Brown v. Commissioner

T.C. Memo. 1996-325

UNITED STATES TAX COURT

R. EDWIN BROWN AND WINSOME S. BROWN, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 7462-94. Filed July 17, 1996.

Rex L. Sturm, for petitioners.

Lindsey D. Stellwagen, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

PARR, Judge: Respondent determined a deficiency in

petitioners’ Federal income tax for the taxable year 1990 in the

amount of $179,597 and an accuracy-related penalty under section

6662(a)1 in the amount of $35,919.

1

All section references are to the Internal Revenue Code in

effect for the taxable year in issue, and all Rule references are

(continued...)

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The issues for decision are: (1) Whether the amount of debt

outstanding on certain computer equipment contributed to the

Barnesville School is includable in the amount realized by

petitioners from the transaction. We hold the debt is includable

in the amount realized. (2) Whether petitioners are entitled to

a charitable contribution deduction for computer equipment and

lease rights contributed to the Barnesville School. We hold they

are not. (3) Whether petitioners are liable for an accuracy-

related penalty under section 6662(a) due to substantial

understatement of income tax. We hold they are liable.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

The stipulation of facts and the attached exhibits are

incorporated herein by this reference. At the time the petition

was filed, petitioners resided in Dickerson, Maryland.

Petitioners are married and filed a joint Federal income tax

return for the year in issue. Since petitioner husband entered

into the transaction at issue, the term “petitioner” refers to R.

Edwin Brown.

On July 2, 1985, Federal Data Corp. (hereinafter FDC)

entered into a Non-Recourse Loan and Security Agreement with and

executed a promissory note to the Old Stone Bank (hereinafter

(...continued)

to the Tax Court Rules of Practice and Procedure, unless

otherwise indicated.

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OSB) for the purpose of purchasing computer equipment. FDC

leased the equipment to American Telephone and Telegraph Co.

(hereinafter AT&T). FDC assigned its rights, title, and interest

in the lease to OSB.

On December 31, 1985, FDC and petitioner entered into a

sale/leaseback transaction with respect to the computer equipment

(hereinafter sometimes referred to as the equipment leasing

transaction). Pursuant to the equipment leasing transaction, the

parties executed a Master Purchase Agreement, a Bill of Sale, and

a promissory note entitled “Recourse Note and Security

Agreement”2 (FDC note) in the amount of $2,358,994. On January

2, 1990, petitioner and the Barnesville School (hereinafter the

School) executed an Assignment--Master Purchase Agreement and

Master Lease Agreement (hereinafter the agreement) and Bill of

Sale. The Bill of Sale provides for the sale of the computer

equipment and all rights in the lease with FDC to the School for

$1 consideration. The agreement provides, in relevant part, as

follows:

all right, title, and interest in the equipment and

rights described in the Master Purchase Agreement and the

Master Lease Agreement dated the 31st day of December, 1985,

entered into by and between Federal Data Corporation * * *

and R. Edwin Brown is by these presents hereby transferred,

assigned, and set over to The Barnesville School. * * * The

Barnesville School shall be substituted for the Buyer and

that all applicable terms and conditions of the aforesaid

2

Although the note was entitled Recourse Note, the parties have

acknowledged that the note, due to a stop loss clause, see sec.

465(b)(4), was treated as a nonrecourse note.

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Master Purchase Agreement and Master Lease Agreement shall

remain in full force and effect.

The Barnesville School agrees to use the proceeds from

the aforesaid Master Lease Agreement to first satisfy the

obligations under the Recourse Note and Security Agreement

dated December 31, 1985, between R. Edwin Brown, Payor, and

Federal Data Corporation, Payee, as provided in the Agency

Agreement between said parties.

On January 2, 1990, petitioner’s outstanding obligation under the

FDC note was $1,540,280.

On their Federal income tax returns for years 1985-89,

petitioners claimed deductions for depreciation and interest

relating to the equipment-leasing transaction. Three separate

statutory notices of deficiency were issued, in which respondent

disallowed petitioners’ claimed deductions pursuant to section

465. Petitioners petitioned the Tax Court in each instance.

Losses in the amount of $549,122 were disallowed for those years

and were treated as a carryforward of suspended losses. On July

21, 1993, respondent sent petitioners a statutory notice of

deficiency for the 1990 tax year, determining a gain on the

disposition of the computer equipment to the School and allowing

the gain to be reduced by suspended losses for years 1985-89.

