t c no united_states tax_court osteopathic medical oncology and hematology p c petitioner v commissioner of internal revenue respondent docket no filed date p a professional_service_corporation specializes in the treatment of cancer through chemotherapy p uses drugs and ancillary pharmaceuticals collectively the drugs during its treatment the chemotherapy treatments are prescribed by p’s professional staff and patients do not select the type or quantity of drugs used during the treatments p uses the cash_method to expense the cost of the drugs r determined that the drugs were merchandise under sec_1_471-1 income_tax regs and that p must use an accrual_method to report all amounts attributable to the drugs held the inherent nature of p's business is that of a service provider p’s use of the drugs is subordinate to the provision of its services and p uses the drugs as an indispensable and inseparable part of the rendering of its services thus the drugs are not merchandise under sec_1_471-1 income_tax regs and p properly used the cash_method to expense the drugs’ cost david c may for petitioner grant fe gabriel for respondent opinion laro judge the parties submitted this case to the court without trial see rule petitioner petitioned the court to redetermine respondent's determination of a dollar_figure deficiency in its federal_income_tax the sole issue for decision is whether petitioner a professional_service_corporation may use the cash_receipts_and_disbursements_method cash_method to expense the drugs and ancillary pharmaceuticals collectively chemotherapy drugs used by it while providing chemotherapy treatments to its patients we hold it may unless otherwise stated section references are to the internal_revenue_code as applicable to and rule references are to the tax_court rules_of_practice and procedure background all facts are stipulated and are so found the stipulation of facts and exhibits submitted therewith are incorporated herein by this reference petitioner's principal_place_of_business was in clinton township michigan when it petitioned the court petitioner is a professional medical corporation that provides osteopathic services with a speciality in oncology mainly chemotherapy and hematology petitioner's staff consists of physicians nurses and nursing assistants laboratory technicians administrative personnel and office workers petitioner has three offices in the clinton township area at each of these offices petitioner stores chemotherapy drugs and has the staffing equipment and supplies necessary to administer chemotherapy treatments chemotherapy drugs are pharmaceutical drugs which under applicable state michigan law must be prescribed by a doctor and may be sold only by a licensed pharmacist petitioner is not a licensed pharmacist and it is unlawful for petitioner to sell the drugs petitioner may use the drugs during the performance of its chemotherapy services chemotherapy drugs come in ready-to-use form or as powders or liquids that require mixing petitioner generally maintains about a 2-week supply of chemotherapy drugs and it regularly purchases chemotherapy drugs from suppliers to insure that it has enough on hand to administer prescribed treatments chemotherapy drugs in an unmixed form have shelf-lives varying from about months to year when an individual first becomes a patient of petitioner one of petitioner's physicians examines him or her to prescribe necessary treatments and that physician records the individualized chemotherapy treatment in the patient's file after the patient is evaluated and the physician prescribes a chemotherapy regime the patient begins regular periodic treatments the patient does not select the type or quantity of drugs used in the treatments this selection is within the sole discretion of petitioner’s professional staff in accordance with standard oncology practice patients are not examined by a physician at every chemotherapy treatment but are usually reexamined by a physician every to weeks during the ongoing course of treatments any changes in the future course of treatments are documented in the patient's file at that time petitioner's personnel mix and otherwise prepare the chemotherapy drugs that petitioner administers to a patient the chemotherapy drugs cannot be self-administered one of petitioner's oncology nurses generally performs the administration and a physician is always on site to respond to emergencies the physician is not always in the room during the administration petitioner is a participating provider with medicare’ and several other private insurance carriers virtually all of petitioner's patients who receive chemotherapy treatments are covered by medicare or private insurance and those patients are billed only for the cost of the treatments to the extent of co-payments deductibles and other uncovered charges for each ' see health insurance for aged act publaw_89_97 79_stat_291 currently codified pincite u s c secs through 1395ccece patient visit petitioner's staff prepares a physician's statement known as a charge sheet which is the document from which petitioner's billing department generates its bills the charge sheet specifically lists the type amount and cost of chemotherapy and other drugs administered and the type and cost of all professional services rendered the charge sheets are specific as to the particulars of chemotherapy treatments so as to comply with the guidelines of medicare and the private insurance industry petitioner submits the charge sheets directly to medicare or other responsible_party and petitioner bills its patients for the copayments or other charges not covered by insurance medicare and private insurers analyze on an item--by-item basis whether to reimburse the charges shown on the charge sheets the dollar amount reimbursed for a drug administered to a patient is ascertained by reference to the average wholesale price awp of the units in which the drug is packaged and sold wholesale which awp is published annually with quarterly updates generally the reimbursement amount for drugs equals the awp times the units used with rounding up to the next whole unit of a drug when billing for administration of a partial unit it is common industry practice to charge for all medical services provided even when the health care provider anticipates it will not be paid in full for all charges the standard charge nationally for chemotherapy drugs i sec_1 times the awp and petitioner bills its patients for the drugs at this rate with the expectation that the patient will pay the excess over the amount reimbursed with all reimbursement payments from medicare or private insurers petitioner receives an explanation of benefits that details the amounts allowed and disallowed as to each specific charge and the amounts for each charge which are due from secondary insurance and or the patient petitioner has always used the cash_method for purposes of both financial and tax_accounting and it has never maintained an inventory of any of the items used in its practice petitioner expenses as supplies the cost of all chemotherapy drugs purchased during the year the actual cost of chemotherapy drugs which it had on hand at the end of was dollar_figure petitioner deducted on its tax_return dollar_figure in medical_supplies for the actual cost of the chemotherapy drugs and dollar_figure in laboratory supplies for the actual cost of miscellaneous nonpharmaceutical items petitioner reported on its tax_return dollar_figure in gross_receipts and no cost_of_goods_sold respondent determined that petitioner had to inventory its chemotherapy drugs and thus that petitioner's use of the cash_method did not clearly reflect its income respondent changed petitioner's method_of_accounting to a hybrid method which hybrid method accounted for the chemotherapy drugs on an accrual_method and the balance of petitioner's business on the cash_method respondent's change to the hybrid method increased petitioner's income by dollar_figure the actual cost of the chemotherapy drugs on hand at the end of and dollar_figure the value of petitioner's accounts_receivable relating to chemotherapy drugs conveyed to patients as of the end of discussion we decide for the first time whether the furnishing of pharmaceuticals by a medical treatment facility as an integral indispensable and inseparable part of the rendering of medical services is the sale of merchandise for purposes of sec_1_471-1 income_tax regs in 107_tc_116 hca we held that medical_supplies and pharmaceuticals used by hospitals are so vital to the furnishing of medical services that income earned therefrom constitutes income earned from the performance of services for purposes of the nonaccrual-experience method of sec_448 in hca we explicitly reserved for another day the guestion of whether those supplies and pharmaceuticals were merchandise that had to be inventoried under sec_1_471-1 income_tax regs see id pincite n that day is here in the factual setting of a physician’s outpatient chemotherapy treatment facility we decide this issue in the context of whether it was an abuse of respondent’s discretion to exercise his authority under sec_446 and require petitioner to change from the cash_method to a hybrid method presented is the question of whether petitioner should be required to keep inventories for tax purposes under sec_471 respondent determined that petitioner’s chemotherapy drugs were merchandise that was an income-producing factor that petitioner therefore was required sec_446 provides in pertinent part sec_446 general_rule for methods_of_accounting a general_rule ---taxable income shall be computed under the method_of_accounting on the basis of which the taxpayer regularly computes his income in keeping his books b exceptions --if no method_of_accounting has been regularly used by the taxpayer or if the method used does not clearly reflect income the computation of taxable_income shall be made under such method as in the opinion of the secretary does clearly reflect income c permissible methods ---subject to the provisions of subsections a and b a taxpayer may compute taxable_income under any of the following methods of accounting--- the cash_receipts_and_disbursements_method an accrual_method any other method permitted by this chapter or any combination of the foregoing methods permitted under regulations prescribed by the secretary to inventory the drugs and that petitioner was required to use an accrual_method to account for this inventory in order to reflect its income clearly petitioner asserts that it is not a merchandising business but a provider of services to wit chemotherapy treatments for patients stricken with cancer petitioner argues that it need not maintain inventories for the chemotherapy drugs used in the treatments we agree with petitioner that it is not required to inventory its chemotherapy drugs we are mindful of the broad discretion accorded the commissioner in applying sec_446 and sec_471 taxpayers challenging the commissioner’s authority must prove that the commissioner’s determination is clearly unlawful or plainly arbitrary see 439_us_522 see also wal-mart stores inc subs v commissioner tcmemo_1997_1 affd 153_f3d_650 8th cir the fact that the commissioner has broad authority under sec_446 however does not mean that the commissioner may change a taxpayer’s method_of_accounting with impunity see eg 91_tc_1101 affd 882_f2d_820 3d cir the commissioner for example may not change a taxpayer's method_of_accounting from one that clearly reflects income to another one that the commissioner believes more clearly reflects income see -- - 104_tc_367 see also wal-mart stores inc subs v commissioner supra we focus our inquiry on whether the chemotherapy drugs were supplies deductible under sec_162 or merchandise that must be inventoried under sec_471 sec_162 allows a deduction for all the ordinary and necessary expenses paid_or_incurred during the taxable_year in carrying on any trade_or_business the relevant regulations explain that taxpayers carrying materials_and_supplies on hand should include in expenses the charges for materials_and_supplies only in the amount that they are actually consumed and used in operation during the taxable_year for which the return is made provided that the costs of such materials_and_supplies have not been deducted in