                              T.C. Memo. 2013-231



                         UNITED STATES TAX COURT



             FRONTIER CUSTOM BUILDERS, INC., Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 2678-10.                         Filed September 30, 2013.



      Juan F. Vasquez, Jr., Jaime Vasquez, and Mel E. Myers, for petitioner.

      William G. Bissell and Betina Nadler, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      GOEKE, Judge: Respondent determined a $653,272 deficiency in the

corporate income tax of petitioner, Frontier Custom Builders, Inc. (Frontier), for

its 2005 taxable year. After concessions,1 the issues for decision are:

      1
       The parties stipulated and agreed that of the total $362,240 rent expense
Frontier deducted on its 2005 tax return, Frontier may neither deduct nor capitalize
                                                                       (continued...)
                                         -2-

[*2] (1) whether Frontier, a custom homebuilder, is required to capitalize rather

than deduct all direct and certain indirect costs of production. We hold that it is;

      (2) whether Frontier can change its accounting method without having

previously secured respondent’s consent. We hold that it cannot and therefore we

must decide whether respondent’s determination that petitioner must change from

an improper to proper accounting method is unlawful. We hold that it is not;

      (3) whether Frontier must capitalize a portion of the cost of its officer’s

compensation. We hold that it must;

      (4) whether Frontier must capitalize a portion of the cost of its nonofficer

employees’ compensation. We hold that it must;

      (5) whether Frontier must capitalize a portion of its other expenses

incurred. We hold that it must; and




      1
        (...continued)
$73,601 but may deduct $288,639. The parties also agreed the following expenses
are fully deductible: salaries and bonuses for sales and marketing employees;
State franchise tax; corporate income tax; employment tax; depreciation; legal fees
for warranty claims; office telephone for the Fairfield and Oakhurst offices;
warranty; Web page maintenance; decorating models; bank charges; dues and
subscriptions; meals; charitable contributions; and advertising.
                                         -3-

[*3] (6) whether Frontier qualifies for adjustments for other tax years through

the mitigation provisions. We hold that Frontier’s request for relief under the

mitigation provisions is premature until the decision in this case becomes final.

                               FINDINGS OF FACT

      Some of the facts have been stipulated for trial under Rule 91.2 The

stipulation of facts and the attached exhibits are incorporated by this reference and

are found accordingly.

      At the time the petition was filed, Frontier, a Texas corporation, maintained

its principal place of business in Houston, Texas. Frontier timely filed its Form

1120, U.S. Corporation Income Tax Return, for 2005, the tax year at issue.

Respondent timely issued a notice of deficiency. In the notice, respondent made

adjustments to Frontier’s income totaling $1,888,625 under the uniform

capitalization (UNICAP) rules of section 263A. The total $1,888,625 adjustment

comprises a $1,722,676 section 481(a) adjustment and a $165,949 section 263A

adjustment and resulted in a $653,272 corporate income tax deficiency. Frontier

timely filed a petition with this Court for redetermination of the deficiency.




      2
       Unless otherwise indicated, all Rule references are to the Tax Court Rules
of Practice and Procedure, and all section references are to the Internal Revenue
Code in effect for the year at issue.
                                         -4-

[*4] I. Frontier

      Frontier was founded in 1990 and incorporated in 1992. Since 1994

Frontier has been a builder of custom and speculative homes.

      On its 2005 tax return Frontier capitalized direct material and labor costs

and post-production-period carrying costs but claimed deductions for salaries,

yearend bonuses, and other miscellaneous expenses.

      Frontier used the same accounting method for tax that it used for financial

(book) accounting. Frontier did not submit Form 3115, Application for Change in

Accounting Method, to respondent requesting permission, nor has it received

permission, to change its accounting method for 2005. Frontier maintained no

contemporaneous time records showing how many hours Frontier employees spent

on their various activities on the company’s behalf.

II. Ronald W. Bopp

      At all relevant times Mr. Bopp was president and CEO of Frontier. He

founded Frontier after working for many years--during high school and college--in

the construction industry as a framer, roofer, and carpenter and later acquiring

management experience at Kroger.

      As president Mr. Bopp worked long hours and performed a variety of jobs

at Frontier. He worked 55-70 hours per week, rarely took a vacation, and was
                                        -5-

[*5] never away for more than three days. His duties involved managing all of the

company’s departments, monitoring and preparing its financial statements, writing

company policy manuals, determining its hiring needs and recruitment, and

overseeing its legal affairs. In 2005 Frontier paid Mr. Bopp a regular salary and a

yearend bonus. Frontier did not produce contemporaneous time records showing

how many hours Mr. Bopp spent on each of his various activities.

      Mr. Bopp was well connected with the operations of his company and had

several reports and tools that he used to track the progress of homes. He

conducted weekly meetings with the project managers as an opportunity to learn

what stage of completion the homes were in and to discuss critical situations. He

would occasionally stop by worksites for other meetings and to solve problems the

project managers could not resolve. He received monthly reports and productivity

schedules detailing when a job was going to close and whether the project

managers were running 100% productivity on their homes. Mr. Bopp was the

direct boss of the project managers. He had a very good understanding of the

progress of each homebuilding project and participated in the preparation of the

homes’ progress reports.
                                          -6-

[*6] Mr. Bopp determined which developers Frontier would work with, he

reviewed and approved Frontier’s subcontractors, and he conducted reviews to

make sure the project managers researched the suppliers and vendors.

III. Other Employees

        A. Project Managers

        The duties of a project manager included managing construction, being the

primary contact for customers, performing warranty work, and ensuring that the

homes were built per design and in conformity with building standards.

        In 2005 Frontier paid its project managers regular salaries, bonuses for

warranty work, and yearend bonuses. Mr. Bopp delegated the warranty work to

his project managers. Project managers worked closely with the designers and

decorators throughout the homebuilding process. The project managers did not

personally purchase building materials, nor did they hammer any nail or lay any

wood.

        Mr. Bopp hired David Connery, a supervisor, to directly oversee the work of

the project managers. Despite Mr. Connery’s serving as the project managers’

supervisor, Mr. Bopp would still step in to address specific situations with the

project managers. Mr. Connery left Frontier at the end of July 2005, and Mr.

Bopp continued to oversee the duties of the project managers.
                                          -7-

[*7] B. Designers and Decorators

      The designers met with clients, identified what they wanted in a house, and

designed the house using the company’s AutoCAD software. They also designed

the electrical wiring, plumbing, staircases, elevations, structural plan, doors,

windows, glass blocks, floors, and driveways. Frontier paid the designers regular

salaries, profit-sharing bonuses, and warranty bonuses. The design services were

provided outside of the homebuilding contracts, and a client using these services

could walk away from Frontier and use that design with another builder.

      The decorators worked with clients to create and sell upgraded home

products such as: exteriors, roofing, appliances, wallpaper, countertops, shower

doors/glass trim, wrought iron spindles, paint colors, tile, wood floors, carpets,

counters, plumbing and light fixtures, moldings, hardware, stains, window

treatments, shutters, backsplashes, doors, and other accessories. Frontier paid the

decorators regular salaries and warranty bonuses.