However, on February 10, 1994, in response to petitioners’

continued litigation in the Tax Court with respect to the 1988

and 1989 losses, respondent sent petitioners a second statutory

notice of deficiency for the 1990 tax year allowing the gain to

be reduced by suspended losses for years 1985-87 only.

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Subsequently, on April 19, 1994, this Court entered a decision

reflecting the settlement of petitioners’ 1988 and 1989 tax

years. As a consequence, respondent concedes that to the extent

petitioner realized a gain on the disposal of the computer

leasing equipment, the gain is reduced by suspended losses from

1985-89. Petitioners did not claim a charitable contribution

deduction on their 1990 Federal income tax return relating to the

property transferred to the School.

At the end of the trial, respondent orally moved for leave

to conform the pleadings to the evidence. Petitioners objected.

We took the motion under advisement. We subsequently issued an

order indicating that to the extent we allow respondent to amend

the pleadings to conform to the proof we would grant petitioners

the same privilege. To this end, we directed the parties to

brief the consequences of the sale of the computer equipment and

rights to the lease for purposes of claiming a charitable

contribution deduction.

OPINION

As a preliminary matter, we must resolve two issues:

Whether the second statutory notice of deficiency is valid and

whether respondent’s motion to conform the pleadings to the

evidence should be granted.

Validity of Respondent’s Second Statutory Notice of Deficiency

In their petition, petitioners allege that respondent

improperly issued a second statutory notice of deficiency.

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Respondent argues she was not precluded from issuing a second

notice of deficiency because petitioners had not filed a Tax

Court petition with respect to the first notice of deficiency.

If the Commissioner mails a notice of deficiency in income

tax and the taxpayer files a timely petition with the Tax Court,

the Commissioner is in general precluded from mailing to the

taxpayer a second notice of deficiency determining an additional

deficiency in income tax for the same year. Sec. 6212(c); McCue

v. Commissioner, 1 T.C. 986, 987-988 (1943). See generally

Breman v. Commissioner, 66 T.C. 61, 65-70 (1976). Accordingly,

the Commissioner is restricted from issuing a second notice of

deficiency with respect to the same taxable year only if the

taxpayer has filed a Tax Court petition with respect to the first

notice of deficiency. Goff v. Commissioner, 18 B.T.A. 283, 288-

289 (1929); Gmelin v. Commissioner, T.C. Memo. 1988-338, affd.

without published opinion 891 F.2d 280 (3d Cir. 1989).

On July 21, 1993, respondent sent a statutory notice of

deficiency to petitioners determining a deficiency for taxable

year 1990. Petitioners did not file a petition with respect to

the July 21, 1993, notice of deficiency. Respondent issued a

second statutory notice of deficiency on February 10, 1994, in an

attempt to preserve respondent's position with respect to prior

year deductions being contested by petitioners in another

proceeding before the Court.

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Since petitioners had not filed a petition with the Court,

section 6212(c) did not preclude respondent from issuing a second

statutory notice of deficiency for tax year 1990. Accordingly,

we hold that the second statutory notice of deficiency is valid.

Motion To Conform Pleadings to the Evidence

Respondent’s motion is for leave to file an amended answer

for an increased deficiency and penalty. The increase from

$1,017,248 to $1,540,280 arises due to correction of the amount

realized from the transfer of the computer lease obligation.

Petitioners allege harm and prejudice should we allow respondent

to amend her answer.

At the close of trial, respondent moved pursuant to Rule

41(b) to increase the deficiency. This Court has held on

numerous occasions that it will not consider issues which have

not been properly pleaded or otherwise preserved. Markwardt v.

Commissioner, 64 T.C. 989, 997-998 (1975). Nevertheless, Rule

41(b) provides a procedure whereby in appropriate circumstances

the pleadings may be amended to conform to the evidence presented

at trial.3

3

Rule 41(b) provides as follows:

(1) Issues Tried by Consent: When issues not raised by

the pleadings are tried by express or implied consent of the

parties, they shall be treated in all respects as if they

had been raised in the pleadings. The Court, upon motion of

any party at any time, may allow such amendment of the

pleadings as may be necessary to cause them to conform to

the evidence and to raise these issues, but failure to amend

(continued...)