determining the net_income or loss or taxable_income for any previous year if a taxpayer carries incidental materials or supplies on hand for which no record of consumption is kept or of which physical inventories at the beginning and end of the year are not taken it will be permissible for the taxpayer to include in his expenses and to deduct from gross_income the total cost of such supplies and materials as were purchased during the taxable_year for which the return is made provided the taxable_income is clearly reflected by this method sec_1_162-3 income_tax regs sec_471 provides in pertinent part sec_471 general_rule for inventories a general_rule ----whenever in the opinion of the secretary the use of inventories is necessary in order clearly to determine the income of any taxpayer inventories shall be taken by such taxpayer on such basis as the secretary may prescribe as conforming as nearly as may be to the best_accounting_practice in the trade_or_business and as most clearly reflecting the income the relevant regulations explain that inventories at the beginning and end of each taxable_year are necessary in every case in which the production purchase or sale of merchandise is an income-producing factor sec_1_471-1 income_tax regs jurisprudence provides that a taxpayer with inventories must use an accrual_method unless the taxpayer shows that use of another method would produce a substantial identity of results and that the commissioner’s determination requiring a change is an abuse_of_discretion see 743_f2d_781 llth cir 420_f2d_352 lst cir affg tcmemo_1969_79 ansley-sheppard-burgess co v commissioner t c pincite see also sec_1_446-1 income_tax regs under the facts at hand respondent may require petitioner to utilize an inventory_method of accounting only if we find each of the following as facts petitioner produced purchased or sold merchandise and petitioner's production purchase or sale of that merchandise was an income-producing factor see honeywell inc v commissioner tcmemo_1992_453 affd without published opinion 27_f3d_571 8th cir we need not reach the second part of this inquiry ie whether the production purchase or sale of merchandise is an income-producing factor if we are unable to find first that the chemotherapy drugs are merchandise see wilkinson-beane inc v commissioner supra honeywell inc v commissioner supra sec_1_471-1 income_tax regs the statute and regulations do not define the words merchandise or inventory nor do they clearly distinguish between inventory and materials_and_supplies that are not actually consumed and remain on hand we have held that merchandise as used in sec_1_471-1 income_tax regs is an item acquired and held_for_sale see wilkinson-beane inc v commissioner tcmemo_1969_79 upon appeal the court_of_appeals for the first circuit agreed stating a canvassing of authorities in the accounting field yields several definitions such as goods purchased in condition for sale goods awaiting sale articles of commerce held_for_sale and all classes of commodities held_for_sale clearly the meaning of the term must be gathered from the context and the subject the common denominator however seems to be that the items in question are merchandise if held_for_sale wilkinson-beane inc v commissioner a420 f 2d pincite citations omitted whether an item is acquired and held_for_sale is governed by the substance of the transaction and not its form see honeywell inc v commissioner supra we take into account the particular facts and circumstances of the taxpayer in each case and the manner and context in which the taxpayer operates the business at hand see wilkinson-beane inc v commissioner supra thompson blec inc v commissioner tcmemo_1995_292 honeywell inc v commissioner supra j p sheahan associates inc v commissioner tcmemo_1992_239 we have previously examined service transactions in a variety of industries to determine whether the transactions in substance involved solely the sale of a service or whether the transactions involved the sale of both a service and merchandise those cases are not readily reconcilable and underscore the fact-intense nature of this inguiry we have not however explored this issue in the context of the health care industry and have never had a situation where as here applicable laws would prohibit the taxpayer from selling the items in issue without provision of the attendant service we find the instant setting distinguishable from the setting of those cases in which we have held that goods utilized by a service provider were merchandise for purposes of the inventory rules we give significance to the uniqueness of the industry in see eg addison distribution inc v commissioner tcmemo_1998_289 electronic materials were merchandise thompson elec inc v commissioner tcmemo_1995_292 electrical contractor’s wire conduit and electrical panels were merchandise honeywell inc v commissioner tcmemo_1992_453 rotable spare parts used in maintenance service business were not merchandise court rejected argument that taxpayer’s consideration of the parts' cost to set its fixed fee established that the parts were acquired and held_for_sale affd without published opinion 27_f3d_571 8th cir j p sheahan associates inc v commissioner tcmemo_1992_239 contractor’s roofing materials were merchandise surtronics inc v commissioner tcmemo_1985_277 electroplating metals were merchandise wilkinson--beane inc v commissioner tcmemo_1969_79 funeral business’ caskets were merchandise affd 420_f2d_352 lst cir which petitioner operates in relation to the other service industries we have addressed on this issue and bear in mind the recent case of 107_tc_116 there as explained in more detail below we held that the income attributable to the pharmaceuticals and various medical_supplies frequently used by the personnel of the taxpayer hospital while performing medical services was not income from the sale_of_goods for purposes of the nonaccrual- experience_method of sec_448 we held that those items were inseparably connected to the taxpayer's services see id pincite like the taxpayer in hca petitioner's business is a quintessential service business it is a health care provider that administers chemotherapy treatments to patients with cancer although it furnishes chemotherapy drugs to its patients as part of its service a person cannot obtain the drugs but for the chemotherapy treatments and the treatments require the extensive and specialized service of petitioner's professional staff petitioner's professional staff as an integral and indispensable part of furnishing chemotherapy drugs to a patient must examine the patient and prescribe a treatment regime monitor the length the medical_supplies included items such as radiological dyes casts crutches canes walkers bandages sutures splints skin staples various implants such as joint replacements pacemakers heart valves orthopedic devices and physical and occupational therapy items -- - kind quantity and frequency of the treatments and reevaluate the patient on an ongoing basis that these services are critical and essential to the furnishing of the chemotherapy drugs by petitioner's staff cannot be denied petitioner is not a merchandiser although it is true that petitioner transfers the tangible quality of the chemotherapy drugs to its patients when it administers the drugs to them petitioner does so only as an integral and inseparable part of its service petitioner is precluded by law from selling the chemotherapy drugs to any person without providing the medical service and the drugs are not susceptible of self- administration in fact the only way that a person may legally receive the chemotherapy drugs from petitioner is to agree to petitioner's overall chemotherapy service and when they do agree to this service they have no say in the type or quantity of chemotherapy drugs which petitioner uses in their care usually they are not even aware of the type or quantity of chemotherapy drugs used on them as part of their treatment where as here the service provider dispenses the drugs as an indispensable and inseparable part of the rendering of its services the service provider is not selling merchandise the service provider is using the items as supplies which are essential to the provision of its services a medical practice such as petitioner’s is inherently a service business and the -- - drugs administered in the practice are subordinate to the provision of the medical services we disagree with respondent's contention that the transfer of the drugs is clearly a commercial transaction to the extent he implies a commercial transaction is the conveyance of merchandise given the nature of the services petitioner provides and the substance of the service transactions we are convinced petitioner is not selling merchandise when it administers chemotherapy drugs the case of 425_us_1 parallels that conviction there the supreme court decided whether drugs purchased by a nonprofit_hospital at prices lower than those charged commercial pharmacists were exempt from the antiprice discrimination provisions of the robinson-patman antidiscrimination act ch 49_stat_1526 u s c sec a the exemption generally applies where the nonprofit institution is purchasing the drugs for its own use as opposed to for sale to patients in siding with the hospital's contention that it was exempt the court stated it seems to us to be very clear that a hospital's purchase of pharmaceutical products that are dispensed to and consumed by a patient on the hospital premises whether that patient is bedded or is seen in the emergency_facility or is only an outpatient is a purchase of supplies for the hospital's own use in our view this is so clear that it needs no further explication abbot labs v portland retail druggists association supra pincite emphasis added this court has also stated similarly see 35_tc_236 wherein the court stated that the taxpayer hospital was not a merchandising business and x has no merchandise inventories which would require the use of an accrual_method in keeping its books or reporting its income its income is derived from providing hospital and professional care to the sick respondent's characterization of the chemotherapy drugs as merchandise offends the natural and ordinary meaning of the term merchandise the word merchandise denotes commodities or goods that are bought and sold in business see merriam webster's collegiate dictionary 10th ed although pharmaceuticals could reasonably be construed to be merchandise in some contexts eg when purchased at a grocery store for self-administration at home it does not necessarily follow that pharmaceuticals are merchandise in all contexts the latter proposition is especially true under the facts at hand where petitioner's patients generally cannot be understood to consider themselves as purchasers of merchandise during the course of their medical treatment the chemotherapy drugs are administered by petitioner's trained licensed and specialized physicians and other health-related professionals during the rendition of a unique medical service and when administered the drugs are not goods that were purchased in condition for sale or articles -- - of commerce held_for_sale simply put petitioner is not peddling products respondent looks to the value of the chemotherapy drugs and asserts that petitioner's business is part service part sale we disagree the mere fact that the chemotherapy drugs are expensive is insufficient to transmute the transaction from the sale of a service to the sale of merchandise and a service the common denominator that the items be held_for_sale is lacking on these facts petitioner's chemotherapy treatment business is a pure service business and not as respondent asserts a mixed service and merchandising business see eg 71_f3d_398 fed cir taxpayer's computer maintenance business was a service business not mixed service and merchandise business despite installation of parts honeywell inc v commissioner tcmemo_1992_453 taxpayer's computer maintenance business was a service business not mixed service and merchandise business despite installation of parts affd without published opinion 27_f3d_571 8th cir we find no cases on this issue analogous much less controlling the reported authorities including those cases where the court found that the merchandise at issue there was sold