      C. Elisa Wolfe

      Elisa Wolfe worked as an administrative assistant to Mr. Bopp. She did

day-to-day entries on home and inventory schedules and assisted Mr. Bopp with

talking to lenders and handling warranty issues. Frontier paid Ms. Wolfe a regular

salary and a yearend bonus.
                                         -8-

[*8] D. Charlotte Guarino

       Charlotte Guarino was an accountant for Frontier who worked on accounts

receivable, client billings, payroll, accounts payable invoices for payments to

contractors, and some tax preparation. Frontier paid Ms. Guarino a regular salary

and a yearend bonus.

       E. Sandra Alvarado

      Sandra Alvarado was a tech writer on staff that took the policy manuals Mr.

Bopp wrote and converted them into Web-based PDFs. These documents pertained

to personnel policy, employee handbooks, and benefits packages. Frontier paid

professional fees to Ms. Alvarado for her services in 2005.

      F. Jason Belden

      Jason Belden was Frontier’s information technology specialist. He modified

and improved the programming for the company Web site. Frontier paid Mr.

Belden a regular salary and a bonus.

IV. Carrying Costs

      In 2005 Frontier capitalized post-production-period carrying costs, which

were incurred to keep homes in a marketable condition until they could be sold.

Frontier did not submit Form 3115 to respondent to request permission, nor has

Frontier received permission, to change its accounting method for the homeowner
                                          -9-

[*9] association dues, property taxes, other taxes, utilities, and insurance

capitalized in 2005.

V. Other Expenses

      A. Taxes

      In 2005 Frontier deducted employees’ payroll tax expenses and owner’s

payroll tax expenses.

      B. Employee Benefit Program

      Frontier deducted employee benefit program costs in 2005. The employee

benefit program is representative of the health insurance provided to the employees

during the 2005 year.

      C. Insurance

      In 2005 Frontier deducted costs for builder’s risk insurance, general liability

insurance, and vehicle insurance. The builder’s risk insurance cost is for a policy

specifically related to each job in production or under construction. It covers each

individual job for things like fire, vandalism, and theft. The general insurance cost

represents an umbrella policy that covers the whole company. It covers things like

slip-and-fall cases in the model homes, copyright infringement claims, and

advertising infringement claims. The vehicle insurance covered the vehicle that

Mr. Bopp drove to work.
                                        -10-

[*10] D. Vehicle Expenses

      Frontier deducted vehicle expenses for a company vehicle that Mr. Bopp

drove in 2005. He drove his company-provided vehicle only for business purposes.

      E. Office Expenses

      Frontier deducted office expenses relating to the sales offices, main office,

and model homes in 2005.

      F. Mobile Telephone Expenses

      Frontier deducted mobile telephone expenses relating to the sales offices,

sales personnel, corporate office, project managers, and decorators in 2005.

      G. Office Telephone Expenses

      Frontier deducted office telephone expenses relating to the sales offices,

main office, and model homes in 2005.

      H. Tool Expenses

      In 2005 Frontier deducted costs for small tools used for random repairs on

the job.

      I. Annual Retreat (Training and Seminars)

      Frontier deducted costs, including travel costs, for its annual all-employee

training seminar in 2005. The all-employee training seminar was an annual, three-

day retreat for employees. It was used for teambuilding; discussing what Frontier
                                         -11-

[*11] could do better, future opportunities, and ways to improve processes; going

over financials; and reviewing invoices in a way to ensure the entire team (i.e.,

accounting, project managers, and sales staff) understood the process.

      J. Utility Expenses

      Frontier deducted utility expenses relating to the sales offices, main office,

and model homes in 2005.

      K. Computer Maintenance Expenses

      Frontier deducted computer maintenance costs incurred to repair existing

computer equipment and keep systems updated in 2005. All models had computers

and all design work on the homes required computer systems.

                                     OPINION

I. Burden of Proof

      Generally, taxpayers bear the burden of proving, by a preponderance of the

evidence, that the determinations of the Commissioner in a notice of deficiency are

incorrect. Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115 (1933).

Deductions are a matter of legislative grace, and a taxpayer bears the burden of

proving entitlement to any claimed deductions. Rule 142(a)(1); INDOPCO, Inc. v.

Commissioner, 503 U.S. 79, 84 (1992).
                                           -12-

[*12] Section 7491(a), however, shifts the burden of proof to the Commissioner if

the taxpayer produces credible evidence on any factual issue and satisfies the

requirements of section 7491(a)(2). The benefits of section 7491(a) are unavailable

to a corporation unless the taxpayer can demonstrate that, on the date the Tax Court

petition was filed, it met the net worth and employee threshold in section

7491(a)(2)(C). Frontier contends section 7491(a) applies to shift the burden of

proof, but the record is not clear on whether Frontier meets the requirements of

section 7491(a)(2)(C).

      In respect of any new matter, the Commissioner bears the burden of proof.

Rule 142(a)(1). As discussed later, on brief respondent changed his calculation of

the appropriate method of accounting for Frontier’s indirect costs, which we find to

be akin to new matter. Shea v. Commissioner, 112 T.C. 183, 190-191 (1999)

(“When the Commissioner attempts to rely on a basis that is beyond the scope of

the original deficiency determination, the Commissioner must generally assume the

burden of proof as to the new matter.”).

      However, on the record before us, we do not need to reference the burden of

proof to resolve this case as the facts are adequately presented.
                                          -13-

[*13] II. UNICAP Section 263A

        We begin with a brief overview of how the UNICAP rules work under

section 263A. Section 263A requires taxpayers that produce real property to

capitalize certain direct and indirect costs of production and recover those costs in

a matter appropriate to the situation. Sec. 1.263A-1(c)(1), (3), (4), Income Tax

Regs.

        Direct costs that must be capitalized include direct material and direct labor

costs. Sec. 1.263A-1(e)(2), Income Tax Regs. Indirect costs that must be

capitalized are all indirect costs properly allocable to property produced. Indirect

costs are properly allocable to property produced when the costs directly benefit or

are incurred by reason of the performance of production activities. Sec. 1.263A-

1(e)(3)(i), Income Tax Regs. Accordingly, indirect costs must be allocated

between production and nonproduction activities. Sec. 1.263A-1(c)(1), (e)(3),

Income Tax Regs.

        In addition to production costs, indirect costs include service costs. Service

costs must be allocated among capitalizable, deductible, and mixed service costs.

Sec. 1.263A-1(e)(4)(ii), Income Tax Regs. If an entire department or function

performs only production or only nonproduction service activities, the entire cost

of that department or function will be capitalizable or deductible, respectively.
                                         -14-

[*14] Mixed service costs are those service costs which are partially allocable to

production and partially allocable to nonproduction. Sec. 1.263A-1(e)(4)(ii)(C),

(h)(6), Income Tax Regs.

      A. Custom Homebuilder (Frontier)

      As a preliminary matter, we must decide whether Frontier, as a custom

homebuilder, is subject to the UNICAP rules under section 263A. Frontier

contends its business model is centered around sales and marketing, not

production-related services. The thrust of its argument is that custom homebuilders

differ from speculation homebuilders because their price premiums and

profitability come not from cost control, but rather from the creativity of their

salespeople, designers, decorators, and marketing employees.

