                        T.C. Memo. 1999-339



                      UNITED STATES TAX COURT



    PELTON & GUNTHER, PROFESSIONAL CORPORATION, Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 23914-97.                Filed October 8, 1999.



     Jon L. Brown, for petitioner.

     Margaret S. Rigg, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     GERBER, Judge:   Respondent determined an $81,679 income tax

deficiency for petitioner’s tax year ended May 31, 1993, a $6,082
                               - 2 -


section 6651(a)(1)1 addition to tax, and a $16,366 section 6662

penalty.

     The issues for our consideration are:   (1) Whether

litigation costs paid by petitioner on behalf of clients and then

reimbursed to petitioner are deductible as ordinary and necessary

business expenses or whether such payments are in the nature of

nondeductible advances or loans; (2) whether respondent’s

adjustment to petitioner’s reporting of litigation costs triggers

a section 481 adjustment; (3) whether petitioner’s 1990 and 1991

net operating losses may be carried forward to the 1993 tax year,

without first being applied to years prior to 1990 and 1991; and

(4) whether petitioner is liable for an accuracy-related penalty

under section 6662(a).2   For convenience and continuity, separate

fact findings and opinion portions are set forth for each issue

decided by the Court.3




     1
        Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the year under
consideration, and Rule references are to this Court’s Rules of
Practice and Procedure.
     2
        Petitioner conceded at trial that if the Court determined
that there was a deficiency, then it would be liable for the sec.
6651(a)(1) addition to tax for filing a delinquent return.
     3
        The parties’ stipulated facts and exhibits are
incorporated by this reference.
                                 - 3 -


I.   Advanced Litigation Costs

                           FINDINGS OF FACT

      Petitioner Pelton & Gunther, P.C. (P&G), is a law firm

operating as a professional corporation and had its principal

place of business in San Mateo, California, at the time the

petition was filed.   P&G’s Federal income tax returns are filed

for fiscal years ending May 31.    For the taxable years ended May

31, 1992 and 1993, P&G used the cash method of accounting for

Federal income tax reporting.

      P&G’s legal specialty is the defense of personal injury

automobile accident lawsuits.    More than 90 percent of P&G’s

services were performed pursuant to the request of the California

State Automobile Association (CSAA).     At CSAA’s request, P&G

provided legal services for CSAA policyholders in connection with

controversies arising from automobile accidents.     Under this

arrangement, CSAA generally paid P&G $400 at the time P&G was

asked to represent one of CSAA’s policyholders.     P&G would pay

various litigation costs including filing fees; deposition

expenses; the costs of medical records; fees for witnesses, court

reporters, and interpreters; and similar expenses as they would

occur.   The litigation costs P&G paid on each case, more often

than not, exceeded $400.

      P&G would bill CSAA for its legal services and the

litigation costs that it incurred on behalf of CSAA’s
                                  - 4 -


policyholders after the controversies were resolved and the cases

were closed.    Cases were often open for more than 1 year.        Some

bills from P&G to CSAA were for litigation costs only, some were

for legal fees (services) only, and some were for both costs and

fees.   P&G’s fees were paid by CSAA at a stated hourly rate.           P&G

claimed as a deduction litigation costs it paid on behalf of

CSAA’s policyholders, either from the $400 retainer or as

advances, in the year that it paid the litigation costs.          P&G

reported the $400 retainers and the reimbursements of litigation

costs as income in the year they were received by P&G.

     P&G’s deductions for litigation costs were as follows:

           Fiscal year ending                  Litigation costs

               May   31,   1990                   $262,771.60
               May   31,   1991                    280,332.39
               May   31,   1992                    382,365.84
               May   31,   1993                    358,092.07
               May   31,   1994                    254,562.73

     P&G reported retainers and reimbursed litigation

costs as income as follows:
                                          Retainers and reimbursed
           Fiscal year ending                 litigation costs

               May   31,   1991                   $242,867.08
               May   31,   1992                    361,880.37
               May   31,   1993                    377,767.17
               May   31,   1994                    276,686.05

     Respondent, in the notice of deficiency, disallowed a

portion of the total deduction petitioner claimed for litigation

costs, reduced income by the amount of reimbursed previously
                                 - 5 -


claimed deductions that P&G had included in its 1993 fiscal year,

and made a section 481 adjustment that again caused the

reimbursed prior year costs to be included in P&G’s income for

its 1993 fiscal year.   The section 481 adjustment had the effect

of reversing respondent’s adjustment backing out petitioner’s

inclusion of the prior year costs that were reimbursed during the

1993 fiscal year.