either with or without a service are all materially distinguishable from the facts herein given the uniqueness of the service provided respondent relies on the seminal case of 420_f2d_352 1st cir affg tcmemo_1969_79 there the taxpayer was an undertaker that sold caskets as part of its funeral service in finding that the caskets were merchandise for purposes of sec_471 the court_of_appeals for the first circuit noted that the taxpayer normally kept an inventory of some caskets that the caskets were not necessarily used during the year but were purchased and occasionally carried for long periods of time that the caskets were on display and played a central role in the sale of the taxpayer's service and that there was a direct relationship between the magnificence of the caskets and the cost of the service see id those factors are not present here petitioner kept no more than a 2-week supply of chemotherapy drugs on hand and used virtually all the drugs during the taxable_year the drugs also were not displayed to patients for selection and patients played no role in determining the type or amount of drugs used on them furthermore unlike the taxpayer’s business in wilkinson-beane inc the type of chemotherapy drugs or the magnificence thereof played no role in whether patients chose to purchase petitioner's services the variable factor in the cost of a patient's treatment is a factor out of the patient's control ie the type and severity of the patient's condition we also find it critical that a person is unable to obtain the - - chemotherapy drugs without purchasing petitioner's service we find nothing in the case of wilkinson-beane inc that would cause us to believe that the taxpayer's services there depended on the purchase of caskets from it instead the taxpayer in wilkinson-beane inc by choice sold the funeral services and caskets as a package respondent also relies on 743_f2d_781 11th cir there the court_of_appeals for the eleventh circuit considered whether the taxpayer who produced and sold newspapers was required to keep inventories the taxpayer argued that it was a service business in that it provided information for its readership and advertisement for its clients the court found that even though the taxpayer sold an extremely perishable commodity a 2-day-old newspaper is stale and had no inventory of finished goods the taxpayer was required to account for inventories because the newspapers were merchandise and there was a significant fluctuation of newsprint and ink on hand the facts of knight---ridder newspapers inc v united_states supra are materially distinguishable from the facts at hand in contrast to the instant case the taxpayer in knight-- ridder inc clearly manufactured a product newspapers and used raw materials paper and ink in the manufacturing process we like the court_of_appeals for the eleventh circuit find unconvincing the taxpayer's argument that the readership was purchasing a service we also find the facts herein to be markedly different from the facts presented in the various cases on this issue involving contractors and subcontractors in all of those cases where we found the taxpayer was selling merchandise the contractor's services involved installation of products and the customers came to the contractors to purchase the products as well as the installation services see eg thompson eblec inc v commissioner tcmemo_1995_292 taxpayer was selling merchandise in connection with a service when he installed wiring conduits electrical panels and lighting fixtures j p sheahan associates inc v commissioner tcmemo_1992_239 contractor's roofing materials were merchandise surtronics inc v commissioner tcmemo_1985_277 electroplating metals were merchandise the customers of the taxpayers also could have personally purchased the merchandise elsewhere and either installed the merchandise themselves if they had the time and expertise to do so or contracted with a third party to install the merchandise for them in the instant case by contrast persons seeking chemotherapy treatment may not buy the drugs elsewhere and they may not apply the drugs themselves respondent unduly focuses on the fact that petitioner listed on the bills submitted to medicare and private insurers the type and amount of chemotherapy drugs used on its patients but did not itemize the less expensive supplies while we agree with respondent that the itemization of the drugs on the bills is a fact properly considered see eg thompson elec inc v commissioner supra we disagree with respondent that it is dispositive of the issue the substance of the transactions at issue is that a service is provided by and purchased from petitioner petitioner and other health care providers today must operate under a myriad of statutory regulatory and contractual mandates the purpose of which is aimed at management of care and cost containment in the health care industry see eg u s c secs through 1395ccce c f_r sec_405 through health care finance administration medicare provider reimbursement manual pubs and rev undoubtedly as the costs of medical_supplies increase so do the regulatory and contractual directives for itemization and justification there is no evidence petitioner provided those itemizations for merchantable purposes or because it was selling merchandise rather the manner and form in which petitioner prepares its bills are dictated by applicable laws contracts with private insurers and the environment of the industry in which it operates we decline to attach further accounting or other significance thereto - - our declining to attach accounting significance to the bills is supported by federal medicare statutes and regulations as stipulated by the parties the chemotherapy treatments and drugs at issue are covered by medicare medicare covers only medical services and does not cover prescription drugs that can be self-administered see c f_r sec dollar_figure in creating legislative coverage for medical services congress was astutely aware that health care providers may need to use supplies or administer drugs incident to and as an integral part of their services as pertinent the health insurance for aged act publaw_89_97 sec 79_stat_291 u s c sec 1395x s provides as follows the term medical and other health services means any of the following items or services physicians' services a services and supplies including drugs and biologicals which cannot as determined in accordance with regulations be self- administered furnished as an incident to a physician's professional service of kinds which are commonly furnished in physicians’ offices and are commonly either rendered without charge or included in the physicians' bills this is true for the fee-for-service statutory coverage under medicare the secretary of health and human services may contract with private insurers health maintenance organizations to provide benefits to beneficiaries under medicare see health insurance for aged act publaw_89_97 79_stat_291 u s c sec 1395mm the beneficiaries that opt for coverage under a health_maintenance_organization plan may have prescription drug coverage under their contract with the insurer the chemotherapy treatments administered by petitioner including the chemotherapy drugs are considered part of the medical service under medicare and are within the scope of medicare's coverage congress explicitly provided that charging for the drugs on the bill does not change the nature of the transaction from the provision of a covered_service to the sale of noncovered prescription drugs see u s c sec 1395x s see also c f_r sec_410 dollar_figure respondent is also unduly impressed by the fact that petitioner's physicians do not administer the treatments and are generally not present when treatments are administered by oncology nurses this is irrelevant to the inguiry of whether petitioner is selling a service or a service and merchandise and we place no significance on it we disagree with respondent's likening the facts herein to prescription drugs in a drug store --- drugs which are clearly merchandise requiring the use of inventories when a drug store sells drugs there is little if any specialized and personalized service element attendant to the sale respondent's analogy is flawed respondent argues the chemotherapy drugs comprised percent of petitioner's gross_receipts that the drugs are billed to responsible parties pincite times the awp and that the cost of the chemotherapy drugs was dramatically higher than the cost of other supplies these factors go to whether the sale of the - - merchandise is an income-producing factor without addressing the merits of these arguments we do not interpret sec_1_471-1 income_tax regs to require that if a material is an income-producing factor it must per se be merchandise the section provides that inventories are necessary in every case in which the production purchase or sale of merchandise is an income-producing factor see sec_1_471-1 income_tax regs because we conclude that the chemotherapy drugs used in the administration of the chemotherapy treatments are not merchandise we need not and do not reach the question of whether merchandise is an income-producing factor in petitioner’s business as mentioned above our conclusion parallels our holding in hospital corp of am v commissioner t cc where the hospital's professional staff frequently used pharmaceuticals and medical_supplies to provide medical_care to patients respondent argued in that case that the income attributable to the pharmaceuticals and supplies could not be reported using the nonaccrual-experience method of sec_448 because the income was attributable to the sale_of_goods id pincite under that method an accrual_method taxpayer need not accrue amounts to be received for the performance of services that on the basis of experience will not be collected see sec_448 the nonaccrual-experience method may not be used to - - the extent amounts are attributable to a taxpayer's activities with respect to selling goods sec_1_448-2t d temporary income_tax regs fed reg date we held in hca that the taxpayer's income attributable to the pharmaceuticals and medical_supplies was service income because it was inseparably connected to the performance of services hospital corp of am v commissioner t c pincite consistent with that holding the income that petitioner earned here from its use of the chemotherapy drugs must also be considered service income service income by definition does not include income from the sale_of_goods see eg sec_1_448-2t d temporary income_tax regs fed reg date the logical conclusion is that the underlying items giving rise to service income also are not merchandise as we discussed above the meaning of the word merchandise is no broader than the meaning of the word goods and if anything the word merchandise is a subset of the word goods as a matter of fact not even respondent has argued that an item can be merchandise for one purpose of the code but not a good for a different purpose nor has respondent argued that an item the income from which may be reported on the nonaccrual-experience method may be inventory for purposes of sec_471 the notice_of_deficiency is worded broadly as to the specific basis for respondent's determination that the cash_method does not clearly reflect petitioner’s income on brief however respondent’s argument as to why petitioner's use of the cash_method does not clearly reflect income articulates that the chemotherapy drugs are merchandise that must be inventoried respondent does not dispute that petitioner's use of the cash_method clearly reflects income to the extent that the chemotherapy drugs are not merchandise we need not and do not engage in further analysis of the clear_reflection_of_income standard of sec_446 see 89_tc_105 n 46_tc_214 n based on the foregoing we hold that respondent abused his discretion in requiring petitioner to use the hybrid method and that petitioner may report all its income and expenses under the cash_method we have considered all arguments in this case for a contrary holding and to the extent not discussed above find those we are mindful of 796_f2d_843 6th cir affg in part and revg in part akers v commissioner tcmemo_1984_208 revd on another issue 482_us_117 wherein the court_of_appeals for the sixth circuit held that the taxpayer’s method_of_accounting did