Alacare Emphasizes Periodic Review of Corporate Policy on Expensing of Capital Items

In Alacare Home Health Services, Inc., TC Memo 2001-149, the Tax Court held that a corporate taxpayer could not rely on a specific dollar threshold as a basis for expensing capital items because the approach did not result in a clear reflection of income. Alacare should be a reminder to all taxpayers to perform periodic reviews of their expensing policy for capital items to ensure that it results in a clear reflection of income.

Taxpayers should maintain documentation of their policy for expensing, because it is reasonably likely that the IRS will request a copy during an audit. Further, taxpayers face a greater risk that the IRS will challenge their expensing practices if the amounts expensed under the policy constitute more than a fraction of their income or if a regulatory agency did not mandate the policy.

Facts

Alacare Home Health Services Inc. is a Medicare-certified home healthcare agency that uses the accrual method of accounting. Alacare was incorporated in 1982; since then, it has expensed all capital items for which it has paid less than $500. Alacare followed that practice in 1995 and 1996 (the years in dispute). The items expensed included computer equipment, furniture (such as desks, chairs and bookcases), tables and refrigerators.

As approximately 98% to 99% of Alacare's revenues are Medicare reimbursements, Alacare's expensing policy complies with Medicare guidelines for the capitalization of depreciable assets (contained in the Medicare Provider Reimbursement Manual issued by the Federal Health Care Financing Administration (HCFA)). The guidelines on providers' capitalization and expensing policies state:

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

 The guidelines also state, "[t]he provider may, if it desires, establish a: capitalization policy with lower minimum criteria, but under no circumstances may the above minimum limits be exceeded."

The Service issued a deficiency notice for 1995 and 1996, determining that Alacare's policy of expensing assets costing less than $500 was not a proper accounting method under Sec. 446(e).

Sec. 263 and Regs. Sec. 1.263(a)-2(a). According to Regs. Sec. 1.263(a)-2(a), examples of capital expenditures include amounts paid to acquire machinery and equipment, furniture and fixtures and similar property with a useful life substantially beyond the tax year.

Sec. 446. Sec. 446(a) sets forth the general rule that, "[t]axable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books." However, Sec. 446(b) provides an exception that, "[i]f 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."

Tax Court

The Tax Court held that Alacare could not rely on a specific dollar threshold to expense capital items, because this approach did not result in a clear reflection of its income. Instead, Alacare had to capitalize the costs of the disputed assets over their useful lives.

The Tax Court referred to Knight-Ridder Newspapers, Inc., 743 F2d 781 (11th Cir. 1984), for its use of a mathematical analysis to determine if the taxpayer's accounting method clearly reflected income. It also distinguished two cases that Alacare had raised as support for its position, Cincinnati, New Orleans & Tex. Pac. Ry. Co., 424 F2d 563 (Ct. Cl. 1970), and Union Pac. R.R. Co., 524 F2d 1343 (Ct. Cl. 1975).

Cincinnati and Union Pacific each involved a railroad company that, for accounting purposes, was required by the Interstate Commerce Commission to expense certain purchases under $500, even though the items had useful lives in excess of one year. In each of those cases, the Court of Claims held that the railroad company was similarly entitled to deduct the cost of those items in the year of purchase. The court noted that the determinative question was whether the approach resulted in a clear reflection of income, determining that the railroad companies met the requirement.

In considering whether these cases constituted support for Alacare's position, the Tax Court performed a comparative mathematical analysis of the facts in Alacare, Cincinnati and Union Pacific. It found that Alacare's ratios of disputed items to various measures (such as total gross receipts, total operating expenses, total depreciation expense, etc.) were substantially larger than those in Cincinnati and Union Pacific. For example, in Cincinnati, the taxpayer's disputed items were less than one percent of its net income in the three years at issue; in Alacare, the disputed items were 165% of its 1995 taxable income and 83.5% of its 1996 taxable income. Therefore, Cincinnati and Union Pacific did not establish that Alacare's expensing of capital items costing under $500 resulted in a clear reflection of income.

The court noted that Alacare offered no evidence that HCFA had considered whether its minimum expensing policy for the home healthcare agencies would result in financial statements that clearly reflected income. Also, HCFA guidelines did not require use of the minimum expensing policy. In contrast, the ICC had considered whether its policy would result in a clear reflection of income and required the taxpayers in Cincinnati and Union Pacific to expense the items according to its policy.

From Kelly Gaffaney, and Glenn Mackles, J.D., Washington, DC