T.C. Memo. 2001-145

UNITED STATES TAX COURT

SMARTHEALTH, INC., f.k.a. SEMANTODONTICS, INC., Petitioner v. 

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 8048-99. Filed June 20, 2001.

Jeffrey N. Kelm, Denton N. Thomas, and Dennis I. Leonard, 

for petitioner.

David A. Winsten and J. Robert Cuatto, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

VASQUEZ, Judge: Respondent determined deficiencies in

petitioner’s Federal income taxes of $306,731 and $80,346 for 

the taxable years ending May 31, 1995, and May 31, 1996,

respectively. The sole issue for decision is whether amounts

which petitioner received from its customers in excess of the 
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amounts petitioner was owed (customer overpayments) constitute

gross income in the year of receipt. 

Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the taxable years in

issue, and all Rule references are to the Tax Court Rules of

Practice and Procedure. 

FINDINGS OF FACT

The stipulation of facts and the accompanying exhibits are

incorporated by this reference. Petitioner is an Arizona

corporation whose principal place of business was in Phoenix,

Arizona, at the time the petition in this case was filed. During

the years at issue, petitioner used the accrual method of

accounting for tax reporting purposes. 

Petitioner’s Business

Petitioner’s business involved the manufacture, sale, and

distribution of health care marketing materials, health care

educational materials, and clinical and infection control

products. Petitioner’s client base consisted of dental offices,

veterinary clinics, and other health care professional offices

located throughout the United States and Canada. During the

years at issue, petitioner served approximately 55,000 customers. 

The majority of petitioner’s business marketing was

conducted through mail-order catalogs. Petitioner took orders

for its products through the mail, over the telephone, and
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through sales representatives. Petitioner’s customers generally

ordered small dollar amounts of merchandise, with the average

order amounting to approximately $100. Many of petitioner’s

customers placed orders on a periodic basis. 

During the years in issue, petitioner received approximately

600 orders per day. It was petitioner’s goal and general

practice to ship the ordered product on the same day the order

was received. With each shipment, petitioner enclosed an invoice

containing a description of the product, the sales price, and

applicable shipping and handling charges. In addition,

petitioner mailed monthly statements to those customers who had

outstanding balances payable to petitioner. 

Petitioner offered its customers a variety of payment

options, including open credit, cash on delivery, and payment by

credit card. Petitioner’s customers who paid by check sent their

payments directly to a lockbox operated by Marshall and Isley

Thunderbird Bank (the lockbox agent). It was the responsibility

of the lockbox agent to empty the lockbox, process the payments,

and deposit the payments to petitioner’s non-interest-bearing

operating account. Each day, the lockbox agent would send

computer files to petitioner containing the payment data for the

prior day, which petitioner would use to update its accounts

receivable and other records. 

 
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1 In their arguments, the parties distinguish between

overpayments and duplicate payments. We, however, see no

principled reason for distinguishing between the two. 

Accordingly, in our opinion we shall refer only to customer

overpayments, which include overpayments of any amount. 

2 In certain instances in which the customer was not

completely satisfied with the delivered product but nonetheless

intended to use it, petitioner would negotiate with the customer

an adjustment to the amount billed. Where the customer had

previously paid the full invoice amount, this adjustment would

result in a credit in favor of the customer. For purposes of

this opinion, we shall consider invoice adjustments as part of

customer returns. 

Overpayments, Refunds, and Credit Balances

Some of petitioner’s customers remitted payment in excess of

the amounts they actually owed. In certain instances, the

customer would duplicate the required payment by first paying

pursuant to the product invoice and subsequently making payment

according to a monthly statement issued by petitioner prior to

the receipt of the customer’s initial payment.1 All overpayments

were applied to the customer’s account, generally producing a

credit balance in favor of the customer. 

Petitioner’s marketing materials and shipping invoices

contained a statement of its return policy. The policy allowed

customers to return any item with which the customer was not

satisfied, for any reason, within 60 days of receipt.2 The

customer had the option of selecting a replacement, a full

refund, or a credit to his account. Product returns during the

1995 taxable year totaled $1,154,395, which amounted to
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approximately 2.89 percent of gross sales. With respect to the

1996 taxable year, product returns totaled $1,251,401,

approximately 2.82 percent of gross sales. 