      Section 263A requires taxpayers that produce real property to capitalize

certain costs. The term “produce” includes “construct, build, install, manufacture,

develop, or improve.” Sec. 263A(g)(1).

      Frontier contends it is outside the scope of section 263A because it does not

employ the tradesmen--e.g., carpenters, welders, and plumbers--who actually build

the homes. All of those activities are subcontracted out. It therefore claims its

actual employees’ services, and the related costs incurred, are more reflective of a
                                          -15-

[*15] sales and marketing company that manages the creation of a custom product

rather than a construction company producing streamlined goods.

      Our holding in Von-Lusk v. Commissioner, 104 T.C. 207 (1995), illustrates

that activities in addition to physical construction may be included in the

production of real property. In Von-Lusk, the question was whether a partnership

had to capitalize costs such as performing engineering and feasibility studies and

drafting architectural plans. We held that those activities were development

activities even though they had no immediate physical impact on the property. Id.

at 216. In deciding Von-Lusk, we reviewed the text and legislative history of

section 263A and observed that Congress intended the term “produce” to be

broadly construed.

      Frontier sells custom and speculative homes. Speculative homebuilding is

the classic production activity to which section 263A applies. Frontier’s argument

is that custom homebuilding is different from speculative homebuilding and that

this difference keeps its activities out of the reach of section 263A. Before Frontier

sells a home, it builds it; before Frontier builds a home, it designs it. After Frontier

creates the design for each custom home, it subcontracts out the physical labor to

the tradesmen who actually build the home. Frontier’s use of subcontractors for the

physical home construction is not enough to exempt Frontier from section 263A.
                                          -16-

[*16] See, e.g., sec. 1.263A-2(a)(1), Income Tax Regs. The creative design of

custom homes is ancillary to the actual physical work on the land and is as much a

part of a development project as digging a foundation or completing a structure’s

frame. The construction of a home cannot move forward if the design step is not

taken. Therefore, we reject Frontier’s argument and find Frontier is a producer of

real property subject to section 263A.

      B. Accounting Method

      We turn to the issue of Frontier’s accounting method vis-a-vis section 263A.

A taxpayer must compute its taxable income under an accounting method that in

the Commissioner’s opinion clearly reflects income. See sec. 446.

      Frontier used the same accounting method for tax that it used for financial

(book) accounting. In 2005 Frontier capitalized direct material and labor costs and

post-production-period carrying costs, but it claimed deductions for salaries,

yearend bonuses, and other miscellaneous expenses. Frontier requests this Court to

sustain its original reporting position of deducting all of the above expenses.3

       3
       Frontier asserted an accounting method in its pretrial memorandum
different from the one asserted at trial or in its posttrial briefs. In its pretrial
memorandum, Frontier argued that additional sec. 263A costs should be allocated
to ending inventory using the standard cost method under sec. 1.263A-1(f)(3)(ii),
Income Tax Regs., or one of its close variants, the specific identification method
under sec. 1.263A-1(f)(2), Income Tax Regs., the burden rate method under sec.
                                                                             (continued...)
                                       -17-

[*17] The Commissioner has broad discretion to decide whether a taxpayer’s

accounting method clearly reflects income, and his determination is to be upheld

unless it is clearly unlawful. Thor Power Tool Co. v. Commissioner, 439 U.S. 522

(1979). Respondent determined the accounting method Frontier used in 2005 did

not comply with section 263A and therefore did not clearly reflect income. Once

the Commissioner determines that a taxpayer’s method does not clearly reflect

income, he may select for the taxpayer a method which, in his opinion, does clearly

reflect income. Sec. 446(b). The courts will uphold the Commissioner’s

determination unless the taxpayer makes a clear showing that the Commissioner

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

Cir. 1970), aff’g T.C. Memo. 1969-79; Standard Paving Co. v. Commissioner, 190

F.2d 330, 332 (10th Cir. 1951), aff’g 13 T.C. 425 (1949). The taxpayer carries the

burden of showing that the method selected by the Commissioner is incorrect; this




      3
       (...continued)
1.263A-1(f)(3)(i), Income Tax Regs., or a permitted modified version thereof.
Because Frontier made no argument to that effect at trial or on brief, we deem it
waived. See Bernstein v. Commissioner, 22 T.C. 1146, 1152 (1954) (holding
against the taxpayer with respect to an issue because, among other things, the
taxpayer did not press the issue on brief), aff’d per curiam, 230 F.2d 603 (2d Cir.
1956); Lime Cola Co. v. Commissioner, 22 T.C. 593, 606 (1954) (“Petitioners in
their brief do not argue anything about * * * [the issue]; and, although they do not
expressly abandon the issue * * *, we presume they no longer press it.”).
                                        -18-

[*18] burden is extremely difficult to carry. Hamilton Indus., Inc. v.

Commissioner, 97 T.C. 120 (1991).

      Upon examination, respondent placed Frontier on a method of accounting

that respondent determined clearly reflected income. The chosen method was a

combination of the simplified production and simplified service cost methods of

accounting.

      The simplified production method provides a simplified method for

determining the additional section 263A costs properly allocable to property on

hand at the end of the taxable year. Sec. 1.263A-2(b)(1), Income Tax Regs. The

simplified service cost method provides a simplified method for determining

capitalizable mixed service costs properly allocable to the taxpayer’s production

activities. Sec. 1.263A-1(h)(1), Income Tax Regs. Both methods can be used for

noninventory property held primarily for sale to customers in the ordinary course of

business. Secs. 1.263A-2(b)(2)(i)(B), 1.263A-1(h)(2)(i)(B), Income Tax Regs.

Homes built by homebuilders are noninventory property subject to section 263A.

Carpenter v. Commissioner, T.C. Memo. 1994-289.

      Section 263A required Frontier to capitalize certain costs. As discussed

below, Frontier did not capitalize those costs. Therefore, its previous method of

accounting was not in compliance with section 263A. Accordingly, we reject
                                         -19-

[*19] Frontier’s argument that it should be allowed to maintain its original

reporting position of deducting the capitalizable costs under section 263A.

      Because Frontier’s previous accounting method was not in compliance with

section 263A and Frontier has made no showing that respondent abused his

discretion in choosing the simplified production and simplified service cost

methods of accounting, we uphold respondent’s determination.

      C. Calculation of Accounting Method

      Before trial the parties agreed to a stipulated exhibit showing respondent’s

calculation of the appropriate method of accounting for Frontier’s indirect

production costs. See Rule 91. Respondent on brief presented a different

calculation. Respondent proposes to change the way he characterizes some of

Frontier’s expenses (e.g., changing a cost allocation from partly capitalizable,

deductible, and mixed-service to entirely mixed service). This posttrial adjustment

is akin to presenting a new matter.4 However, we find this posttrial adjustment

permissible for two reasons. First, it does not alter the original deficiency or


       4
       “A new theory that is presented to sustain a deficiency is treated as a new
matter when it either alters the original deficiency or requires the presentation of
different evidence. * * *A new theory which merely clarifies or develops the
original determination is not a new matter in respect of which * * * [the Internal
Revenue Service] bears the burden of proof.” Shea v. Commissioner, 112 T.C.
183, 191 (1999).
                                        -20-

[*20] require the presentation of different evidence. Respondent’s new

calculations rely on evidence that was presented at trial. This adjustment merely

clarifies or develops respondent’s original determination. Second, this adjustment

is not prejudicial to Frontier’s case-in-chief because Frontier made no idiosyncratic

argument based on respondent’s stipulated, pretrial calculation. Frontier simply

maintained on brief that this Court should sustain Frontier’s original reporting

position of fully deducting all of its 2005 expenses at issue. Accordingly,

respondent is permitted to use his posttrial calculation adjustments.