                              OPINION

     Section 162 permits the deduction of ordinary and necessary

expenses incurred in carrying on a trade or business.     P&G

contends that the litigation costs it paid on behalf of clients

were ordinary and necessary expenses of its law practice.

Respondent, on the other hand, contends that, in essence, the

payments were in the nature of loans to P&G’s clients because P&G

paid the litigation costs with the understanding that it would be

reimbursed by CSAA.

     We agree with respondent.    On the basis of longstanding case

precedents, P&G’s payments or advances of the client’s litigation

costs should be treated like loans.      See Canelo v. Commissioner,

53 T.C. 217 (1969), affd. per curiam 447 F.2d 484 (9th Cir.

1971); see also Herrick v. Commissioner, 63 T.C. 562 (1975).

Canelo v. Commissioner, supra, involved a law firm which

primarily engaged in plaintiffs’ personal injury litigation on a

contingent fee basis.   The firm advanced the clients’ litigation
                               - 6 -


costs, and the clients were obligated to repay the advances only

in the event of a favorable settlement or judgment.   Accordingly,

if nothing was recovered, the client would have no obligation.

In Canelo, prospective clients were screened and were accepted

only if there were good prospects for recovery.   In holding that

the advanced costs constituted loans and not deductible expenses,

the Court emphasized that “If expenditures are made with the

expectation of reimbursement, it follows that they are in the

nature of loans, notwithstanding the absence of formal

indebtedness.”   Id. at 225.

     In this case, we note that the repayment of the advances was

in no way contingent upon the outcome of the underlying

litigation.   P&G expected to be and was repaid for all costs

advanced to CSAA’s policyholders.   “It has been firmly

established that where a taxpayer makes expenditures under an

agreement that he will be reimbursed therefor, such expenditures

are in the nature of loans or advancements and are not deductible

as business expenses.”   Patchen v. Commissioner, 27 T.C. 592, 600

(1956), affd. in part and revd. in part on other grounds 258 F.2d

544 (5th Cir. 1958).

     Petitioner relies on Boccardo v. Commissioner, 56 F.3d 1016

(9th Cir. 1995), revg. T.C. Memo. 1993-224, in support of the

contention that its advances on behalf of clients were ordinary

and necessary expenses of the law practice.   That case is
                                - 7 -


factually distinguishable because the Boccardo law firm received

a flat percentage (gross fee arrangement) of the client’s

recovery.    The Boccardo law firm was entitled to the fee if the

client recovered, but it was not entitled to reimbursement of the

litigation costs “off the top” or before computing its percentage

fee.    By contrast, a net fee arrangement would normally permit

reimbursement of the costs before computing the percentage fee.

P&G’s fee arrangement did not involve either a gross or net fee

arrangement.    P&G’s fee, which was paid by CSAA, was billed at a

stated hourly rate, not on any form of contingency basis.

Therefore, payment of P&G’s fees and reimbursement of litigation

costs were on a dollar-for-dollar basis.    P&G’s factual situation

is clearly distinguishable from that of the law firm in Boccardo.

Ultimately, the litigation costs in this case were not a burden

on P&G or a reduction of P&G’s fee income received from CSAA for

legal service rendered.

       Petitioner advanced additional arguments with respect to the

reimbursed expenses and litigation costs.   Petitioner argued that

respondent is estopped from denying the deductibility of the

litigation costs because petitioner relied on the contents of an

Internal Revenue Service publication entitled “Business Expenses

for 1988” (publication).   The publication contains the following

statement, at 3:
                                - 8 -


     If you are a cash method taxpayer who pays an expense
     and then recovers any part of the amount paid in the
     same tax year, reduce your expense deduction by the
     amount of the recovery. If you have recovery in a
     later year, include the recovered amount in income.
     * * *

     Petitioner’s reliance on that publication is unwarranted

because the excerpt relied upon assumes that the expenditure is

deductible in the first instance.   The material relied on by

petitioner does not address the critical preliminary question of

whether the costs advanced were loans or expenses.   Reliance on

the Commissioner’s publication, in this instance, is misplaced

because it does not contain guidance on the question of which

costs, payments, or disbursements constitute a deductible

expense.4

     Respondent, in the notice of deficiency, disallowed

petitioner’s claimed deduction of litigation costs for 1993.