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Section 6214(a) requires a claim for increased deficiency to

be asserted at or before the hearing or a rehearing. It is well

established that the word “hearing” as used in section 6214(a)

encompasses the entire “proceeding” up until the decision of the

Tax Court has been entered. Henningsen v. Commissioner, 243 F.2d

954 (4th Cir. 1957), affg. 26 T.C. 528 (1956); Law v.

Commissioner, 84 T.C. 985, 989 (1985).

As part of the parties’ joint stipulations, Exhibit 8-H was

admitted into evidence. That exhibit is the recourse note

entered into between petitioner and FDC. In addition, page 8 of

Exhibit 8-H is the debt service schedule. The schedule begins

with the principal balance of $2,358,994 and chronicles the

payments made on the note. As of January 2, 1990, the date of

the transfer to the School, the debt service schedule shows a

balance of $1,540,280.

3

(...continued)

does not affect the result of the trial of these issues.

(2) Other Evidence: If evidence is objected to at the

trial on the ground that it is not within the issues raised

by pleadings, then the Court may receive the evidence and at

any time allow the pleadings to be amended to conform to the

proof, and shall do so freely when justice so requires and

the objecting party fails to satisfy the Court that the

admission of such evidence would prejudice such party in

maintaining such party’s position on the merits.

(3) Filing: The amendment or amended pleadings

permitted under this paragraph (b) shall be filed with the

Court at the trial or shall be filed with the Clerk at

Washington, D.C., within such time as the Court may fix.

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The basic issue in the instant case--whether the nonrecourse

debt should be included in the amount realized upon transfer of

the computer to the School--was not altered by the increase in

the deficiency asserted by respondent. Petitioners had full

opportunity to meet the claim for an increased deficiency because

it was apparent from the outset of this suit that respondent

included the "nonrecourse debt" in the amount realized by

petitioners from the transfer of the equipment, and they

themselves stipulated the document which showed that the debt was

$1,540,280 rather than $1,017,248, thus giving rise to the

corresponding assertion of an increased deficiency. We find that

justice requires that we allow respondent’s answer to be amended.

Rule 41(a).

Accordingly, respondent’s motion to amend her answer to

conform to the evidence so as to assert an increased deficiency

will be granted. Respondent has the burden of proving, however,

that petitioners are liable for the increased deficiency. Rule

142(a).

Issue 1. Income From the Disposition of the Equipment Leasing

Interest

Respondent asserts that petitioners’ amount realized from

the transfer to the School must include the obligation under the

FDC note as a consequence of the School’s assumption of the note.

Petitioners argue that the note was not assumed by the School

and, furthermore, that the note was illusory.

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Generally, gain or loss from the disposition of property is

measured by the amount realized less the adjusted basis of the

property. Sec. 1001(a). The amount realized from the sale or

other disposition of property is defined as money received plus

the fair market value of any property received. Sec. 1001(b).

Furthermore, the amount realized generally includes the amount of

liabilities from which the transferor is discharged as a result

of the sale or disposition. Sec. 1.1001-2(a), Income Tax Regs.

An exception to this rule applies if the liability was incurred

by reason of the acquisition of the property but such liability

was not taken into account in determining the transferor’s basis

for the property. Sec. 1.1001-2(a)(3), Income Tax Regs.; see

also Brown-Forman Corp. v. Commissioner, 94 T.C. 919, 940 (1990),

affd. 955 F.2d 1037 (6th Cir. 1992); cf. Mendham Corp. v.

Commissioner, 9 T.C. 320 (1947); Lutz & Schramm Co. v.

Commissioner, 1 T.C. 682 (1943).

When a nonrecourse liability is at issue, a discharge of

the liability occurs when there is a sale or other disposition of

the property that secures the nonrecourse liability. Sec.

1.1001-2(a)(4)(i), Income Tax Regs. A charitable contribution of

property can be treated as a sale or exchange. Guest v.

Commissioner, 77 T.C. 9, 25 (1981); sec. 1.1011-2(a)(3), Income

Tax Regs.

Both parties cite Commissioner v. Tufts, 461 U.S. 300

(1983), in their arguments.