      D. Officer Compensation (Mr. Bopp)

      Frontier fully deducted the compensation of its corporate officer, Mr. Bopp,

for 2005, and respondent determined that this compensation expense is subject to

section 263A as a mixed-service cost. In 2005 Mr. Bopp was paid a regular annual

salary and a yearend profit-sharing bonus. Frontier argues his compensation

should be wholly deductible for the year in which paid. We start by addressing his

salary, then turn to his bonus.

             1. Salary

      Frontier argues Mr. Bopp’s compensation is a deductible service cost

because he was being compensated for his responsibilities relating to overall

management, overall company policy, general financial accounting, strategic
                                         -21-

[*21] business planning, and “marketing, selling, or advertising”. See sec. 1.263A-

1(e)(4)(iv), Income Tax Regs.

      The cost of overall management of the taxpayer may be deductible provided

that no substantial part of the cost of that function benefits a particular production

activity. Sec. 1.263A-1(e)(4)(ii)(A), Income Tax Regs. Therefore, if a substantial

part of the cost benefits production, then at least a portion of that cost must be

capitalized. Respondent does not dispute that Mr. Bopp acted as a CEO of Frontier

and was responsible for Frontier’s overall management. Respondent argues that a

substantial part of Mr. Bopp’s services benefited production and therefore a

portion of his salary should be capitalized as a mixed-service cost.

      Respondent relies on PMT, Inc. v. Commissioner, T.C. Memo. 1996-303, to

support his determination to capitalize a portion of Mr. Bopp’s salary. In PMT, we

were faced with a corporate president, Mr. Penalba, who worked in both production

and sales for a company owned jointly by him and his wife. We held 75% of the

compensation paid to Mr. Penalba was subject to section 263A.

      The facts of PMT are similar to the facts here. PMT, Inc., designed its own

fabrics, purchased the raw materials, contracted out the production operations to

fabric manufacturers, and sold the fabrics to customers. Mr. Penalba met with

customers to discuss fabric designs. He then designed those fabrics according to
                                         -22-

[*22] the customer’s specifications. He shared responsibility for ensuring the

fabric manufacturing process was cost efficient, so it was also his responsibility to

select the efficient and capable factories that were going to produce the fabrics.

Mr. Penalba also supervised and worked directly with his production manager who

managed the production of the fabrics. In addition, Mr. Penalba was responsible

for PMT’s sales operations, including: recruiting and training salespeople, serving

as sales manager, and supervising sales staff.

      Like PMT, Inc., Frontier designs homes, purchases raw materials, contracts

out production operations, and sells homes to customers. Similar to Mr. Penalba,

Mr. Bopp would meet with his clients to discuss house designs. Frontier’s

designers do the bulk of the design work, but the record also shows Mr. Bopp did

some design work on clients’ homes during the year at issue. These designs are

done according to the specifications clients make during their initial meeting with

Mr. Bopp. Mr. Bopp also managed the efficiency of the production by monitoring

monthly reports and productivity schedules to determine whether the project

managers were running 100% productivity on the homes. Mr. Bopp worked

closely with his project manager supervisor, Mr. Connery, and with the project

managers directly. Further, he selected the developers Frontier would work with

and reviewed the project managers’ choices on vendors and suppliers.
                                         -23-

[*23] The PMT case demonstrates that a corporate officer can be heavily involved

in sales, as Mr. Penalba was and as Mr. Bopp claims to have been; and yet when

some of his other activities directly benefited production, a portion of his

compensation will be subject to capitalization under section 263A.

      Frontier distinguishes PMT on the sole premise that Mr. Bopp employed a

full sales, design, decorating, project management, and marketing staff, which freed

him to do other deductible service duties.5

      However, Frontier stipulated its inability to produce contemporaneous time

records to show how many hours Mr. Bopp spent on his various activities on behalf

of Frontier. Frontier relies on Mr. Bopp’s uncorroborated testimony to show the

number of hours he spent on each of his various activities. In Tokarski v.

Commissioner, 87 T.C. 74, 77 (1986), we held that the Court is not required to

accept a party’s self-serving testimony that is uncorroborated by persuasive

evidence. Frontier then concludes that after considering the amount of time Mr.

Bopp testified to spending on these duties, an inference can be drawn that little

time remained to perform production-related activities. Frontier asks the Court to

find such an inference in hopes that we find Mr. Bopp spent over 90% of his time

       5
       Frontier listed various duties Mr. Bopp performed on behalf of Frontier that
were most in line with the deductible service activities listed under sec. 1.263A-
1(e)(4)(iv), Income Tax Regs.
                                         -24-

[*24] on policy- and sales-related functions, thus entitling Frontier to deduct 100%

of Mr. Bopp’s salary under the de minimis rule in section 1.263A-1(g)(4)(ii),

Income Tax Regs.6

      We find Mr. Bopp’s testimony regarding the number of hours he spent on

each activity insufficient to show that no substantial portion of his time was spent

on production-related activities. The record indicates Mr. Bopp engaged in

production-related services; and because Mr. Bopp cannot substantiate the time he

spent on each of his other activities, we find the de minimis rules to be of no use to

Frontier. See sec. 1.263A-1(g)(4)(ii), Income Tax Regs. Accordingly, we hold that

Mr. Bopp’s salary is partially allocable to production-related services and partially

allocable to non-production-related services. Therefore, his compensation is

subject to section 263A as a mixed service cost.




       6
              (ii) De minimis rule. --For purposes of administrative
       convenience, if 90 percent or more of a mixed service department’s
       costs are deductible service costs, a taxpayer may elect not to allocate
       any portion of the service department’s costs to property produced or
       property acquired for resale. * * * Under this election, however, if 90
       percent or more of a mixed service department’s costs are
       capitalizable service costs, a taxpayer must allocate 100 percent of the
       department’s costs to the production or resale activity benefitted.
                                            -25-

[*25]           2. Bonus

        Frontier makes two arguments for deducting Mr. Bopp’s yearend bonus.

First, according to Frontier, Mr. Bopp received no direct benefit from any of his

annual bonuses7 when they were issued; every year that a bonus was received, Mr.

Bopp redeposited the entire bonus, less employment taxes, into the company for

additional working capital. Frontier furthers this argument by pointing out that Mr.

Bopp did not live an extravagant lifestyle as he drove a 1994 Ford truck and lived

on the company’s premises. Second, Frontier claims the bonus was deductible

because it is determined by profits from homes sold and thus cannot be related or

capitalized to ending inventory.

