting method was an abuse of

discretion.     Petitioner also contends that respondent cannot

change its method of accounting because petitioner has

consistently used an accounting method that clearly reflects

income.

      3.    Comparison of Facts in Cincinnati, Union Pacific, and
            This Case

      The following chart compares petitioner to the taxpayers in

Cincinnati and Union Pacific (to the extent a comparison can be

made based on the record in this case and the Court of Claims’

opinions in Cincinnati3 and Union Pacific):
                       Cincinnati       Union Pacific     Petitioner
                  (1947, 1948 and 1949)    (1942)       (1995 and 1996)

1.   Disputed Items
     Disputed          $12,854
     items              11,006                            $467,944
                        24,715             $113,718        351,543




      3
        See Cincinnati, New Orleans & Tex. Pac. Ry. Co. v. United
States, 191 Ct. Cl. 572, 600 (1970). The numerical data from
Cincinnati can be found only in the Court of Claims reports.
                                        - 9 -
2.   Taxable Income1

     Taxpayer’s             8,087,437
     net taxable           11,012,143                           284,062
     income                 7,657,574                           420,950

     Disputed items/       .16%
     Net taxable           .10%                                 165.0%
     income                .32%                                  83.5%

3.   Capital Expenses

     Taxpayer’s            2,805,532
     total capital           751,690
     expenses              3,341,014

     Disputed items/        .46%
     total capital         1.46%
     expenses               .74%

4.   Operating Expenses2

     Taxpayer’s total       23,413,171
     operating              26,239,267          218,307,770
     expenses               24,451,126

     Disputed items/        .06%                  .05%
     Yearly operating       .04%
     expense                .01%

5.   Total Investment
     Account3

     Taxpayer’s total       71,305,124
     investment             75,626,528
     account                75,813,924          442,726,752

     Disputed items/        .02%                  .03%
     Total investment       .01%
     account                .03%

6.   Depreciation4

     Disputed items/        1.0%                                288%
     total depreciation      .8%                                189%
     expenses               1.8%

7.   Gross Receipts

     Taxpayer’s gross       34,854,625                        55,128,001
     receipts               40,272,864                        49,184,394
                            36,180,454
     Disputed               .04%                              .85%
     items/gross            .03%                              .71%
     receipts               .07%
                                   - 10 -
      1
         The ratio of the taxpayer’s expenses for disallowed minimum rule
items to its net taxable income was considered in Cincinnati, New Orleans &
Tex. Pac. Ry. Co. v. United States, 424 F.2d at 571.
     2
         The ratio of the taxpayer’s expenses for disallowed minimum rule
items to its yearly operating expenses was considered in Cincinnati, New
Orleans & Tex. Pac. Ry. Co. v. United States, 424 F.2d at 571, and Union Pac.
R.R. Co. v. United States, 524 F.2d at 1348.
      3
         The ratio of the taxpayer’s expenses for disallowed minimum rule
items to its total investment account was considered in Union Pac. R.R. Co. v.
United States, 524 F.2d at 1348.
     4
         The ratio of the taxpayer’s expenses for disallowed minimum rule
items to its yearly depreciation expenses was considered in Cincinnati, New
Orleans & Tex. Pac. Ry. Co. v. United States, 424 F.2d at 571.

     4.    Whether Petitioner’s Method of Accounting Clearly
           Reflects Income

     As discussed next, we conclude that the Cincinnati and Union

Pacific cases do not establish that petitioner’s expensing of

capital items costing less than $500 results in a clear

reflection of its income.       See, e.g., Knight-Ridder Newspapers,

Inc. v. United States, 743 F.2d 781, 791-793 (11th Cir. 1984)

(Court used mathematical analysis to decide that the taxpayer’s

accounting method did not clearly reflect income).

     First, the above chart shows that the ratios of disputed

items to various measures of petitioner’s size are substantially

larger than in Cincinnati and Union Pacific.           For example, in

Cincinnati, the taxpayer’s disputed items were less than one

percent of the taxpayer’s net income in the 3 years at issue,

see Cincinnati, New Orleans & Tex. Pac. Ry. Co. v. United States,

424 F.2d at 571; in the instant case, the disputed items were 165

percent of petitioner’s 1995 taxable income and 83.5 percent of

its 1996 taxable income.       In Cincinnati, the taxpayer’s disputed
                              - 11 -

items were less than 2 percent of its total deduction for

depreciation for the years in issue; in contrast, petitioner’s

disputed items were 288 percent and 189 percent of its total

depreciation deduction for 1995 and 1996.

     Petitioner contends that comparing the disputed items to its

gross receipts shows that its accounting method did not

materially distort its income.   We disagree.   First, the disputed

items of the taxpayer in Cincinnati were .04 percent, .03

percent, and .07 percent of its gross receipts in the years at

issue, whereas petitioner’s disputed items were .85 percent and

.71 percent of its gross receipts in 1995 and 1996.   Thus,

petitioner’s ratios were 10 to 28 times larger than those in

Cincinnati.   Petitioner points out that the court in Cincinnati

compared the taxpayer’s disputed items to its total operating

expenses, and contends that we should compare petitioner’s

disputed items to its total expenses.   We disagree that this

helps petitioner.   In Cincinnati, the taxpayer’s disputed items

were .06 percent, .04 percent, and .01 percent of its total

operating expenses for the years in issue; petitioner’s disputed

items were .84 percent and 1.12 percent of its total expenses.