Respondent also reversed petitioner’s 1993 income inclusion

attributable to reimbursement of litigation costs deducted in

prior years (including 1992).   Finally, respondent determined

that section 481 applied, and so the reimbursement income



     4
        Assuming arguendo that the publication was applicable to
the question of whether or not advanced costs are deductible, the
statement relied on by petitioner is the statement of a legal
principle (i.e., Tax Benefit Rule). Because a necessary element
for estoppel is that there be reliance on a factual statement,
the circumstances here would not satisfy that necessary
prerequisite. See Estate of Emerson v. Commissioner, 67 T.C.
612, 617-618 (1977).
                               - 9 -


reversed out by respondent was again included in 1993 income.     On

brief, respondent contended that the section 481 adjustment was

necessary “to correct the distortion caused by the double

exclusion.”   That is, petitioner deducted litigation costs for

1992 and, under respondent’s deficiency notice approach reversing

the reimbursement income, petitioner did not have to account for

the 1993 reimbursement of the previously deducted items.

     Section 481(a) provides that where taxable income from any

year is computed under a method of accounting that is different

from the method used for the preceding year, then the computation

of the taxable income for the year of the change shall take into

account those adjustments that are determined to be necessary

solely by reason of the change in order to prevent duplications

and/or omissions.   A section 481 change includes a change in the

overall plan or method of accounting for income or deductions.     A

section 481 change also includes a change in the treatment of any

material item used in the overall plan.   See secs. 1.481-1(a)(1),

1.446-1(e)(2)(ii)(a), Income Tax Regs.    A material item is

defined as “any item which involves the proper time for the

inclusion of the item in income or the taking of a deduction.”

Sec. 1.446-1(e)(2)(ii)(a), Income Tax Regs.    A “change in method

of accounting does not include adjustment of any item of income

or deduction which does not involve the proper time for the

inclusion of the item of income or the taking of a deduction.”
                               - 10 -


Sec. 1.446-1(e)(2)(ii)(b), Income Tax Regs.; see also Copy Data,

Inc. v. Commissioner, 91 T.C. 26, 30-31 (1988); Schuster’s

Express, Inc. v. Commissioner, 66 T.C. 588, 597 (1976), affd.

without published opinion 562 F.2d 39 (2d Cir. 1977).

     Here, petitioner claimed deductions for its clients’

litigation costs, which petitioner expected would be reimbursed.

The focus of respondent’s adjustment addressed whether petitioner

was entitled to deductions for those costs.   Respondent did not

change the method of accounting by which petitioner reported a

particular item but instead determined that the item was not

deductible, ab initio.   The result of petitioner’s deduction in

one year and inclusion in another may appear like a timing

question because it could result in increased deductions reducing

petitioner’s income in one year and petitioner’s reporting as

income any reimbursed deductions in a subsequent year.   The

essence of respondent’s determination, however, was that

petitioner’s payments of litigation costs were loans to its

clients, so the deductions were not allowable and the

reimbursements were not includable in income.

     Accordingly, section 481 is not applicable here, and

respondent’s attempt to obviate “the distortion caused by the

double exclusion” must fail.   Respondent’s determination and

position on brief does not mention tax benefit principles that

might require petitioner to report, as income, the reimbursed
                                - 11 -


litigation costs during 1993.    By reversing petitioner’s

reporting of reimbursement income, respondent chose not to rely

on tax benefit principles.   Respondent relied solely on section

481 to correct any improper prior year benefit and to cause the

inclusion in income of the reimbursed costs.    Therefore,

petitioner is not entitled to deduct the litigation costs for its

1993 taxable year, and no section 481 adjustment is appropriate

for petitioner’s 1993 tax year.5

     Finally, we note that respondent did not include in the

reversal of the reimbursements the aggregate of the $400 amounts

CSAA advanced to petitioner upon the beginning of each case.

Under petitioner’s approach the $400 amounts were included as

part of the reimbursement income reported.    On brief, respondent

contended that petitioner had unrestricted use of the $400

amounts because they were first deposited in petitioner’s general

bank account and then transferred to a segregated account for

payment of litigation costs.    Accordingly, respondent did not

reverse the $400 amounts out of income or include them in the

section 481 adjustment.   Petitioner, however, has not


     5
        There is some question as to whether tax benefit
principles apply where a deduction was improperly or erroneously
taken (as it was in this case). We note, however, that an appeal
of this case would normally be to the Court of Appeals for the
Ninth Circuit, where tax benefit principles have been held to
apply concerning improper or erroneous deductions.   See Unvert
v. Commissioner, 656 F.2d 483 (9th Cir. 1981), affg. 72 T.C. 807
(1979).
                               - 12 -


specifically alleged error or countered, on brief, respondent’s

position with respect to respondent’s treatment of the $400

amounts.    Accordingly, respondent’s decision not to reverse the

“$400 portion” of the reimbursement income is not in controversy,

and there is no need to consider that aspect of the

determination.