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In Tufts, the Supreme Court held that where a taxpayer

disposes of property encumbered by nonrecourse indebtedness in an

amount that exceeds the fair market value of the property, the

outstanding amount of the nonrecourse obligation is includable in

the amount realized by him. Moreover, the Supreme Court

concluded:

Unless the outstanding amount of the mortgage is deemed

to be realized [at the time of sale], the mortgagor

effectively will have received untaxed income at the

time the loan was extended and will have received an

unwarranted increase in the basis of his property.

* * * [Id. at 310; fn. ref. omitted.]

“In so holding, the Supreme Court reaffirmed the Crane ‘balancing

entry’ theory which is that the amount of the nonrecourse

liability is to be included in calculating both the basis and the

amount realized upon disposition.” Rice’s Toyota World, Inc. v.

Commissioner, 81 T.C. 184, 196 n.9 (1983), affd. in part, revd.

in part and remanded 752 F.2d 89 (4th Cir. 1985). This theory is

based upon the assumption that the mortgage was properly

includable in basis from the beginning and that it will be repaid

in full. Id. Accordingly, we have concluded that Tufts involved

the symmetrical treatment to be accorded where nonrecourse

liability has been properly included in basis initially and must

thereafter also be included in the amount realized on disposition

of the encumbered property. Dean v. Commissioner, 83 T.C. 56, 78

n.10 (1984).

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Respondent argues that Tufts is controlling, while

petitioners argue that the transaction at issue was subject to

section 465(b)(4) and therefore Tufts has no application.4

We essentially rejected petitioners' argument when we previously

held that the at-risk rules of section 465 do not supersede the

judicial doctrines for testing the inclusion of purported

nonrecourse debt in basis. Waddell v. Commissioner, 86 T.C. 848,

899 (1986) (citing S. Rept. 94-938 (1976), 1976-3 C.B. (Vol. 3)

49, 86, and noting that the at-risk rules do not replace the

rules for basis determination), affd. 841 F.2d 264 (9th Cir.

1988). Since the debt is included in basis notwithstanding any

limitations imposed by section 465, the exception in section

1.1001-2(a)(3), Income Tax Regs., would not apply. Moreover,

under the symmetrical analysis, it follows that where nonrecourse

liability has been properly included in basis initially, it must

thereafter also be included in the amount realized on disposition

of the encumbered property.

Furthermore, we note that the losses limited by section 465

are recognized upon disposition of the property. Allen v.

Commissioner, T.C. Memo. 1988-166; see also sec. 465(a)(2).

4

Petitioners refer to a footnote in Tufts in support of their

position: “this congressional action [enactment of sec. 465] may

foreshadow a day when nonrecourse and recourse debts will be

treated differently”. However, respondent points out that the

Supreme Court went on to say that “neither Congress nor the

Commissioner has sought to alter Crane’s rule of including

nonrecourse liability in both basis and the amount realized.”

Commissioner v. Tufts, 461 U.S. 300, 309 n.7 (1983).

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Respondent has conceded this effect. Therefore, we disagree with

petitioners that section 465 and the inclusion of the debt in

amount realized are mutually exclusive.

Moreover, we find no support in the record that respondent

and petitioners treated the debt as illusory. In contrast,

petitioners included the amount of the debt in their basis and

attempted to claim deductions relating thereto. Similarly,

respondent disallowed those deductions, not because the debt was

illusory, but rather because the section 465 at-risk rules

applied. Accordingly, we hold that petitioners must include in

their amount realized the amount of the FDC liability.

Since we have granted respondent’s motion to increase the

deficiency, she has the burden of proving the increased amount.

In light of the debt service schedule reflecting a balance of

$1,540,280 as the principal balance of the FDC note on January 2,

1990, and since petitioners have not offered any evidence to the

contrary, we hold that respondent has met her burden of proof

with respect to the increased deficiency.

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Issue 2. Charitable Contribution Deduction

Respondent argues that petitioners are not entitled to a

charitable contribution deduction because the amount of the

encumbrance exceeded the fair market value of the property at the

time of the transfer. Petitioners argue that they should be

allowed a charitable contribution deduction for the projected

income stream associated with the lease.

A taxpayer may make a charitable contribution by selling or

disposing of property to a charity for less than its fair market

value. Estate of Bullard v. Commissioner, 87 T.C. 261, 265

(1986). The amount of the charitable contribution resulting from

such a “bargain sale” generally is the excess of the fair market

value of the property over its sale price. Id.; Stark v.