not clearly reflect its income the setting of asphalt prods co is distinguishable from the setting at hand the issue there was not the issue before us today ie whether the furnishing of pharmaceuticals by a medical treatment facility as an integral indispensable and inseparable part of the rendering of medical services is the sale of merchandise for purposes of sec_1_471-1 income_tax regs that case also involved primarily a significant accumulation of accounts_receivable at yearend and neither involved nor addressed whether the disputed items of inventory asphalt were merchandise in the first place - - arguments to be without merit or irrelevant to reflect the foregoing decision will be entered for petitioner reviewed by the court chabot parr wells colvin beghe foley vasquez gale and thornton jj agree with this majority opinion marvel j concurs in the result only ruwe j dissents - - parr j concurring i agree with the majority's opinion and write separately merely to emphasize that each case that comes before this court presents a unigue set of facts and is decided on its own merits although we now find that the facts of this case are markedly different from the facts of some of the cases we have decided involving construction contractors i believe that the principles enunciated here also apply to construction cases this is true for example when a building material is indispensable and inseparable from the service provided by the construction contractor see eg galedrige constr inc v commissioner tcmemo_1997_240 beghe j agrees with this concurring opinion -- - beghe j concurring i write separately to tie up or at least pick at a loose end left by respondent’s determination and arguments the proper tax treatment of the slightly more than week supply of chemotherapy drugs costing dollar_figure on hand at the end of the taxable_year ’ respondent having tried to put petitioner on the accrual_method with respect to sales of chemotherapy drugs determined that petitioner’s income should be increased not only by the cost of such drugs on hand at yearend in the amount of dollar_figure but also by dollar_figure the value of petitioner’s accounts_receivable relating to such drugs transmitted to patients during the year rejecting respondent’s sales characterization in favor of treating petitioner’s operations as an overall service business we have thereby rejected respondent’s determination putting petitioner on a hybrid method that would reguire accrual of its yearend receivables with respect to transmissions of such drugs respondent did not assert or argue as an alternative fall- back position that petitioner’s deduction of the cost of drugs on hand at yearend should be deferred to the following year the court need not sua sponte make that adjustment particularly where the proper result in this case is not clear in part because respondent did not make a stand-alone clear-reflection-- ' dollar_figure dollar_figure4 average cost of 2-week supply dollar_figure actual on hand --- - of-income determination or even argument with respect to such drugs but because other cases under submission to the court present similar or analogous issues and because the issue seems to be a recurring one a premonitory attempt to tidy up may not be amiss the relevant authority is sec_1_162-3 income_tax regs cost of materials which provides as follows taxpayers carrying materials_and_supplies on hand should include in expenses the charges for materials_and_supplies only in the amount that they are actually consumed and used in operation during the taxable_year for which the return is made provided that the costs of such materials_and_supplies have not been deducted in determining the net_income or loss or taxable_income for any previous year if a taxpayer carries incidental materials or supplies on hand for which no record of consumption is kept or of which physical inventories at the beginning and end of the year are not taken it will be permissible for the taxpayer to include in his expenses and to deduct from gross_income the total cost of such supplies and materials as were purchased during the taxable_year for which the return is made provided the taxable_income is clearly reflected by this method the accounting authorities are in accord this regulation means that supplies in and of themselves are not considered inventory and thus will not cause the taxpayer to be required to use accrual accounting bauernfeind income_taxation accounting methods and periods supplies are deferred expenses under reg sec_1_162-3 and not inventory under sec_471 id n and when the taxpayer’s inventories are of supplies only use of the cash_method is permitted these items are not - - inventories under sec_471 they are not held_for_sale in the ordinary course of business gertzman federal tax_accounting 2d ed gertzman the regulation says that materials_and_supplies cannot be currently expensed unless four tests are met they are incidental no record of consumption is kept no physical inventories are taken at the beginning and end of the year and income is clearly reflected petitioner in this case would appear to flunk the first three tests chemotherapy drugs transmitted to patients in the course of petitioner’s rendering of medical services are a substantial portion of petitioner’s gross_receipts and are a material income producing factor as evidenced by the markups shown in petitioner’s billing records and and records of consumption and of supplies on hand at yearend are kept indeed such records seem to be required by medicare however as to respondent has not made a stand-alone clear-reflection-of- income determination having chosen to rely solely on the presence of merchandise requiring inventories as compelling automatic adoption of the accrual_method of accounting the position that we have rejected in other cases of service providers such as small contractors in the construction industry an adjustment treating yearend supplies as deferred expense might very well be - - appropriate provided that respondent makes the necessary determinations compare j p sheahan associates inc v commissioner tcmemo_1992_239 with thompson elec inc v commissioner tcmemo_1995_292 which present different findings_of_fact regarding yearend materials_and_supplies as gertzman states pincite the rationale behind this provision the sec regulation seems clear many taxpayers do not maintain financial_accounting records of consumption and do not take physical inventories of the supplies on hand at the beginning and end of the year for business purposes in these cases it would be inconsistent with the book_conformity_requirement of sec_446 impractical and unduly burdensome to require that they undertake such record-keeping responsibilities or make such physical counts solely for tax purposes however to protect the treasury against taxpayers who might avoid undertaking these activities solely for the purpose of obtaining a tax_benefit two protections are afforded first the supplies must be incidental and second the taxable_income so computed must be reflected clearly citation omitted the regulation appears to be not much more than an illustration of the rule that expenditures that result in assets having a life beyond the end of the year must be capitalized see sec_263 503_us_79 without attempting to predict the outcome of a hypothetical see 89_tc_1010 chabot j concurring affd on other grounds 914_f2d_396 3d cir it suffices to note that the sec_162 regulation authorizes the commissioner in appropriate cases to treat supplies on hand at yearend as deferred expenses halpern j dissenting i introduction respondent determined a deficiency in petitioner’s federal_income_tax liability that deficiency resulted from respondent’s rejection of the cash_receipts_and_disbursements_method of accounting the cash_method used by petitioner to compute taxable_income and his recomputation of petitioner’s taxable_income under a hybrid method_of_accounting under that method the hybrid method petitioner was required to use an accrual_method to account for purchases and sales of merchandise respondent recomputed petitioner’s taxable_income pursuant to his authority to reguire a taxpayer to use a method_of_accounting that clearly reflects income if the method used by the taxpayer does not clearly reflect income see sec_446 whether a particular method_of_accounting clearly reflects income is a question of fact and the issue must be decided on a case-by-case basis see eg 97_tc_120 generally where respondent has determined that a taxpayer’s method_of_accounting does not clearly reflect income the taxpayer must demonstrate either that his method_of_accounting clearly reflects income or that respondent’s method does not clearly reflect income see 796_f2d_843 6th cir affg in part and revg in part tcmemo_1984_208 -- - petitioner has demonstrated neither that the cash_method clearly reflected its income nor that the hybrid method does not petitioner has demonstrated to the majority’s satisfaction however that its business is a service business the majority holds service income by definition does not include income from the sale_of_goods majority op p therefore reasons the majority petitioner is not engaged in the sale of merchandise a word that the majority equates with the word goods id since petitioner is not engaged in the sale of merchandise the majority concludes that respondent may not require petitioner to use an inventory_method of accounting majority op p see sec_1_471-1 income_tax regs finally limiting its consideration to the incompatibility of the cash_method with an inventory_method of accounting see sec_1 l c income_tax regs the majority finds that respondent abused his discretion in requiring petitioner to use the hybrid method and that petitioner may continue to report all of its income and expenses under the cash_method i dissent from the conclusion that petitioner is not engaged in the sale of merchandise i also wish to caution against undue reliance on the majority’s conclusion that respondent abused his discretion in requiring petitioner to use the hybrid method as will be explained by his answer to the petition respondent has limited the issues before the court ti facts the majority has set forth many of the facts stipulated by the parties and for the most part i shall not repeat those facts the following facts relate to petitioner’s return respondent’s determination_of_a_deficiency and the pleadings in this case on its form_1120 u s_corporation income_tax return for petitioner reported gross_receipts of dollar_figure no amount of cost_of_goods_sold and a gross_profit equal to its gross_receipts among other items petitioner deducted dollar_figure for medical_supplies chemotherapy drugs dollar_figure for compensation paid to its three physician-shareholder-officers officer compensation and other salaries and wages of dollar_figure petitioner’s deduction for chemotherapy drugs equaled percent of its reported gross_receipts and gross_profits and percent of its officer compensation_for under the hybrid method respondent disallowed the deduction for chemotherapy drugs claimed by petitioner and required petitioner to recompute its gross_profit by subtracting from gross_receipts determined under an accrual_method the cost of the chemotherapy drugs conveyed sold by petitioner during that year the net_adjustment to petitioner’s taxable_income the net_adjustment was an increase of dollar_figure resulting from an increase of dollar_figure in gross_receipts to -- - reflect accounts_receivable with respect to chemotherapy drugs and an increase in closing_inventory for the actual cost dollar_figure of such drugs on hand at the end in respondent’s notice_of_deficiency respondent explains the net_adjustment as it is determined that since the of in tax the notice follows cash_basis of accounting does not clearly reflect income as required by the sec_446 the government is changing the taxpayer’s method_of_accounting from the overall cash_receipts_and_disbursements_method of accounting to a hybrid method by which purchases and sales of merchandise are accounted for on the accrual_method of accounting with maintenance of inventories in the petition petitioner avers among other things it 1s a qualified_personal_service_corporation within the meaning of sec_448 thus allowing it the use of the