        Frontier’s first argument is wholly erroneous. Mr. Bopp’s taste in living

quarters and mode of transportation is in no way relevant to whether Frontier can

deduct his bonus distribution. Section 263A(c), (d), and (h) identify the situations

in which section 263A will not apply. Nowhere do those subsections, nor any

other applicable Code or regulation sections, state an exception or exemption from

section 263A for compensation paid to persons living a modest lifestyle.

        Frontier’s second argument raises a method of accounting question. Frontier

attempts to allocate the bonus distribution exclusively to homes sold by yearend

        7
            This refers to bonuses he received in 2005 as well as years not at issue.
                                         -26-

[*26] because the payment came from the moneys obtained from those homes sold,

i.e., profits. However, this argument must fail because such a method of

accounting does not clearly reflect income. See sec. 446(b). Allowing Frontier to

allocate the bonus distribution in this manner would create a distorted view of

Frontier’s income. Most of Frontier’s costs and expenses are likely paid from its

sales proceeds. If Frontier’s purported cost allocation method were allowed, all

production costs could escape capitalization under section 263A with a simple

journal entry (i.e., saying payments came out of profits from homes sold as opposed

to cash on hand). Similarly, this would hold true for all taxpayers subject to section

263A. If we were to adopt this view, it would be a rare phenomenon for any

taxpayer to ever be required to capitalize production (or reseller) costs.

Accordingly, we hold that Mr. Bopp’s yearend profit-sharing bonus is a mixed-

service cost, the same as his regular annual salary.

      E. Employee Compensation

             1. Employee Bonuses

      Frontier makes the same argument for deducting the yearend profit-sharing

bonuses paid out to its employees that it made for Mr. Bopp’s bonus distribution.

We deny this claim for the same reasons we denied it for Mr. Bopp’s
                                         -27-

[*27] bonus distribution. Therefore, these bonuses will be accorded the same

treatment as the regular salary payments made to each respective employee.

             2. Project Managers

      Frontier claims the project managers’ compensation should not be

capitalized because they perform sales, marketing, and warranty services. Frontier

further justifies its position by asserting its project managers did not do any of the

construction work themselves, i.e., they did not hammer any nail or lay any wood.

In support of the sales and marketing claim, Frontier argues that project managers

are the first point of contact for customers and often have the opportunity to sell

upgrades such as better quality windows for more energy efficiency or added

service on blinds or shutters and to simply remind the customers that Frontier has a

furniture department where they can get accessories and furniture.

      Respondent does not dispute the deductibility of the warranty bonuses.

Accordingly, those expenses are deductible. Respondent does however dispute the

deductibility of the salaries and yearend bonuses. We have already addressed the

treatment of all employee bonuses under the previous heading, so we will focus

only on the salary expense.

      It is irrelevant that the project managers did not hammer any nail or

otherwise engage in physical construction. Project managers were responsible for
                                           -28-

[*28] overseeing the actual physical construction of homes and ensuring each home

was built per design and in conformity with building standards. They also chose

and approved the replacement suppliers and vendors, subject to Mr. Bopp’s review.

Frontier asserts that the project managers’ duties, at least in part, fall under

“marketing, selling, or advertising”. See sec. 1.263A-1(e)(4)(iv)(N), Income Tax

Regs. Frontier relies on testimony stating how project managers often had the

opportunity to sell upgrades. However, Frontier points to no evidence showing that

project managers in fact sold upgrades. Frontier has also failed to produce any

contemporaneous time records showing how many hours Frontier’s project

managers spent on their various activities, e.g., supervising construction versus

selling upgrades.

      Direct labor costs include the costs of labor that can be identified or

associated with particular units or groups of units of specific property produced.

Sec. 1.263A-1(e)(2)(i)(B), Income Tax Regs. Mr. Bopp’s own testimony indicated

that building homes was the primary responsibility of the project managers.8 He

also testified that project managers would work on 8 to 10 homes at a time and that

       8
           Direct examination of Mr. Bopp:

                Q: Who has primary responsibility for building homes?

                A: The project managers.
                                         -29-

[*29] they could complete the build of a home in about six months.9 Therefore, we

find the project managers’ duties are direct costs as the cost of their labor can be

identified with particular groups of homes (i.e., the 8 to 10 homes each project

manager worked on). Accordingly, we find the project managers’ compensation

must be fully capitalized under section 263A.

               3. Designers and Decorators

      Frontier contends the compensation paid to Frontier’s designers and

decorators is deductible because their services relate to exempt or deductible

activities. According to Frontier, its design and sales functions overlapped.

Frontier claims the designers were incorporated into the sales process to increase

sales, while the decorators worked alongside the sales team to entice customers to

purchase upgrades.


       9
           Direct examination of Mr. Bopp:

                Q: How many homes is a project manager responsible for
                at a time?

                A: You know, a typical project manager should be able to
                run between eight to ten homes annually--I mean at a time.

                Q: How long does it take to manage the building of a home?

                A: To complete a home, the typical build time is approximately
                six months.
                                         -30-

[*30] Respondent does not dispute the deductibility of the warranty-work bonuses

paid to both the designers and decorators. Accordingly, those expenses are

deductible.

      The record shows the designers designed homes using AutoCAD software,

including designing electrical wiring, plumbing, staircases, elevations, structural

plans, doors, windows, glass blocks, floors, and driveways. It also shows the

design services were provided outside of the homebuilding contract, and a client

using these services could walk away from Frontier and use that design with

another builder.

      The record shows the decorators met with clients to discuss what selections

they wanted in their homes, i.e., creating an opportunity for upgrading tile

selections, light fixtures, window treatments, etc. Both designers and decorators

worked closely with the project managers throughout the homebuilding process.

      Frontier did not produce contemporaneous time records to show how many

hours these employees actually spent on activities related to marketing, advertising,

or selling any homes, nor did it produce any records detailing what portion of

design services was provided that did not end up attaching to a custom home built

by Frontier. Nothing in the record supports the claim that the designers and

decorators actually made any sales in the performance of their duties. It merely
                                         -31-

[*31] shows that there was an opportunity created for suggesting upgrades while

talking to clients about which features the construction crew should build into the

custom home. The costs incurred during the production process for the designers’

work10 --designing electrical wiring, plumbing, staircases, structural plans, etc.--

and the decorators’ work--upgrading tile selections, window treatments, etc.--are

indirect costs that directly benefited or were incurred by reason of Frontier’s

production activities.

      Therefore, we find these costs must be capitalized as indirect costs properly

allocable to produced property as the costs directly benefited or were incurred by

reason of the performance of production activities. Sec. 1.263A-1(e)(3)(i), Income

Tax Regs.

             4. Elisa Wolfe

      Ms. Wolfe, Mr. Bopp’s administrative assistant, was paid both a regular

salary and a yearend bonus.

      Respondent argues Ms. Wolfe’s compensation should be characterized the

same as Mr. Bopp’s compensation because she assisted Mr. Bopp in his daily




       10
       Sec. 1.263A-1(e)(3)(ii)(P), Income Tax Regs., specifically identifies
design work as an indirect cost required to be capitalized.
                                         -32-

[*32] duties, which we found to be partially production related and partially

nonproduction related. Frontier argues her compensation is deductible in full.