     In addition to contesting the substance of respondent’s

determination, petitioner also contends that the amounts

disallowed by respondent are unreasonable and inaccurate.    The

problem is generated by the fact that petitioner did not

specifically account for litigation costs in reporting its

income.    Petitioner used a form of netting to arrive at the

amount of the claimed deduction.    Petitioner’s approach is to

treat receipts and expenses as part of a “revolving pool into

which unsegregated receipts” were deposited and then used to pay

expenses.    Respondent determined that $129,815 of petitioner’s

$358,092 in claimed deductions was not allowable by concluding,

in part, that reimbursements during the first 6 months of the

next fiscal year (ended May 1994) represented litigation costs

advanced by petitioner during the 1993 fiscal year.    Petitioner

argues that respondent ignored the revolving pool concept and,

instead, calculated the disallowed portion of the deduction using

an analysis of individual cases pending in petitioner’s office.
                               - 13 -


     Respondent explained that his agent used a statistical

sampling technique to calculate the amount of the deduction to

disallow for the 1993 tax year.    The agent analyzed a sampling of

cases to find the average time delay between expenditure and

reimbursement by calculating the average length of time a sample

case remained open.   This was corroborated by reviewing the

frequency of bank deposits and comparing specific deposits to a

sampling of cases.    By this type of methodology, respondent’s

agent estimated a 6-month period between expenditure and

reimbursement.

     Although respondent’s determination involved estimates, it

is reasonably accurate under the circumstances because of

petitioner’s failure to maintain records that would identify the

amount of unreimbursed litigation costs for the fiscal year.      In

that regard, petitioner bears the burden of showing that

respondent’s determination is in error.    Petitioner has not

provided the Court with a method that is more reliable than

respondent’s.    Petitioner’s failure to keep or present respondent

or the Court with adequate records showing the amounts involved

is of its own doing, and, accordingly, petitioner must bear those

consequences.    See Silverton v. Commissioner, T.C. Memo. 1977-

198, affd. without published opinion 647 F.2d 172 (9th Cir.

1981).   Accordingly, we sustain respondent’s determination as to
                              - 14 -


the amount and characterization of the nondeductible advanced

litigation costs.

II.   Net Operating Losses

                         FINDINGS OF FACT

      P&G incurred a $3,382 net operating loss (NOL) for its 1990

fiscal year.   For the 1991 fiscal year, P&G incurred a $277,478

NOL, and it did not carry either the 1990 or 1991 NOL back to

prior fiscal years.   In addition, no election was made waiving

the NOL carryback with respect to prior years.    On its Federal

income tax returns for the years ended May 31, 1992 and 1993, P&G

reported taxable income of $163,295 and $239,422, respectively,

without considering the NOL deductions.     P&G carried the 1990 and

1991 NOL’s forward, applying them first to absorb fiscal year

1992 taxable income, and the NOL balance (deduction) was then

carried forward and applied to the 1993 fiscal year.

      P&G sent a letter to the Internal Revenue Service Center in

Fresno, California, on August 14, 1990, containing the following

statement/question:

           QUESTION TO IRS. We have a loss for the year
      6/1/89 -- 5/31/90. Are we required to carry that loss
      back to previous years, requiring amendment of previous
      years’ returns, or may we just carry the loss forward
      to future years and thus avoid the necessity of
      amending prior returns? Thank you for your assistance.

P&G did not receive a response.
                                 - 15 -


     Ultimately, respondent determined that the loss available

for use against the 1993 income should be reduced by the amount

of the loss which would have been absorbed if carried back to

pre-1990 fiscal years.

                                 OPINION

     Taxpayers are permitted to carry net operating losses from

one taxable year to another.     See sec. 172(a).   In general,

taxpayers who sustain NOL’s must first carry such losses back 3

years, and, if unabsorbed for the earlier years, then the losses

may be carried forward, for as long as 15 years.      See sec.

172(b)(1)(A) and (2).    A taxpayer, however, may elect to

relinquish the 3-year carryback period and simply carry a loss

forward.   See sec. 172(b)(3).    To make this election, the statute

expressly requires taxpayers to file an election relinquishing

the carryback period by the return due date, including any

extensions of time, for the taxable year in which the NOL was

first incurred.   Once made, the election is irrevocable.     The

statute directs the Secretary to prescribe the manner in which

taxpayers shall make the election.        See id.