cash_method_of_accounting see sec_448 and b respondent denies petitioner’s averment that it is allowed to use the cash_method and a lleges that the petitioner is required to maintain inventories and therefore is required to use the accrual_method for the purchase and sale of inventories til pertinent provisions of the code and regulations gross_income is defined in sec_61 which includes an item_of_gross_income g ross income derived from business sec_61 in pertinent part sec_1_61-3 regs provides in a manufacturing merchandising business ‘gross income’ means the total sales or mining that in the answer income_tax less the cost of -- - goods sold plus any income from investments and from incidental or outside operations or sources the regulations thus recognize that a necessary step in the calculation of the gross_income from sales at least in a manufacturing merchandising or mining business is a determination of the cost_of_goods_sold that recognition implies the use of inventories to determine the cost_of_goods_sold sec_1_162-1 income_tax regs confirms the role that inventories play in the determination of the determination of cost_of_goods_sold and gross_income from sales for a manufacturer involves the use of inventories pursuant to the basic accounting equation described below beginning_inventory sdollar_figurexxx purchases of inventory xxx production_costs incurred xxx total cost of goods available for sale xxx less ending inventory xxx cost_of_goods_sold s xxx gross_receipts from sales s xxx less cost_of_goods_sold xxx gross_income from sales sec_61 s xxx it can be seen from the foregoing equation that the amount of a taxpayer’s ending inventory and cost_of_goods_sold both have a very direct effect on the amount of the taxpayer’s gross_income from sales however those effects are exerted in opposite directions all other things being constant as a taxpayer’s ending inventory increases in amount its cost_of_goods_sold decreases and its gross_income from sales increases in contrast as a taxpayer’s ending inventory decreases in amount its cost_of_goods_sold increases and its gross_income from sales decreases the foregoing equation and comment appear in schneider federal income_taxation of inventories sec_1 pp -- -- gross_income from sales the cost of goods purchased for resale with proper adjustment for opening and closing inventories is deducted from gross_sales in computing gross_income sec_446 provides the general_rule for methods_of_accounting taxable_income shall be computed under the method_of_accounting on the basis of which the taxpayer regularly computes his income in keeping his books in pertinent part sec_446 provides i f the method used does not clearly reflect income the computation of taxable_income shall be made under such method as in the opinion of the secretary does clearly reflect income sec_471 is specific with respect to the use of inventories sec_471 general_rule ----whenever in the opinion of the secretary the use of inventories is necessary in order clearly to determine the income of any taxpayer inventories shall be taken by such taxpayer on such basis as the secretary may prescribe as conforming as nearly as may be to the best_accounting_practice in the trade_or_business and as most clearly reflecting the income the secretary has exercised the discretion conferred upon him by congress in sec_471 by requiring pursuant to regulations that i n order to reflect taxable_income correctly inventories at the beginning and end of each taxable_year are necessary in every case in which the production purchase or -- - sale of merchandise is an income-producing factor sec_1 income_tax regs the determination that a taxpayer must maintain inventories has two important consequences for the computation of the taxpayer’s taxable_income first to the extent that costs incurred by the taxpayer are reflected in items of inventory that at the end of the taxpayer’s taxable_year remain unsold such costs will not contribute to the cost_of_goods_sold for that year and thus will result in a correspondingly higher gross_income from sales for the year second if a taxpayer is required to use inventories then to reflect its income clearly it must use an accrual_method of accounting with respect to purchases and sales of inventory_items see sec_1 c i income_tax regs the rationale behind this accrual requirement is explained in 743_f2d_781 11th cir according to accounting wisdom the income realized from the sale of but cf sec_1_471-4 income_tax regs inventories at cost or market whichever is lower the taking of inventories does not of itself represent a separate and distinct method_of_accounting as professor chirelstein states rather it is a component of the over-all accounting procedure whose essential purpose is to establish the cost_of_goods_sold as a step towards determination of the taxpayer’s gross_income from business operations chirelstein federal income_taxation a law student’s guide to the leading cases and concepts par dollar_figure pincite 8th ed rev - al --- merchandise is most clearly measured by matching the cost of that merchandise with the revenue derived from its sale even if a taxpayer need not maintain inventories the recovery_of costs associated with the production_of_income may not be governed by the taxpayer’s method_of_accounting that treatment is well known with respect to the recovery_of certain capital expenditures by way of the deduction for depreciation see sec_167 sec_1_446-1 income_tax regs expenditures made during the year shall be properly classified as between capital and expense more pertinent to our case is sec_1_162-3 income_tax regs which addresses the cost of materials_and_supplies without distinction supplies that do not constitute inventory unless the purchase of such supplies constitutes a capital_expenditure sec_1_162-3 income_tax regs provides taxpayers carrying materials_and_supplies on hand should include in expenses the charges for materials_and_supplies only in the amount that they are actually consumed and used in operation during the taxable_year for which the return is made provided that the costs of such materials_and_supplies have not been deducted in determining the net_income or loss or taxable_income for any previous year if a taxpayer carries incidental materials or supplies on hand for which no record of consumption is kept or of which physical inventories at the beginning and end of the year are not taken it will be permissible for the taxpayer to include in his expenses and to deduct from gross_income the total cost of such supplies and materials as were purchased during the taxable_year for which the return is made provided the taxable_income is clearly reflected by this method - -- sec_1_162-3 income_tax regs provides for the deferred expense treatment of nonincidental supplies without regard to the taxpayer’s overall_method_of_accounting iv discussion a purchases and sales of inventory respondent’s pleading petitioner expended dollar_figure for chemotherapy drugs during and treated that expenditure as an expenditure for incidental supplies that was plain error under sec_1_162-3 income_tax regs see concurring opinion of judge beghe pincite respondent treated the expenditure as if it constituted the cost of goods purchased for resale on the facts of this case in terms of accounting for the cost of the chemotherapy drugs it makes no difference whether the dollar_figure expended for chemotherapy drugs is treated as the cost of goods held for resale or as a deferred expense ’ the only issue open to debate is whether respondent can compel petitioner to account for amounts billed to medicare and to patients under an accrual_method although sec_1 l c income_tax regs leaves no doubt that the secretary can so compel petitioner if purchases and sales of inventory are involved nothing in sec_446 prohibits the secretary from the notice_of_deficiency shows a dollar_figure sec_481 adjustment -- - so compelling petitioner if purchases and sales of inventory are not involved sec_446 specifically permits a taxpayer to compute taxable_income under the cash_method nevertheless that permission is made subject_to the secretary’s sec_446 b authority to reject the taxpayer’s method_of_accounting see sec_446 by the pleadings however the parties have limited what petitioner must prove to stay on the cash_method above in section ii i have set forth both respondent’s explanation of the net_adjustment and his allegation in response to petitioner’s averment that it is entitled to use the cash_method that petitioner is required to maintain inventories and therefore 1s required to use the accrual_method for the purchase and sale of inventories emphasis added correctly the majority thinks that a fair reading of the issue for trial in this case as framed by the pleadings is whether petitioner is required to maintain inventories i agree with the limited scope of the majority’s inquiry in this case i do not agree however that petitioner need not use inventories inventories are required as set forth in section iii supra regulations provide inventories are necessary in every case in which the sale of merchandise is an income-producing factor and with limited exceptions in any case in which it is necessary to use an inventory an accrual_method must be used with regard to purchase -- -- and sales see sec_1_446-1 income_tax regs thus generally if the purchase and sale of merchandise is an income-producing factor an accrual_method must be used with regard to such purchases and sales the nominal focus of the majority’s inquiry is whether the chemotherapy drugs are merchandise we focus our inquiry on whether the chemotherapy drugs were supplies deductible under sec_162 or merchandise that must be inventoried under sec_471 majority op p the majority states respondent’s characterization of the chemotherapy drugs as merchandise offends the natural and ordinary meaning of the term ‘merchandise’ id pincite the majority concedes however although pharmaceuticals could reasonably be construed to be merchandise in some contexts it does not necessarily follow that pharmaceuticals are merchandise in all contexts id the majority reaches the conclusion that the chemotherapy drugs are not merchandise on the basis that petitioner is not a merchandiser id pincite its business is inherently a service business id pincite or s jimply put petitioner is not peddling products id pincite the majority’s conclusions seem to be informed by its view a medical practice such as petitioner’s is inherently a service business and the drugs administered in the practice are subordinate to the provision of the medical services id pincite conclusion of law the majority’s conclusion that the chemotherapy drugs are not merchandise is not a finding of fact the majority’s conclusion that the chemotherapy drugs are not merchandise appears to rely on a number of propositions that when taken together amount to a rule_of law ie a rule_of general application the majority’s view that a medical practice such as petitioner’s is inherently a service business is dependent on a number of factors some of which are conclusory the uniqueness of the industry in which petitioner operates the fact that petitioner’s business is a quintessential service business the inseparable connection of the chemotherapy drugs to the performance of services and finally s ervice income by definition does not include income from the sale_of_goods from those factors the majority composes the following rule_of law doctors medical and osteopathic are not in trade the dictionary gives as one definition of trade the business of buying and selling commodities commerce the american heritage dictionary of the english language 3d ed the majority believes that doctors are not in trade because they are members of a learned profession whose stock_in_trade is knowledge not goods or merchandise see majority op p the majority relies on 425_us_1 to support its -- - conviction that doctors are not in trade e are not merchants abbott labs however is an antitrust case in which the supreme court addressed purchases by nonprofit hospitals of pharmaceutical products at favored prices from the manufacturers of those products the issue was the proper construction of the phrase purchases of their supplies for their own use as it appears in 52_stat_446 u s c