      Because Frontier maintained no contemporaneous time records detailing the

hours Ms. Wolfe spent on her designated duties, we agree her compensation should

be treated very similarly to that of Mr. Bopp, whom she assisted day after day.

Therefore, we agree that Ms. Wolfe’s duties were partially production related and

partially nonproduction related. Accordingly, her compensation is a mixed-service

cost, the same as Mr. Bopp’s compensation.

             5. Charlotte Guarino

      Ms. Guarino was in charge of accounts receivable, client billings, payroll,

and some tax preparation. Frontier argues that her salary and bonus are deductible

under section 1.263A-1(e)(4)(iv)(C), Income Tax Regs., as general accounting

services.

      Respondent does not dispute that managing accounts receivable, client

billings, and tax preparation are all deductible service costs. Sec. 1.263A-

1(e)(4)(iii)(E), (iv)(C), (M), Income Tax Regs. Therefore, Frontier may deduct her

compensation to the extent it relates to these services.

      However, per section 1.263A-1(e)(4)(iii)(E), Income Tax Regs., Frontier

must capitalize her compensation to the extent it relates to Frontier’s payroll
                                         -33-

[*33] functions that are allocable to Frontier’s production activities. Accordingly,

her compensation is a mixed-service cost as it is partially allocable to production

activities and partially allocable to nonproduction activities. See sec. 1.263A-

1(e)(4)(ii)(C), Income Tax Regs.

             6. Sandra Alvarado

      Ms. Alvarado was paid to convert the construction, general administration,

and decorating manuals into online PDFs. Frontier claims the manuals pertain to

design, construction, decorating, sales, and general administration making Ms.

Alvarado’s compensation deductible under section 1.263A-1(e)(4)(iv)(F), Income

Tax Regs., as quality control policy services.

      Respondent contends that Ms. Alvarado’s compensation expense should be

treated as a mixed-service cost to the extent the costs directly benefit production

(e.g., construction, design, and decoration).

      Section 263A applies to costs properly allocable to tangible personal

property produced by the taxpayer. Sec. 1.263A-1(a)(3), Income Tax Regs.

Frontier produced company handbooks and manuals--i.e., tangible personal

property. Costs incurred to create personnel policy or quality control policy are not

generally allocated to production activities. Sec. 1.263A-1(e)(4)(iv)(E) and (F),

Income Tax Regs. Respondent relies on the parenthetical in section 1.263A-
                                         -34-

[*34] 1(e)(4)(iv)(E), Income Tax Regs.,11 for the notion that these manuals fall

short of the exception in the regulations because they relate to production of the

custom homes. However, the parenthetical is clear that establishing and managing

personnel policy in general is a deductible service. The qualifying language (i.e.,

“unrelated to particular production or resale activities”) respondent relies on is

applicable only to the development of employee training programs.

      The manuals Mr. Bopp created were not created for employee training

programs. They were created as a general personnel policy guide and as a

reference for maintaining good-quality homes. Therefore, we find the

policymaking Mr. Bopp engaged in fits within section 1.263A-1(e)(4)(iv)(E) and

(F), Income Tax Regs. Because Ms. Alvarado was just converting the policy

manuals Mr. Bopp created, we find this cost should be given the same treatment.

But see Domestic Mgmt. Bureau, Inc. v. Commissioner, 38 B.T.A. 640, 644

(1938). Accordingly, the costs incurred to have Ms. Alvarado convert Frontier’s

policy manuals are fully deductible.




       11
              (E) Personnel policy (such as establishing and managing
       personnel policy in general; developing wage, salary, and benefit
       policies; developing employee training programs unrelated to
       particular production or resale activities; negotiating with labor
       unions; and maintaining relations with retired workers).
                                         -35-

[*35]         7. Jason Belden

        Frontier paid Mr. Belden a salary and a profit-sharing bonus as Frontier’s

information technology specialist. Mr. Belden modified and improved the

programming for the company’s Web site. The Web site was designed to inform

clients about amenities Frontier offered. And according to Mr. Bopp’s own

testimony, it also helped him keep track of change orders and follow leads.

        Respondent argues that Mr. Belden’s compensation is a mixed-service cost

as his work benefited both sales and production.12 See sec. 1.263A-1(e)(4)(ii)(C),

Income Tax Regs. Frontier asserts that this Web site only provided information for

customers and therefore argues for full deductibility. However, the record reflects

this cost relates to more than just marketing homes to customers. In his testimony,

Mr. Bopp admitted that Frontier used the Web site for internal uses such as

referencing change orders and following leads. Therefore, Mr. Belden’s

compensation for reprogramming the Web site is a mixed-service cost as it is

partially allocable to production activities and partially allocable to nonproduction

activities. See id.




        12
       Respondent agrees the Web page maintenance cost of $2,653 was a
deductible expense.
                                         -36-

[*36] F. Carrying Costs

      Frontier capitalized 2005 carrying costs consisting of HOA fees, property

taxes, interest, utilities, and insurance. Frontier now wishes to change its

accounting so these costs will be treated as having been deducted for 2005, not

capitalized.13 Frontier argues these costs were paid to maintain homes after the

completion of the homebuilding project and therefore cannot be deemed production

related.

      When a taxpayer in a court proceeding retroactively attempts to alter the

manner in which he accounted for an item on his tax return, the taxpayer cannot

prevail if consent for the change in accounting method has not been secured. Sec.

446(e); S. Pac. Transp. Co. v. Commissioner, 75 T.C. 497, 682-683 (1980).

Frontier did not submit Form 3115 to respondent to seek permission to change its

method of accounting for these costs, and it has not received permission.

Accordingly, Frontier may not now change its method of accounting for its claimed

carrying costs.




       13
        These costs were properly capitalized for 2005 as the regulations
specifically require carrying costs to be capitalized as an indirect cost. Sec.
1.263A-1(e)(3)(ii)(H), Income Tax Regs.
                                         -37-

[*37] G. Other Expenses

             1. Taxes

      Frontier deducted its employees’ payroll tax expenses and owner’s payroll

tax expenses for 2005. Respondent argues the employees’ payroll tax expenses

should be allocated among capitalizable, deductible, and mixed-service costs in

accordance with the treatment afforded to each respective group of employees.

Respondent also argues the owner’s payroll tax expenses should be treated the

same as Mr. Bopp’s compensation--partially allocable to production activities and

partially allocable to nonproduction activities.