Commissioner, 86 T.C. 243, 255-256 (1986); Knott v. Commissioner,

67 T.C. 681 (1977); Waller v. Commissioner, 39 T.C. 665, 677

(1963). Furthermore, to the extent that the fair market value of

property contributed exceeds the debt on the property, taxpayers

are entitled to a charitable contribution deduction. Guest v.

Commissioner, supra at 25.

A taxpayer has the burden of proving the amount of a

charitable contribution that he or she may deduct. Rule 142(a);

Guest v. Commissioner, supra; Lamphere v. Commissioner, 70 T.C.

391 (1978). Section 1.170A-1(c)(1), Income Tax Regs., provides

that the amount of a charitable contribution of property other

than money is the fair market value of the property at the time

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of the contribution subject to certain reductions. Section

1.170A-1(c)(2), Income Tax Regs., defines fair market value as

“the price at which the property would change hands between a

willing buyer and a willing seller, neither being under any

compulsion to buy or sell and both having a reasonable knowledge

of relevant facts.”

Petitioners offered virtually no evidence regarding the fair

market value of the computer and lease. The School received

lease payments on the Master Lease, but there is no proof that

those amounts were contributed by petitioners. Petitioners did

not contribute any cash to the School. Nor did petitioners

report as income any of the lease payments received by the

School. Moreover, petitioners have not offered proof on the

projected income stream, if any, with respect to the lease of the

computer equipment.

Petitioners have not proven that the fair market value of

the contributed property was in excess of the debt assumed.

Accordingly, we hold that petitioners are not entitled to a

charitable contribution deduction.

Issue 3. Section 6662 Substantial Understatement Penalty

Respondent determined that petitioners are liable for the

section 6662(a) penalty for 1990. Petitioners argue that there

was substantial authority for the position taken on their return.

Furthermore, petitioners argue that the complexity of the matter

- 16 -

and the prior inconsistent positions of respondent make any

penalty inappropriate.

Section 6662(a) imposes an accuracy-related penalty of 20

percent on any portion of an underpayment of tax that is

attributable to items set forth in section 6662(b). Section

6662(b)(2) specifies as one of those items “Any substantial

understatement of income tax.” An understatement is substantial

if it exceeds the greater of 10 percent of the amount of tax

required to be shown on the return or $5,000. Sec. 6662(d)(1)(A)

and (B). An understatement means the excess of the amount of the

tax required to be shown on a return over the amount of tax

imposed which is shown on the return, reduced by any rebate

(within the meaning of section 6211(b)(2)). Sec. 6662(d)(2)(A).

An understatement is reduced to the extent it is (1) based

on substantial authority or (2) adequately disclosed in the

return or in a statement attached to the return. Sec.

6662(d)(2)(B). To determine whether the treatment of any portion

of an understatement is supported by substantial authority, the

weight of authorities in support of the taxpayer’s position must

be substantial in relation to the weight of authorities

supporting contrary positions. Antonides v. Commissioner, 91

T.C. 686, 700-704 (1988), affd. 893 F.2d 656 (4th Cir. 1990);

sec. 1.6662-4(d)(3), Income Tax Regs.

Furthermore, the accuracy-related penalty under section

6662(b)(2) does not apply with respect to any portion of an

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underpayment if it is shown that there was reasonable cause for

such portion of the underpayment and that the taxpayers acted in

good faith with respect to such portion. Sec. 6664(c)(1). The

determination of whether the taxpayers acted with reasonable

cause and in good faith depends upon the pertinent facts and

circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs. The most

important factor is the extent of the taxpayers’ effort to assess

their proper tax liability for the taxable year. Id.

After carefully examining the record, we find no basis on

which we can find that petitioners had substantial authority,

that they adequately disclosed the relevant facts concerning the

items on their tax return, or that they acted with reasonable

cause and in good faith with respect to any portion of the

understatement determined by respondent. We have considered all

of petitioners’ arguments on this point and find them to be

without merit. On the instant record, we sustain respondent’s

determination that petitioners are liable for the accuracy-

related penalty with respect to their entire underpayment of tax

for 1990.

To reflect the foregoing, and to take into account

concessions made,

An appropriate order will be

issued and decision will be

entered under Rule 155.