With regard to client credit balances resulting from

overpayments or returns, petitioner’s customers had the option of

(1) applying any or all of the credit balance to a subsequent

purchase, (2) causing a refund check to be issued, (3) having the

amount credited back to the customer’s credit card, or (4)

retaining the credit balance in the customer’s account with

petitioner. Petitioner did not routinely contact customers

having a credit balance in their accounts due to the large number

of orders, the relatively small amount of the credit balance, and

the likelihood that the credit would be applied toward future

purchases. Nonetheless, it was the practice of petitioner’s

customer service personnel to inform the customer of any credit

balance on his or her account when the customer called to place

an order. In addition, petitioner had a sales force of around 70

employees who were dedicated to serving those customers who

purchased petitioner’s infection control products (approximately

one-third of petitioner’s total customers). The sales personnel

were paid a commission on the amount of goods ordered. Given

that the existence of the credit balance made additional sales

more likely (since the customer did not have to come out of

pocket to the extent of the credit), the sales personnel had an
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3 During the years in issue, Arizona followed a version of

the Uniform Unclaimed Property Act of 1981 (UUPA 1981). See

Ariz. Rev. Stat. Ann. secs. 44-301 to 44-340 (West 1994). Under

UUPA 1981, intangible property held or owing in the ordinary

course of the holder’s business that has remained unclaimed by

the owner for more than 5 years is considered abandoned. See

UUPA 1981 sec. 2(a), 8B U.L.A. 595 (1993); see also Ariz. Rev.

Stat. Ann. sec. 44-302 (West 1994). As a general rule, abandoned

property must be delivered to the State of the owner’s last known

residence. See UUPA 1981 sec. 3(1), 8B U.L.A. 598 (1993); see

also Ariz. Rev. Stat. Ann. sec. 44-303 (West 1994). 

incentive to inform their customers of the existence of any

credit balance. 

In the absence of direction from the customer, petitioner

retained the credit balance in the customer’s account. If the

customer placed a subsequent order, the credit balance was

automatically applied against the cost of such order. If a

client did not use or otherwise claim the amount reflected as a

credit on his or her account, it was petitioner’s practice to

dispose of such amounts pursuant to the unclaimed property laws

of the jurisdictions in which its customers resided.3 Petitioner

did not pay its customers interest with respect to the credit

balances. 

As of the close of the 1995 taxable year, 7,611 customers

had credit balances on account with petitioner. These balances

totaled $760,063. Gross sales during this period totaled

$37,159,244. As of May 31, 1996, the number of customers having

credit balances increased to 9,669, while the outstanding amount 
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4 The record does not reflect what portion of the credit

balances were attributable to customer returns as opposed to

customer overpayments. 

5 Petitioner nonetheless continued to consider the amounts

of the customer credit balances that were brought into income as

(continued...)

of such balances grew to $1,049,610. Gross sales during the 1996

taxable year were $40,045,119.4 

Money received by petitioner which gave rise to a customer

credit balance was deposited to petitioner’s general 

non-interest-bearing bank account. The funds in this bank

account were available to and used by petitioner for regular

operating needs. Although petitioner did not maintain a separate

account for funds attributable to the customer credit balances,

such amounts were reflected as a liability on petitioner’s

general ledger for financial accounting purposes. 

Petitioner’s Method of Accounting and Respondent’s Determination

In the course of an audit of petitioner’s 1989 taxable year,

respondent determined that petitioner was required to include in

income the amount of customer credit balances that had been

outstanding for 2 years or more. During the years at issue,

petitioner continued this practice by including in income for

financial and tax accounting purposes the amounts represented by

customer credit balances which had aged for 2 years.5 By way of
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5(...continued)

an obligation in favor of the customer. In other words, the

credit balance still appeared on the customer’s account, and the

customer was still entitled to have the balance refunded or

applied toward additional purchases. 

the notice of deficiency for the years in issue, respondent

determined that amounts represented by the customer credit

balances outstanding as of the close of the taxable years in

issue constitute income in such year (to the extent not

previously included in income), regardless of how long each

particular credit balance had been outstanding. In response to

respondent’s determination, petitioner contends that the amounts

reflected by the customer credit balances constitute income only

if and when such credit balance is applied toward subsequent

purchases. 

OPINION

In his posttrial brief, respondent now concedes that the

portion of the customer credit balances attributable to product

returns does not constitute gross income to petitioner, and we

accept his concession in this regard. Given respondent’s

concession, the sole issue for decision is whether petitioner

must include in income the customer overpayments remaining on

hand at the close of the taxable periods in issue. The parties

agree that the issue should be analyzed under the “claim of

right” doctrine.

The claim of right doctrine was established by the Supreme
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Court in North Am. Oil Consol. Co. v. Burnett, 286 U.S. 417

(1932). In determining the proper taxable year in which to

include income generated from land the legal title to which was

subject to litigation, the Court stated as follows: 

If a taxpayer receives earnings under a claim of right

and without restriction as to its disposition, he has

received income which he is required to return, even

though it may still be claimed that he is not entitled

to retain the money, and even though he may still be

adjudged liable to restore its equivalent. [Id. at

424.]