      Taxes otherwise allowable as deductions shall be capitalized as an indirect

cost to the extent they are attributable to labor used in production. Sec. 1.263A-

1(e)(3)(ii)(L), Income Tax Regs. Frontier’s employees’ payroll tax expenses and

owner’s payroll tax expenses are attributable to Frontier’s labor force. To the

extent the labor contributed to the production of custom homes, those taxes must be

capitalized. Therefore, we agree with respondent. The employees’ payroll tax

expenses shall be allocated among capitalizable, deductible, and mixed-service

costs in accordance with the treatment afforded to each respective group of

employees; the owner’s payroll tax expenses shall be treated as a mixed-service

cost, the same as Mr. Bopp’s compensation.
                                          -38-

[*38]         2. Employee Benefit Program

        Frontier deducted employee benefit program costs in full for 2005. These

costs related to health insurance for Frontier’s employees. Premiums on health

insurance and miscellaneous benefits provided for employees such as safety and

medical treatment are indirect costs that must be capitalized to the extent they are

properly allocable to property produced. Sec. 1.263A-1(e)(3)(ii)(D), Income Tax

Regs. Not all of Frontier’s employees performed production-related duties.

Therefore, like the employees’ payroll taxes, these costs should be allocated among

deductible, capitalizable, and mixed-service costs in accordance with the treatment

afforded to each respective group of employees.

              3. Insurance

        Frontier deducted costs for builder’s risk insurance, general liability

insurance, and vehicle insurance on the car Mr. Bopp drove in furtherance of

Frontier’s activities. In response to respondent’s request for admissions, Frontier

admitted that the vehicle insurance was an indirect cost. Insurance costs are an

indirect cost that must be capitalized to the extent they are properly allocable to

property produced. Sec. 1.263A-1(e)(3)(ii)(M), Income Tax Regs. We earlier

determined Mr. Bopp’s activities are partially allocated to production-related

activities and partially allocated to non-production-related activities. Therefore,
                                           -39-

[*39] the vehicle he used in furtherance of those activities should be afforded the

same treatment as the activities for which he used the vehicle. Accordingly, we

find the vehicle insurance expense shall be accorded the same calculated allocation

as Mr. Bopp’s compensation.

        Mr. Bopp testified that the builder’s risk insurance covered the building of

homes. This is clearly production related. Therefore, the builder’s risk insurance

cost must be capitalized.

        Frontier claims that the general liability insurance was an umbrella policy for

the whole corporation and used for issues like copyright infringement, advertising

claims, tort liability, etc. Frontier asserts that it benefited all of Frontier’s

departments and benefited production activities (which used builder’s insurance)

only at a de minimis level. See sec. 1.263A-1(b)(11)(iii), (g)(4)(ii), Income Tax

Regs.

        Respondent agrees that the general liability insurance was an umbrella

policy, but he asserts that it covered incidents arising from the production of homes

and thereby capitalizes the full expense. Respondent relies on section 1.263A-

1(e)(3)(ii)(M), Income Tax Regs.

        Section 1.263A-1(e)(3)(ii)(M), Income Tax Regs., provides that the cost of

insurance on plant or facility, machinery, equipment, materials, or property
                                         -40-

[*40] produced is an indirect cost that must be capitalized to the extent it is

properly allocable to property produced. By Frontier’s own admission, the general

liability insurance covers departments that are production related. Because Frontier

has produced no documentation to substantiate its de minimis claim, we disagree

that it falls outside the scope of section 263A. Section 1.263A-1(e)(4)(iii)(A),

Income Tax Regs., also requires capitalization of general administration costs of

production activities incurred. It therefore follows that the general liability

insurance is partly allocable to production-related departments and partly allocable

to non-production-related departments like the other expenses that apply company

wide (e.g., taxes, employee benefits, office expenses, and utilities). Thus, we find

the proper calculation for the general liability insurance is to allocate that expense

among deductible, capitalizable, and mixed-service costs in accordance with the

treatment afforded to each respective department covered by the general liability

insurance.

             4. Vehicle Expenses

      Frontier deducted vehicle expenses related to the vehicle Mr. Bopp drove for

the company in 2005. He drove his company-provided vehicle only for business.

For the same reasons we find the vehicle insurance expense partially allocable to

production activities and partially allocable to nonproduction activities, we find the
                                         -41-

[*41] same treatment proper for the vehicle expenses. Therefore, because Mr.

Bopp used his company vehicle in the performance of his duties, the vehicle

expenses are a mixed-service cost the same as Mr. Bopp’s compensation.

             5. Office Expenses

      Frontier deducted office expenses incurred for models, sales offices, and the

main office. Mr. Bopp testified that this expense covered things like telephone and

Internet charges for models, sales offices, and the main office. Because we address

the office telephones separately below, these office expenses will refer to all office

expenses excluding the office telephones. Frontier states that these offices were

rarely if ever used by project management staff. Consequently, it is argued that

only a de minimis portion of the expenses could be said to be allocable to

production. See sec. 1.263A-1(b)(11)(iii), (g)(4)(ii), Income Tax Regs.

      Because Frontier acknowledges some portion of these expenses is allocable

to production and did not provide any substantiation for its claim that that portion

is de minimis, we find these expenses partially allocable to production-related

activities and partially allocable to non-production-related activities. Respondent

argues these expenses should be allocated among capitalizable, deductible, and

mixed-service costs using the ratio of each category of employee compensation to

total compensation. We agree this is a good way of allocating the expense to
                                         -42-

[*42] identify which services (production related versus nonproduction related) the

expenses attached to. Accordingly, the office expenses shall be allocated among

deductible, capitalizable, and mixed-service costs in accordance with the treatment

afforded to each respective group of employees.

                6. Mobile Telephone Expenses

      Frontier deducted mobile telephone expenses relating to sales offices, sales

personnel, the corporate office, and project managers. Frontier argues only 10% of

this expense is allocable to production-related operations and it is therefore fully

deductible under the de minimis rule. See id. Because Frontier produced no

documentation substantiating this claim, we find the basis of its argument

insufficient.

      The record indicates mobile telephones were used partially in production

activities and partially in nonproduction activities. Respondent allocates 79% of

the mobile telephone expense to production activities by dividing the total

compensation expense of $536,875 for project managers and decorators by the total

compensation expense of $679,131 for project managers, decorators, and

salespeople. We stated above that the project managers’ and decorators’

compensation is a capitalizable expense; therefore, we find this formula acceptable.
                                         -43-

[*43] Accordingly, 79% ($536,875/$679,131 = 79%) of the mobile telephone

expense shall be capitalizable.

             7. Office Telephone Expenses

      Frontier deducted office telephone expenses relating to the models and main

offices. Frontier claims the project managers seldom used the office telephones, if

ever. Respondent disagrees with Frontier’s claim and maintains the telephone

expense should be allocated among capitalizable, deductible, and mixed-service

costs per section 1.263A-1(e)(3)(ii)(N), Income Tax Regs.14 We agree with

Frontier that because the project managers had company-provided mobile

telephones, they would seldom use office phones, if ever. However, the project

managers were not the only people in these offices. Therefore, the telephones

benefited both the production-related and non-production-related services being

conducted from the offices and models. Accordingly, the office telephone

expenses are allocable among deductible, capitalizable, and mixed-service costs the

same as the other office expenses discussed above.




       14
        Utilities, including the cost of electricity, are an indirect expense required
to be capitalized to the extent they are properly allocable to property produced.
                                          -44-

[*44]         8. Tool Expenses

        Frontier deducted tool expenses for 2005 for miscellaneous tools used on the

job. Frontier justifies this deduction by saying they were used in the company’s

sales function since they were used to repair the model homes, which were used as

a selling tool. Tools and equipment, as well as the costs for repairs and

maintenance, are capitalizable indirect costs to the extent they are properly

allocable to property produced. Sec. 1.263A-1(e)(3)(ii)(O), (R), Income Tax Regs.