sec 13c referred to by the supreme court as the nonprofit institutions act the precise question was whether the nonprofit hospitals’ purchases in question were exempt from the proscription of the robinson-patman antidiscrimination act ch 49_stat_1526 u s c secs 13a 13b and 21a because they were for the hospitals’ own use within the meaning of the nonprofit institutions act abbott labs v portland retail druggists association inc supra pincite the majority states the exemption generally applies where the nonprofit institution is purchasing the drugs for its ‘own use’ as opposed to for sale to patients majority op p emphasis added apparently since in abbott labs the supreme court found that at least some of the drugs in question were purchased by the hospitals for their own use within the meaning of u s c sec 13c the majority concludes that those drugs were not purchased for resale which i assume leads to the conclusion that doctors like the hospitals are not -- - merchants the majority mischaracterizes a provision of the nonprofit institutions act u s c sec c that provision provides as follows nothing in the robinson- patman antidiscrimination act shall apply to purchases of their supplies for their own use by schools colleges universities public libraries churches hospitals and charitable institutions not operated for profit the provision does not establish a dichotomy between use and sale as suggested by the mmajority see eg de mo743_f2d_1388 9th cir referring to abbott in 425_us_1 each of the hospitals in question operated a pharmacy which was a separate department of the hospital and whose operations produced revenue in excess of cost the pharmacies dispensed the pharmaceutical products in question the supreme court used the terms sales and dispensations with reference to those products and without any clear distinction between the two terms the supreme court categorized the following dispensations as for the hospitals’ own use to the inpatient or to the emergency_facility patient upon his discharge and for his personal_use away from the premises to the outpatient for personal_use away from the premises to the hospital’s physicians employees or students for their personal_use or for_the_use_of their dependents clearly the third category if not all three constitutes sales of merchandise by the pharmacies notwithstanding that such merchandise was acquired for the hospitals’ own use nothing in the opinion indicates that the pharmacies failed to inventory their pharmaceuticals -- - labs v portland retail druggists association inc 425_us_1 and holding d rugs purchased by an hmo for resale to its members are purchased for the hmo’s ‘own use’ within the meaning of the nonprofit institutions act and thus qualify for protection under the act abbott labs is no support for the proposition that as a matter of law petitioner is not selling merchandise the majority also cites 35_tc_236 for the proposition that petitioner is not selling merchandise when it administers chemotherapy drugs the principal issue in st luke’s hosp inc was whether the taxpayer having requested and received permission from the commissioner to change from an accrual_method to the cash_method_of_accounting for and thereafter properly reported income on the cash_method when it continued to employ primarily an accrual_method in keeping its books_and_records we concluded that it did properly report income on the cash_method since notwithstanding the taxpayer’s retention of an accrual_method its cash-basis income could readily be ascertained from its books_and_records our findings_of_fact included the following petitioner owns and operates a hospital in bluefield its business is the customary hospital service business it is not a merchandising business and petitioner has no merchandise inventories which would require the use of an accrual_method in keeping its books or reporting its income its income is derived --- - from providing hospital and professional care to the sick id pincite those are not statements of law but findings_of_fact the findings that the bluefield hospital is in the customary service business of hospitals and has no merchandise is not necessarily applicable to petitioner petitioner is not a hospital but runs a chemotherapy clinic where chemotherapy drugs constitute both a significant cost and a substantial source of revenue there is no finding as to how significant drugs and similar items were to the overall cost of treatment at the bluefield hospital in st luke’s hospital inc v commissioner supra which dealt with medicine as it was practiced over more than years ago the commissioner did not even suggest that inventories were required it is no authority for any conclusion of law nor can the majority rely on any rule_of law that service providers need never use inventories we have previously examined service transactions in a variety of industries to determine whether the transactions in substance involved solely the sale of a service or whether the transactions involved the sale of both a service and merchandise majority op p in abbott labs v portland retail druggists association inc supra pincite decided in the supreme court stated with respect to nonprofit hospitals we recognize that the concept of the nonprofit_hospital and itss appropriate and necessary activity has vastly changed and developed since the enactment of the nonprofit institutions act in needless to say much more has changed in the last years -- - finally the majority’s reliance on 107_tc_116 to support its proposition that petitioner’s income is attributable solely to services and not to some combination of services and merchandise is puzzling in hospital corp of am we did indeed find that for purposes of sec_448 the use of medical_supplies is part of the medical services furnished patients by the hospitals in question see id pincite in the same breath however we found the cost of those supplies is an incidental cost of the health care services provided by the hospitals id given that finding the fact that hospital corp of am involves a different section of the statute and our specific reservation in hospital corp of am that we were not deciding the question of whether the furnishing of medical_supplies by the hospitals as a part of the rendering of services to their patients could be considered to be a sale of inventory i do not consider that case as persuasive with respect to the issue before us today the majority cannot escape an examination of the particular facts of this case in light of the relevant provisions of law finding of fact we find the instant setting distinguishable from the setting of those cases in which we have held that goods utilized by a service provider were merchandise for purposes for the inventory rules we give significance to the uniqueness of the industry in which petitioner operates in relation to the other service industries we have addressed on this issue and bear in -- - mind the recent case of 107_tc_116 majority op p what facts distinguish this case from those cases in which we have held that goods utilized by a service provider were merchandise for purposes of sec_1_471-1 income_tax regs i agree with the majority’s observations that medicine is unique and that it is inherently a service business so what contrary to the majority’s impression health care providers do sell goods see eg de modena v kaiser found health plan inc supra drugs purchased by an hmo for resale to its members are purchased for the hmo’s own use the relevant distinction is between supplies for which inventories need not be taken and merchandise held_for_sale merchandise for which inventories must be taken compare sec_1_162-3 income_tax regs with sec_1_471-1 income_tax regs i agree with the majority when it states the statute and regulations do not define the words ‘merchandise’ or ‘inventory’ nor do they clearly distinguish between ‘inventory’ and ‘materials and supplies’ that are not actually consumed and remain on hand majority op p as previously discussed supra section iv a it was plain error for petitioner to treat the expenditure for the chemotherapy drugs as an expenditure for incidental supplies and in terms of properly accounting for that expenditure it makes no difference whether the expenditure is treated as being for merchandise or - - for supplies the relevant difference is with respect to the application of sec_1_446-1 income_tax regs which with an exception not here relevant and taking into account sec_1_471-1 income_tax regs requires an accrual_method with regard to purchases and sales of merchandise the majority agrees that the distinction between supplies and merchandise does not turn on the nature of the underlying commodity pharmaceuticals could reasonably be construed to be merchandise in some contexts majority op p in 420_f2d_352 lst cir affg tcmemo_1969_79 the court_of_appeals for the first circuit determined that the meaning of the term merchandise as used in sec_1_471-1 income_tax regs must be gathered from the context and the subject the context and the subject are the explicit requirement that a taxpayer’s method_of_accounting clearly reflect income see sec_446 income realized from the sale of merchandise is most clearly measured by matching the cost of that merchandise with the revenue derived from its sale knight-ridder newspapers inc v united_states f 2d pincite given the lack of any clearly pertinent distinction between the term supplies and the term merchandise where the facts raise some guestion as they do here we should inquire which classification results ina clearer reflection of the taxpayer’s income -- - the majority describes as seminal the opinion of the court_of_appeals for the first circuit in wilkinson-beane inc v commissioner supra the taxpayer in wilkinson-beane inc was an undertaking establishment which argued the primacy of the services that it provided to its customers the court_of_appeals affirmed the finding of the tax_court that the taxpayer was selling merchandise the court_of_appeals stated we fully recognize that petitioner was in the business or providing valuable services but we think it would be anomalous to hold that a taxpayer in a service business can have no merchandise even though he derives a substantial portion of his income from the regular purchase and sale of tangible_personal_property we certainly have no basis for so restricting the application of the word 'merchandise’ since the caskets play a central role in the 'sale' of taxpayer's service to use its term we see no error in the determination that the caskets were merchandise id pincite the court of appeals’ inquiry into the centrality of the property to the sale and the substantiality of the income attributable to the property has been followed in subsequent cases for example in j p sheahan associates inc v commissioner tcmemo_1992_239 we determined whether roofing materials constituted merchandise and we looked to whether the materials were shown separately on the customer’s bill they represented a substantial amount of the total bill and they were marked up in thompson elec inc v commissioner tcmemo_1995_292 which involved an electrical contractor we said tf the cost of material a taxpayer uses to provide a service is -- -- substantial compared to its receipts the material is a substantial income-producing factor even if the taxpayer does not markup the prices charged to its customers for the material what i distill from the wilkinson-beane inc line of cases is that where the question is whether a provider of services is using supplies or selling merchandise the answer turns on whether the commodity in question is a substantial and identifiable source of revenue if so and if the merchandise is an income-producing factor than such merchandise must be inventoried and an accrual_method is appropriate and may be required to match costs and revenue on the facts before us i would require inventories because petitioner is selling merchandise that is an income-producing factor the majority’s finding that the chemotherapy drugs are subordinate to the services rendered ignores the substantiality and centrality of the income attributable to the chemotherapy drugs and involves conclusions that have no basis in the record the only facts stipulated with respect to the medical aspects of petitioner’s business are set forth