Petitioner’s ratios are 14 to 112 times larger than those in

Cincinnati.

     Second, additional factors were present in Cincinnati that

have not been shown to be present here.   The court in Cincinnati
                              - 12 -

considered 17 years of data such as the taxpayer’s gross

receipts, capital expenses, total investment, net taxable income,

total operating expenses, total depreciation, and the disputed

minimum items, in deciding that the taxpayer’s method of

accounting clearly reflected income.   See id. at 569, 571.

Petitioner did not offer evidence from its years other than the

years at issue.

     The court in Cincinnati noted that the record there

contained evidence that the ICC had adopted the minimum rule

after concluding that imposition of the minimum rule would not

distort income or cause the railroads' financial statements not

to clearly reflect income.   See id. at 570.   In contrast, here

petitioner offered no evidence that HCFA considered whether a

minimum expensing policy would cause financial statements of home

health care agencies not to clearly reflect income.

     The taxpayer’s expensing method in Cincinnati was in

accordance with generally accepted accounting principles (GAAP).

See id. at 569-570.   Petitioner contends that its minimum

expensing rule also complies with GAAP but offered no evidence to

support that contention.

     The ICC required the taxpayers in Cincinnati and Union

Pacific to expense the items that were the subject of the

disallowed deductions.   In contrast, Medicare guidelines permit,

but do not require, petitioner to expense the disputed assets.
                              - 13 -

Cf. Commissioner v. Idaho Power Co., 418 U.S. 1, 14-15 (1974)

(where a taxpayer’s generally accepted method of accounting is

made compulsory by a regulatory agency and that method clearly

reflects income, it is almost presumptively controlling for

Federal tax purposes); Sprint Corp. v. Commissioner, 108 T.C.

384, 403-404 (1997).

     Petitioner contends that we have sanctioned the use of a

minimum expensing rule, citing Galazin v. Commissioner, T.C.

Memo. 1979-206, in which we allowed the taxpayer to deduct the

cost of a calculator due to the small amount of the expenditure

($52.45) and the relatively short (2-year) useful life of the

asset.   Here, respondent disallowed deductions of $467,944 and

$351,543 for the disputed items.    These amounts are not

comparable to the amount at issue in Galazin.    Cf. Sharon v.

Commissioner, 66 T.C. 515, 527 (1976) (taxpayer must capitalize

$801 bar examination fees and expenses to practice law in

California because amount was too large to disregard its capital

nature), affd. 591 F.2d 1273 (9th Cir. 1978).

     We conclude that petitioner has not shown that its

accounting method clearly reflected income nor that it was an

abuse of discretion for respondent to require petitioner to

change that method of accounting.    Thus, we hold that petitioner

may not expense the cost of its assets that cost less than $500

and that have a useful life greater than 1 year.
                                - 14 -

B.   Whether Petitioner Is Liable for the Penalty Under Section
     6662 for Substantial Understatement

     Respondent determined that petitioner is liable for the

accuracy-related penalty for substantial understatement for 1995

and 1996 under section 6662.

     The accuracy-related penalty may not apply if the taxpayer

reasonably relied on the advice of a professional, such as an

accountant, and acted in good faith.     See sec. 6664(c)(1); sec.

1.6664-4(c), Income Tax Regs.    The understatement is reduced to

the extent that it (1) is based on substantial authority, or (2)

is attributable to an item that was adequately disclosed and that

has a reasonable basis.   See sec. 6662(d)(2)(B).

     Respondent contends that petitioner offered no evidence that

it gave its tax preparer all of the information needed to

correctly prepare its 1995 and 1996 tax returns or that its

preparer and petitioner thoroughly reviewed petitioner’s return

information.   We disagree.   Petitioner relied on Pearlman,

Nebben, a C.P.A. firm with experience in the health care

industry, to prepare petitioner’s tax returns for the years in

issue. Petitioner has consistently followed a minimum expensing

policy since it was incorporated.    Pearlman, Nebben prepared

petitioner’s tax returns for those years, which reasonably led

petitioners to believe that it agreed with petitioner’s minimum

expensing policy.   Cf. Bokum v. Commissioner, 94 T.C. 126, 147-

148 (1990) (accountant's failure to sign the tax return should
                               - 15 -

have put the taxpayer on notice that he was not backing the

advice embodied in the return), affd. 992 F.2d 1132 (11th Cir.

1993).   Respondent contends that petitioner did not have

substantial authority or reasonable cause for its minimum

expensing position because petitioner’s chief financial officer,

Pamela Rau (Rau), did not discuss the deductibility of the

disputed assets with petitioner’s tax return preparer for 1995

and 1996.   We disagree.   Rau reasonably explained that she did

not discuss petitioner’s expensing policy with the preparer

because petitioner’s expensing policy in 1995 and 1996 was the

same as it had been in previous years.    Petitioner's reliance on

its preparer was reasonable cause for expensing the disputed

assets in 1995 and 1996.

     We hold that petitioner is not liable for the accuracy-

related penalty under section 6662 for 1995 and 1996.

     To reflect the foregoing,

                                          Decision will be entered

                                     under Rule 155.