Frontier built (i.e., produced) these model homes and, as the record indicates, sold

a few to customers in 2005. These expenses are therefore production related and

should be capitalized in full.

              9. Annual Retreat (Training and Seminars)

        Frontier incurred a cost, including travel costs, for its annual all-employee

training seminar in 2005. The all-employee training seminar was an annual three-

day retreat for its employees. It was used for teambuilding; discussing what the

company could do better, future opportunities, and ways to improve processes

throughout the company; going over financials; and reviewing invoices in a way

that allowed the entire team (accounting, project managers, and sales staff) to

understand the process.
                                          -45-

[*45] Costs associated with personnel policy (such as developing employee

training programs unrelated to particular production activities) are a deductible

expense. Sec. 1.263A-1(e)(4)(iv)(E), Income Tax Regs. Reviewing invoices so

that members of a production team can understand the invoicing process or

discussing ways the company can more efficiently build homes seems to be

production related on its face; however, we find in this instance it is not. It does

not simply need to be related to production in the general sense to require

capitalization; rather, it has to be related to “particular production activities”.

Reviewing an invoice from some project done earlier in the year so that a team can

fully understand the company’s internal procedures for invoicing is not related to a

particular production activity. Neither is sitting in a circle discussing ways the

company can build homes more efficiently. Therefore, we find the annual retreat

was geared towards teambuilding and developing ideas for better efficiency; more

importantly, it was unrelated to any particular production activity. Accordingly,

the annual retreat expense is a deductible expense.

      With regard to the travel expense, respondent’s allocation characterizes it as

a partially capitalizable, partially deductible, and mixed-service cost. Frontier

argues this expense should be deductible in the same manner as the rest of the

expenses related to the annual retreat. Because we find the annual retreat unrelated
                                         -46-

[*46] to a particular production activity and therefore nonproduction related, we

see no reason why the travel expense should not enjoy the same treatment.

Therefore, the travel expense is a deductible expense.

             10. Utility Expenses

      Frontier deducted expenses for utilities. These expenses pertained only to

model homes and the main office. Similar to its brief justification with the tools

expense, Frontier merely states that this cost related to model homes and therefore

should be fully deductible.

      Under section 1.263A-1(e)(3)(ii)(N), Income Tax Regs., utilities such as gas,

electricity, and water are indirect costs that must be capitalized to the extent they

are properly allocable to property produced. Since these utility expenses related to

both model homes--produced and held for sale to customers--and the main office,

they are properly allocable to production-related and nonproduction-related

property. Accordingly, like the office expenses, the utility expenses shall be

allocated among deductible, capitalizable, and mixed-service costs.

             11. Computer Maintenance Expenses

      Frontier deducted computer maintenance expenses. These expenses related

to repairing existing computer equipment and keeping systems updated.
                                        -47-

[*47] Computers were maintained for designers and salespeople in model homes.

All models had computers and all design work required computer systems.

      Frontier claims the full expense amounts are deductible because they

primarily related to model homes and design work at its main office. Respondent

argues the expenses are 65% capitalizable. He arrives at this percentage by

dividing the designers’ production-related compensation of $231,567 by the total

compensation for designers and salespeople, including the noncapitalizable bonus

for designers, of $354,048.

      These computer maintenance expenses are partially allocable to production-

related activities as the designers used these computers and systems to design

homes in the production phase. But these expenses are also partially allocable to

non-production-related activities as they were used in model homes by salespeople.

Therefore, we agree with respondent’s calculation and find the computer

maintenance expense to be 65% capitalizable.

III. Mitigation

      Section 1311 provides for the correction of the effect of certain errors under

circumstances specified in section 1312 when one or more provisions of law, such

as the statute of limitations, would otherwise prevent such correction. The

overriding purpose of these provisions is to permit an equitable adjustment by
                                          -48-

[*48] treating an error as if it had never existed. O’Donnell v. Belcher, 414 F.2d

833 (5th Cir. 1969). The party invoking the mitigation provisions carries the

burden of proving the specific requirements are met. Olin Mathieson Chem. Corp.

v. United States, 265 F.2d 293 (7th Cir. 1959).

      Frontier makes a claim for relief under the mitigation provisions because

once it makes the necessary corrections to its capital account, it will have an

increase in basis for 2005 which will result in the corporation’s also capitalizing a

larger amount in the following years. Consequently, Frontier hopes to use the

mitigation provisions to make an adjustment for one or more of those later years.

      While it is true that “it is important that the mitigation provisions be given a

liberal and remedial interpretation”, see O’Brien v. United States, 766 F.2d 1038,

1042 (7th Cir. 1985), it is also true that “‘[t]he danger of an over-liberal

interpretation of statutory purpose is reduced, at least to some extent, by the

necessity for fitting the facts of each case into the concrete, detailed requirements

set out in the statute’”, Belcher, 414 F.2d at 839 (quoting United States v. Rachal,

312 F.2d 376, 383 (5th Cir. 1962)).

      Section 1311 applies only if a determination as defined in section 1313 is

described in one or more paragraphs of section 1312. Section 1313(a)(1) defines

the term “determination” to include a decision by the Tax Court which has become
                                         -49-

[*49] final. Finality of Tax Court decisions is provided for in section 7481. Estate

of Mueller v. Commissioner, 101 T.C. 551, 557 (1993). Section 7481 provides a

decision will become final either (1) upon the expiration of the time allowed for

filing a notice of appeal, if no such notice has been duly filed within that time, or

(2) when this decision is affirmed or the appeal is dismissed.

      Frontier asks this Court to grant equitable relief under the mitigation

provisions with an eye toward the date when the decision in this case becomes

final. That, however, is not consistent with the clear provisions of sections 1313(a)

and 7481.15




       15
         Taylor v. Commissioner, 258 F.2d 89 (2d Cir. 1958) (holding Tax Court
was without jurisdiction to grant or deny relief under the mitigation provisions;
decision of the Tax Court does not become final until the means of appellate
review have been exhausted or barred by the passage of time), aff’g 27 T.C. 361
(1956); Wiener Mach. Co., Inc. v. Commissioner, 16 T.C. 48, 54 (1951) (“The
bringing of this proceeding to this * * * [Tax] Court and a decision by this Court
which becomes final is a first step in * * * [the taxpayer’s] obtaining relief from
* * * [the Commissioner] under * * * [sec. 1311-1314].”); Dolenz v.
Commissioner, 41 B.T.A. 1091, 1101 (1940) (“Upon study of the statute and the
Congressional Committee Reports * * * we have no jurisdiction to make the
desired adjustment. The statute provides for adjustment after the date the
determination becomes final.”).
                                       -50-

[*50] In reaching our holdings herein, we have considered all arguments made,

and, to the extent not mentioned above, we conclude they are moot, irrelevant, or

without merit.

      To reflect the foregoing,

                                                   Decision will be entered

                                              under Rule 155.