in the margin ’ petitioner is ’ when an individual first becomes a patient of petitioner one of petitioner’s physicians examines the patient in order to determine the proper chemotherapy treatment for that patient when a patient has been evaluated and a chemotherapy regime has been prescribed the patient begins regular periodic treatments continued -- - a corporation operating clinics and employing physicians nurses nursing assistants laboratory technicians administrative personnel and office workers the parties have not stipulated how individuals came to be petitioner’s patients given petitioner’s apparent specialization it is likely that patients were referred for chemotherapy drug treatment nothing in the record establishes the majority’s findings that patients played no role in determining the type or amount of drugs used on them majority op p or that patients must agree to petitioner’s overall chemotherapy service and when they do agree to this service they have no say in the type or quantity continued petitioner’s physicians prescribed the chemotherapy regime but with rare exception did not actually administer the chemotherapy drugs to patients during taxable_year to present chemotherapy drugs were administered by oncology nurses during taxable_year prior to the initiation of each course of chemotherapy the patients were seen and evaluated by the attending physician the patients were not examined at the time of every chemotherapy administration pursuant to the standard practice of medical oncology once a patient has begun a chemotherapy regime that patient will see one of petitioner’s physicians approximately every to 6-weeks between treatments while a physician must be available to respond to emergencies a physician is not required to be in every room with a patient while chemotherapy treatment is being administered -- - of chemotherapy drugs which petitioner uses in their care majority op p nor does anything in the record establish usually they patients are not even aware of the type or guantity of chemotherapy drugs used on them as part of their treatment id contrary to the inference in the majority’s opinion petitioner’s physician-employees do not choose or decide that a patient shall receive chemotherapy drugs common experience tells us that although petitioner’s physician-- employees may recommend such treatment the patients are the ones who must make the decision to receive the drugs moreover if those patients decide to receive chemotherapy drugs they want the drugs and nothing in the record or in common sense leads me to believe that the drugs are necessarily subordinate to the physician’s services i cannot agree with the majority’s conclusion that with respect to petitioner’s business the provision of chemotherapy drugs was subordinate to the provision of medical services b clear_reflection_of_income if a taxpayer’s method_of_accounting does not clearly reflect income sec_446 accords the secretary the authority to reguire the taxpayer to compute taxable_income under such method as in the opinion of the secretary does clearly reflect income we have interpreted respondent’s position in this case as requiring petitioner to use an accrual_method the -- - hybrid method only because purchases and sales of inventory were involved having concluded that petitioner did not purchase and sell inventory the majority has determined that respondent abused his discretion in requiring petitioner to use the hybrid method taxpayers should not read too much into that determination as stated although sec_1_446-1 income_tax regs leaves no doubt that respondent can so compel petitioner if purchases and sales of inventory are involved nothing in sec_446 prohibits the secretary from so compelling petitioner if purchases and sales of inventory are not involved moreover although sec_446 specifically permits a taxpayer to compute taxable_income under the cash_method that permission is made subject_to the secretary’s sec_446 authority to reject the taxpayer’s method_of_accounting see sec_446 the legislative endorsement of the cash_method undoubtedly means that wages and salaries can be reported on the cash_method the taxpayer in this case however is not a wage earner petitioner 1s a corporation with three physician-shareholder-employees three other physician-employees numerous other employees and for just shy of dollar_figure million in receipts for that year it paid officer compensation of dollar_figure and other salaries and wages of dollar_figure for a total of just over dollar_figure million if the value of the services provided by all six physicians employed by -- - petitioner is measured by their compensation then that value is somewhere in the neighborhood of dollar_figure million given that there were numerous employees other than physician employees petitioner thus had receipts of about dollar_figure million attributable to something other than the negotiated value to the corporation of physician’s services including chemotherapy drugs costing dollar_figure petitioner’s receivables at the end of were dollar_figure i know of no rule_of law that forecloses an inquiry into whether to reflect clearly petitioner’s income the receivables attributable to the chemotherapy drugs used during the year should not be reported on an accrual_method as would be the case under the hybrid method recently in oakcross vineyards ltd v commissioner tcmemo_1996_433 affd 142_f3d_444 9th cir we sustained the commissioner’s determinations that the cash_method did not clearly reflect a farmer’s receipts from the sale of grapes and an accrual_method was required we surveyed many of the cases dealing with a challenge by the commissioner to the cash_method including cases involving the commissioner’s rejection of the cash_method for reporting receipts among the cases we surveyed were the following 832_f2d_436 7th cir credit card charge account service required to change from cash_method to an accrual_method applied communications inc v commissioner tcmemo_1989_469 --- - concerning sales of computer_software by the developer of the software and taking into account that cash_method_of_accounting is not appropriate for petitioner because it generates substantial amounts of receivables or deferrals of revenue as evidenced by the difference between its software income for tax and financial purposes silberman v commissioner tcmemo_1983_782 cash_receipts_and_disbursements_method of accounting could not be used by a movie production partnership because the predicted delay between expenditures and receipts created a mismatching of funds and a distortion_of_income affd without published opinions sub nom appeal of david whin inc appeal of giordano appeal of malanka stamato v commissioner 770_f2d_1068 3d cir in oakcross vineyards ltd we also pointed out that the question of whether a taxpayer’s method_of_accounting materially distorts or clearly reflects income is one of fact and is to be resolved ona case-by-case basis as previously stated where the commissioner has determined that a taxpayer’s method_of_accounting does not clearly reflect income the taxpayer must demonstrate either that his method_of_accounting clearly reflects income or that the commissioner’s method does not clearly reflect income respondent’s explanation of the net_adjustment in the notice is broader than the ground he relies on in the answer that narrowing of his ground in the -- - answer may not have been intended taxpayers similarly situated to petitioner should be prepared to demonstrate that the cash_method clearly reflects their income or that the hybrid method does not v conclusion for the foregoing reasons i dissent from the majority’s opinion cohen whalen and chiechi jj agree with this dissent taxpayers may have difficulty in proving that a method_of_accounting such as the hybrid method does not clearly reflect income in hospital corp of am v commissioner tcmemo_1996_105 we concluded that certain hospitals’ use of a hybrid method_of_accounting that reported on an accrual_method revenue allocable to charges for supplies and pharmaceuticals clearly reflected the hospitals’ income


t c summary opinion united_states tax_court michael leon and karin policky tilley petitioners v commissioner of internal revenue respondent docket no 26450-06s filed date michael leon and karin policky tilley pro sese frederick lockhart jr for respondent armen special_trial_judge this case was heard pursuant to the provisions of sec_7463 of the internal_revenue_code in effect when the petition was filed pursuant to sec_7463 the decision to be entered is not reviewable by any unless otherwise indicated all subsequent section references are to the internal_revenue_code in effect for the taxable_year at issue and all rule references are to the tax_court rules_of_practice and procedure other court and this opinion shall not be treated as precedent for any other case respondent determined a deficiency in petitioners’ federal_income_tax of dollar_figure as well as an accuracy-related_penalty under sec_6662 of dollar_figure for the taxable_year the issues for decision are to what extent the distributions received from ms tilley’s sec_401 plan are taxable in what year they are taxable whether petitioners are liable for the additional tax imposed on early sec_401 plan withdrawals under sec_72 and whether petitioners are liable for a sec_6662 negligence_penalty for not having included in gross_income the taxable_distributions received from ms tilley’s sec_401 plan in on their federal_income_tax return background some of the facts have been stipulated and they are so found we incorporate by reference the parties’ stipulation of facts and accompanying exhibits petitioners resided in colorado at the time the petition was filed ms tilley began employment with american city business journals inc in and she participated in the company’s sec_401 plan 401_k_plan or the plan until her employment was terminated in date in late ms tilley borrowed dollar_figure from her plan account to purchase a home she signed a promissory note and security_agreement in respect of the loan which was governed by the terms of the plan the loan was repayable with interest through semimonthly payroll deductions over a 10-year term ms tilley made the scheduled payments until her employment was terminated the outstanding balance of the loan became due and payable at the time of ms tilley’s termination but petitioners did not have the money to satisfy the obligation no payments were made on the loan after her termination pursuant to the terms of the loan and the plan the loan went into default in early after the expiration of the 90-day grace or cure period in date fidelity investments sent ms tilley a letter notifying her that she had a deemed_distribution from the plan equal to the then-unpaid loan balance of dollar_figure the letter also identified this distribution as being fully taxable and without any applicable statutory exception on date fidelity sent ms tilley a check for dollar_figure which represented the dollar_figure balance of her plan account less dollar_figure in federal tax withholding petitioner sec_2 although fidelity investments sent the letter to ms tilley fidelity management_trust co is listed as the plan’s administrator we use the name fidelity to refer to these entities interchangeably ms tilley born in was not 59½ at the time of the distribution deposited the entire dollar_figure into their checking account rather than depositing it into the individual_retirement_account ira they had established with fidelity for ms tilley fidelity issued a form 1099-r distributions from pensions annuities retirement or profit-sharing_plans iras insurance contracts etc for reporting a gross distribution to ms tilley of dollar_figure the distribution amount reflected the gross distribution from the remainder of ms tilley’ sec_401 plan as well as the unpaid balance on the loan although petitioners included two other form 1099-r distributions in their income on their federal_income_tax return petitioners did not include this distribution respondent determined in the notice_of_deficiency that petitioners were required to include ms tilley’s distribution in income respondent also determined that the distribution was subject_to the 10-percent additional tax under sec_72 on early distributions from