The Supreme Court elaborated on the claim of right doctrine in

James v. United States, 366 U.S. 213, 219 (1961), as follows:

When a taxpayer acquires earnings, lawfully or

unlawfully, without the consensual recognition, express

or implied, of an obligation to repay and without

restriction as to their disposition, “he has received

income which he is required to return, even though it

may still be claimed that he is not entitled to retain

the money, and even though he may still be adjudged

liable to restore its equivalent.” North American Oil

Consolidated Co. v. Burnet, supra, at p. 424. In such

case, the taxpayer has “actual command over the

property taxed–-the actual benefit for which the tax is

paid,” Corliss v. Bowers, supra [281 U.S. 376, 378

(1930)]. This standard brings wrongful appropriations

within the broad sweep of “gross income”; it excludes

loans. * * *

Accordingly, in order for the customer overpayments to be

excluded from income, petitioner must establish either of the

following: (1) The existence of a consensual recognition of

petitioner’s obligation to repay the overpayments to the

remitting customers, or (2) the presence of a restriction on

petitioner’s disposition of the customer overpayments. 
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While the Supreme Court in James held that an explicit or

implicit consensual recognition of the taxpayer’s obligation to

repay a given sum is sufficient to avoid that sum's being treated

as income pursuant to the claim of right doctrine, the Court did

not elaborate on what constitutes a “consensual” recognition. 

Numerous cases discussing the tax implications of the receipt of

misappropriated funds have since interpreted the phrase (either

explicitly or through application) as requiring a recognition of

the repayment obligation on the part of the obligee as well as

the obligor. See Webb v. IRS, 15 F.3d 203, 207 (1st Cir. 1994);

Collins v. Commissioner, 3 F.3d 625, 632 (2d Cir. 1993), affg.

T.C. Memo. 1992-478; Solomon v. Commissioner, 732 F.2d 1459, 1461

(6th Cir. 1984), affg. T.C. Memo. 1982-603; Moore v. United

States, 412 F.2d 974, 980 (5th Cir. 1969); Howard v.

Commissioner, T.C. Memo. 1997-473. 

The present case, however, does not involve the receipt of

misappropriated funds. Petitioner did not acquire the customer

overpayments through any form of deceit; rather, the overpayments

were the product of inattentive bookkeeping on the part of

petitioner’s customers. Furthermore, there is no indication that

petitioner acted in bad faith with respect to the overpayments. 

When petitioner processed the customer’s payment and realized

that the customer had remitted an amount in excess of the amount 
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owed, petitioner immediately posted a credit to such customer’s 

account and treated the overpayment as a liability for financial

accounting purposes.

While respondent notes that petitioner did not routinely

inform its customers of the existence of the customer credit

balances, we do not view this factor as decisive. First, we

accept the testimony of Dr. Hamann, petitioner’s president and

chief executive officer, that the credit balances tended to be

eliminated through their application toward the purchase price of

subsequent orders. Second, we do not believe that petitioner

intended for its customers to remain ignorant of the credit

balances. It was the practice of petitioner’s customer service

personnel to inform those customers who placed calls to

petitioner of the existence of any credit balance to their

account. Furthermore, the sales personnel charged with servicing

approximately one-third of petitioner’s customers had an

incentive to inform their customers of any credit balances, as

the existence of the credit balance would increase the likelihood

of additional sales upon which such personnel collected a

commission. Third, Dr. Hamann testified that customer

satisfaction is of paramount importance to the financial success

of petitioner’s operation, given the limited number of health

care professionals in need of the product line offered by

petitioner. We therefore do not believe petitioner would risk 
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6 Given this determination, we need not decide whether

there existed a restriction on petitioner’s ability to dispose of

the customer overpayments. 

offending its customers by attempting to prevent their knowledge

and use of the credit balance posted on their accounts. 

There existed an implicit recognition on the part of

petitioner and its customers that the customers would be entitled

to have any amounts which they overpaid returned to them. 

Additionally, the customers who submitted overpayments had at

their disposal all of the information necessary to determine that

they had in fact overpaid. The invoice which petitioner included

with the product shipment, combined with a record of the

customer’s disbursements, would be sufficient for the customers

to determine that they had a credit balance in their favor with

petitioner. Given that the overpayments resulted from the

conduct of petitioner’s customers as opposed to that of

petitioner, we believe that the level of knowledge which

petitioner’s customers possessed in this case is sufficient to

satisfy the existence of a consensual recognition of petitioner’s

obligation to return the overpayments.6 Accordingly, petitioner

is not required to include in income pursuant to the claim of

right doctrine the amount of the customer credit balances

attributable to customer overpayments which remain outstanding as

of the close of the taxable year. 
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To reflect the foregoing, 

Decision will be entered

under Rule 155.