     The Secretary promulgated the following requirements for

making the election:

     [The election] shall be made by a statement attached to
     the return (or amended return) for the taxable year.
     The statement required * * * shall indicate the section
     under which the election is being made and shall set
     forth information to identify the election, the period
                              - 16 -


     for which it applies, and the taxpayer’s basis or
     entitlement for making the election.

Sec. 301.9100-12T(d), Temporary Proced. & Admin. Regs., 57 Fed.

Reg. 43896 (Sept. 23, 1992) (redesignating sec. 7.0, Temporary

Income Tax Regs., 42 Fed. Reg. 1470 (Jan. 7, 1977)).

     We have previously analyzed these statutory and regulatory

requirements under section 172 in Young v. Commissioner, 83 T.C.

831 (1984), affd. 783 F.2d 1201 (5th Cir. 1986).   In Young, it

was held that in order substantially to comply with the election

regulations, “as an absolute minimum, the taxpayer must exhibit

in some manner, within the time prescribed by the statute, his

unequivocal agreement to accept both the benefits and burdens of

the tax treatment afforded by that section.”   Id. at 839.

     P&G’s August 14 letter falls far short of this minimum or

threshold requirement.   First, the letter to the service center

was not attached to P&G’s return as required by the regulation.

Second, the letter does not manifest P&G’s agreement or intention

to make the election; it merely inquires whether such an election

can be made.   In that regard, most of the NOL’s in question were

incurred during 1991, the year after P&G sent the letter of

inquiry to the service center.   Under these circumstances, we

cannot find that P&G has complied with the regulatory

requirements, and we sustain respondent’s determination that
                                    - 17 -


P&G’s NOL should be reduced by the amounts that would have been

absorbed by the carryback of the losses to pre-loss years.6

III.       Accuracy-Related Penalty Under Section 6662

       Respondent also determined that petitioner was negligent and

liable for a penalty under section 6662(a) and (b)(1) for the

year at issue.       Section 6662(a) and (b)(1) imposes an accuracy-

related penalty equal to 20 percent of an underpayment that is

attributable to negligence or disregard of rules or regulations.

       Negligence has been defined as a “lack of due care or a

failure to do what a reasonable person would do under the

circumstances.”       Leuhsler v. Commissioner, 963 F.2d 907, 910 (6th

Cir. 1992), affg. T.C. Memo. 1991-179.           Respondent’s

determination of negligence is presumed correct, and petitioner

bears the burden of showing that respondent’s determination is

erroneous.       See Rule 142(a).   Therefore, petitioner must prove

that it was not negligent; i.e., that it made a reasonable

attempt to comply with the provisions of the Internal Revenue

Code and that it was not careless, reckless, or in intentional

disregard of rules or regulations.           See sec. 6662(b) and (c).   We

find that petitioner was negligent for deducting the advanced

litigation costs as ordinary and necessary business expenses and



       6
        To the extent we have not addressed certain other
arguments made by petitioner, we found them to be wholly without
merit.
                              - 18 -


for disregarding the regulations concerning the treatment of

NOL’s.7

     In deciding whether petitioner was negligent, we take into

account the legal background and years of legal experience

possessed by petitioner’s owner(s).    See Glenn v. Commissioner,

T.C. Memo. 1995-399, affd. without published opinion 103 F.3d 129

(6th Cir. 1996).   P&G and its officer(s) operated a law practice

and should have realized that the advances were to be fully

reimbursed and that they should have been treated as loans, not

expenses, for Federal income tax purposes.   Ample case precedents

supporting our holding were extant at the time P&G claimed the

deductions.   In addition, petitioner has not demonstrated that it

made a reasonable attempt to comply with the regulations

concerning the election to carry forward NOL’s.   Under the

circumstances here, we cannot agree with petitioner, which

operates a law practice, that the inquiry made to respondent




     7
        Respondent also determined that petitioner was liable for
a sec. 6662(b)(2) penalty because its underpayment was
substantial. As a result of our holding with respect to the
negligence penalty, we need not address respondent’s alternative
penalty determination.
                              - 19 -


about the election was sufficient to avoid the penalty for

negligence.   Accordingly, petitioner is liable for the section

6662(a) penalty.

     To reflect the foregoing,

                                      Decision will be entered

                                 under Rule 155.