qualified_retirement_plans further respondent determined that petitioners were subject_to a penalty under sec_6662 discussion a taxable_distribution sec_1 burden_of_proof generally the commissioner’s determinations are presumed correct and the taxpayer bears the burden of proving those determinations wrong rule a 503_us_79 290_us_111 under sec_7491 the burden_of_proof may shift from the taxpayer to the commissioner if the taxpayer produces credible_evidence with respect to any factual issue relevant to ascertaining the taxpayer’s tax_liability sec_7491 in this case there is no such shift because petitioners did not allege that sec_7491 was applicable nor did they establish that they fully complied with the requirements of sec_7491 the burden_of_proof remains on petitioners balance of the 401_k_plan account generally a distribution from a qualified_plan such as ms tilley’ sec_401 plan is includable in the distributee’s gross_income in the year of distribution see sec_61 sec_72 sec_401 sec_402 sec_408 sec_4974 therefore the balance of ms tilley’ sec_401 plan account dollar_figure was disbursed in a taxable_distribution to ms tilley in date accordingly dollar_figure in federal taxes was withheld by fidelity petitioners testified that they had intended to roll over the money into ms tilley’s ira amounts moved from one qualified_plan to another may be treated as a rollover_contribution if the transaction is completed within days and meets certain other requirements sec_408 partial rollovers are permitted sec_408 petitioners did not take advantage of the rollover provisions regardless of their original intentions petitioners cashed the check and spent the money four years later petitioners urge the court to grant them a waiver of the 60-day requirement see sec_408 they argue that fidelity made a mistake sending them the check and that they would now be willing to put the money into ms tilley’s ira on these facts we decline to grant the waiver and we do so without offense to equity or good conscience loan balance sec_72 treats loans from qualified_plans as taxable_distributions see sec_72 a i i plotkin v commissioner tcmemo_2001_71 patrick v commissioner tcmemo_1998_30 affd per curiam without published opinion 181_f3d_103 6th cir prince v commissioner tcmemo_1997_324 however sec_72 provides an exception for certain loans the mere making of a loan that does not exceed one-half of the nonforteitable accrued_benefit of the employee under the plan that is repayable within years and that provides for substantially level amortization does not give rise to a deemed_distribution see sec_72 see also sec_72 providing an exception to the year repayment requirement for loan proceeds used to purchase a primary residence although a loan may initially satisfy the requirements of sec_72 at the time that it is made a deemed_distribution may nevertheless occur subsequently because of the failure to repay the loan in accordance with the loan agreement sec_72 accordingly if a default occurs a distribution is deemed to occur at that time in the amount of the then- outstanding balance of the loan it is clear that ms tilley defaulted on her loan and thus had a deemed_distribution from her 401_k_plan account the issue here is the date on which the default--and thus the deemed distribution--occurred petitioners argue that because the entire loan balance became due and payable upon ms tilley’s termination of employment pursuant to an acceleration clause in the plan documents upon termination of employment the entire outstanding principal and accrued interest shall be immediately due and payable the missed installment_payment took place in date petitioners argue that any distribution therefore took place in it is true that it was in date when ms tilley first missed her payment however the plan documentation provided to us by petitioners shows that the plan had a 90-day grace or cure period the plan documents explain that the plan_administrator shall treat a loan in default if any scheduled repayment remains unpaid more than days therefore ms tilley’s default under the plan did not occur until the expiration of the cure period in under the current regulations when a participant fails to make payments in accordance with the terms of a loan the loan is treated as no longer meeting the requirements of sec_72 and a deemed_distribution results sec_1_72_p_-1 q a-4 income_tax regs the deemed_distribution occurs at the time the installment_payment was due but not made sec_1 p - q a-10 income_tax regs the current regulations also provide that the deemed_distribution will not occur if the installment_payment due is made before the end of any cure period permitted by the plan_administrator sec_1_72_p_-1 q a-10 income_tax regs in other words under the current regulations the deemed_distribution would clearly not occur until the close of any cure period provided under the plan however ms tilley’s loan was made in before the effective date of the current regulations see sec_1_72_p_-1 q a-22 income_tax regs accordingly the final_regulation is not applicable to the case at bar before the promulgation of the final_regulation a proposed regulation had been issued containing the same provisions see sec_1_72_p_-1 q a-4 q a-10 proposed income_tax regs fed reg date the proposed regulation however was to apply only to loans made after a certain period after the final_regulation had been published sec_1_72_p_-1 q a-19 proposed income_tax regs fed reg date further a proposed regulation is given no more weight than a position advanced by the commissioner on brief 108_tc_100 54_tc_1233 given that the regulations do not shed light on this dispute the only logical way to reach a conclusion is to examine the facts before us and in particular the plan documents the materials provided to us at trial suggest that the plan’s administrator defines date of default as being days following an outstanding payment’s due_date although petitioners point to the plan’s loan acceleration clause and urge us to adopt their argument that the default occurred immediately upon ms tilley’s termination of employment a far more reasonable interpretation is that the acceleration clause merely controls the amount due at termination ie the entire balance of the loan becomes due and payable and does not negate the 90-day cure period further petitioners’ own actions belie their argument that they believed the deemed_distribution occurred in as they did not report the deemed_distribution on their federal_income_tax return the record demonstrates that the balance due at the time of the default--the date at which cure was no longer possible--was dollar_figure thus pursuant to sec_72 a dollar_figure distribution is deemed to have been made in sec_402 provides generally that distributions from a qualified_plan are taxable to the distributee in the taxable_year in which the distribution occurs pursuant to the provisions of sec_72 and thus the dollar_figure deemed_distribution was taxable in b 10-percent additional tax sec_72 imposes an additional tax on a distribution from a qualified_retirement_plan made prior to a taxpayer’s attaining the age of 59½ unless an enumerated exception applies for example the additional tax does not apply to distributions that are made to a beneficiary on or after the death of the employee or that are attributable to the employee’s being disabled see sec_72 the additional tax equals percent of the portion of such distribution that is includable in gross_income the additional tax is intended to discourage premature distributions from retirement plans 106_tc_337 see also s rept pincite c b supp petitioners had a deemed_distribution of dollar_figure from the balance of ms tilley’s loan and an actual distribution of dollar_figure from which taxes were withheld from the closure of her 401_k_plan account ms tilley had not yet attained the age of 59½ at the time of the distributions nor did any of the other statutory exceptions to the additional tax apply see sec_72 petitioners do not in fact argue that any statutory exception applies their only argument as to why they should not be subject_to the additional tax is that they didn’t cause the withdrawal and that fidelity made a mistake in failing to roll over the money into ms tilley’s ira but petitioners did receive a distribution and they did use the money distributed further alleged mistakes of the sort claimed here are not among the enumerated exceptions to the additional tax petitioners are therefore liable for it see 111_tc_250 110_tc_1 101_tc_215 swihart v commissioner tcmemo_1998_407 c negligence_penalty sec_6662 imposes a penalty equal to percent of any underpayment that is attributable to either negligence or disregard of rules or regulations see sec_6662 and b the term negligence includes any failure to make a reasonable attempt to comply with the provisions of the internal revenue regardless of whether the sec_72 additional tax is a penalty or an additional_amount under sec_7491 respondent has satisfied his burden of production with respect to the distribution see milner v commissioner tcmemo_2004_111 n laws sec_6662 sec_1_6662-3 income_tax regs the term disregard includes any careless reckless or intentional disregard sec_6662 sec_1_6662-3 income_tax regs respondent determined that petitioners are liable for this penalty by virtue of sec_7491 the commissioner has the burden of production with respect to a taxpayer’s liability for any penalty to meet this burden the commissioner must produce sufficient evidence indicating that it is appropriate to impose the relevant penalty 116_tc_438 once the commissioner meets the burden of production the taxpayer must come forward with persuasive evidence that the commissioner’s determination is incorrect id respondent satisfied his burden of production under sec_7491 because the record clearly demonstrates that petitioners failed to include ms tilley’ sec_401 plan distributions in their gross_income despite being required to do so accordingly we hold that respondent satisfied his burden sec_6664 provides an exception to the imposition of an accuracy-related_penalty if the taxpayer establishes that there was reasonable_cause for the understatement and that the taxpayer acted in good_faith with respect to that portion sec_6664 sec_1_6664-4 income_tax regs the taxpayer bears the burden of proving that he or she acted with reasonable_cause and in good_faith see sec_6664 see also higbee v commissioner supra pincite sec_1_6664-4 income_tax regs the determination of whether a taxpayer acted with reasonable_cause and good_faith is made on a case-by-case basis sec_1_6664-4 income_tax regs generally the most important factor is the extent of the taxpayer’s effort to assess the proper tax_liability for such year id petitioners claim that they relied on the fidelity representative’s assertion that the distribution was not taxable and thus should not be held responsible for the penalty good_faith reliance on professional advice concerning tax laws may be a defense to the negligence_penalty 115_tc_43 affd 299_f3d_221 3d cir see also 469_us_241 sec_1_6664-4 income_tax regs however reliance on professional advice standing alone is not an absolute defense to negligence but rather a factor to be considered 89_tc_849 affd 904_f2d_1011 5th cir affd 501_us_868 see also sec_1_6664-4 income_tax regs in order to be considered as such the reliance must be reasonable see freytag v commissioner supra pincite sec_1_6664-4 income_tax regs petitioners did not have reasonable_cause to believe that the dollar_figure distribution they received from ms tilley’s plan account was not taxable in fact they received three forms 1099-r that year and we are not persuaded by petitioners’ allegation that they believed this distribution alone was not taxable further it was not reasonable for petitioners to rely on a fidelity call-center representative for tax_advice accordingly we sustain respondent’s determination on this issue d conclusion we have considered all of petitioners’ arguments and to the extent we did not specifically address them we conclude they are without merit any remaining adjustments listed in the notice_of_deficiency are mechanical in nature and their resolution flows from this decision to reflect our disposition of the disputed issues decision will be entered for respondent