The opinion
T.C. Memo. 1996-419
UNITED STATES TAX COURT
LOREN F. PAULLUS AND DONNA PAULLUS, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
RIDGEMARK CORPORATION, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 6105-93, 6106-93. Filed September 17, 1996.
Clarence J. Ferrari, Jr., George P. Mulcaire, J. Timothy
Maximoff, and C. David Spence, for petitioners.
Christopher J. Faiferlick and Barbara M. Leonard, for
respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GERBER, Judge: Respondent determined a deficiency in
petitioners Loren F. Paullus and Donna Paullus’ 1989 Federal
income tax in the amount of $124,324 and a penalty under section
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6662(a)1 in the amount of $10,690. Respondent also determined a
deficiency in petitioner Ridgemark Corp.’s 1989 Federal income
tax in the amount of $2,488,051 and a penalty under section
6662(a) in the amount of $497,610.
After concessions, the issues remaining for our
consideration are: (1) Whether real property held and exchanged
in 1989 by petitioner Ridgemark Corp. qualifies for income tax
deferral pursuant to section 1031; and (2) whether petitioners
Ridgemark Corp. or Loren F. and Donna Paullus are separately
liable for penalties under section 6662(a).
FINDINGS OF FACT2
Petitioner Ridgemark Corp. (Ridgemark) is incorporated, and
its principal place of business at the time its petition was
filed was Hollister, California. Petitioners Loren F. and Donna
Paullus (petitioners), at the time their petition in this case
was filed, resided in Paicines, California. Loren F. Paullus
(Paullus) was president of Ridgemark from 1971 until March 1992.
He also served on Ridgemark’s board of directors.
Paullus owned and operated a 110-acre turkey ranch in
Hollister, California, which he considered developing into a golf
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the taxable year under
consideration, and all Rule references are to this Court’s Rules
of Practice and Procedure.
2
The parties’ stipulation of facts and exhibits are
incorporated in this opinion by this reference.
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course as early as 1960. Paullus decided to proceed after
determining that his ranch possessed a substantial water supply
that could support the proposed golf course operation.
Ridgemark was incorporated by Paullus and other investors on
or about November 4, 1971. The Pre-Incorporation Subscription
Agreement provides that Ridgemark will be able to
transact and carry on the business of acquiring, owning
and improving land for recreational and residential
purposes, selling memberships in and playing privileges
in a golf course, and subdividing and selling improved
or unimproved lots for residential purposes * * *
Ridgemark’s articles of incorporation also provide that the
corporation's business purposes are “To engage primarily in the
specific business of acquiring, developing, owning and selling
real property."
Paullus contributed the 110-acre turkey farm to the
corporation in exchange for stock. The other investors
contributed cash and real property in exchange for stock in
Ridgemark. At the time of incorporation, Paullus acquired 59.3
percent of Ridgemark’s outstanding stock.
On or about November 12, 1971, Ridgemark was authorized by
its board of directors to purchase golf course irrigation
equipment from Western Rain Bird Sales. Ridgemark also purchased
102-acre and 70-acre parcels for the golf course project.
On June 22, 1972, Ridgemark filed a Declaration of Covenants
and Restrictions with San Benito County, California, for
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Ridgemark Estates, a planned development. An unincorporated
association, Ridgemark Homes Association, was formed for the
purpose of enforcing and administering covenants and
restrictions, as well as approval for home construction and lot
improvements. Lot owners were eligible to be members of
Ridgemark Homes Association. Ridgemark Estates was located
adjacent to the golf course.
Ridgemark constructed the golf course and related
recreational facility. Upon completion of the Ridgemark Golf and
Country Club, Ridgemark sold golf club memberships. Memberships
consisted of annual, renewable licenses to use the facilities
with no proprietary rights or privileges. Golf memberships were
sold by Ridgemark, in part, to fund the construction, operation,
and expansion of the golf course facility.
For a few years, Ridgemark sold unimproved and unsubdivided
lots. These sales also provided golf course funding to
Ridgemark. Ridgemark generally followed the practice of selling
improved residential lots to purchasers for cash for the
construction by such purchasers of single family houses.
Ridgemark acquired a real estate brokerage license.
Paullus’ daughter ran the sales department. On or about April
1977, however, Ridgemark’s board of directors terminated its
practice of selling improved residential lots. The board decided
that it was desirable to limit Ridgemark’s activities to the sale
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of unimproved and improved land, the operation of Ridgemark Golf
and Country Club, and the conduct of the real estate brokerage
business. The board desired to protect the corporation from
liabilities that might arise from the construction and financing
business. Consequently, on May 3, 1977, Ridgemark Construction
Corp. (Construction) and Ridgemark Financial Corp. (Financial)
were formed to segregate the residential lot activity.
Construction was to engage in construction, subdivision,
development, and sale of residential units and townhomes.
Financial was to engage in financing, development, improvement,
and sale of single family lots. Ridgemark’s board of directors
resolved to sell improved lots to Construction and Financial at
prices equivalent to cost plus no less than 25-percent profit.
Before Financial and Construction were formed, Ridgemark had sold
approximately 200 lots. After that, Ridgemark was not involved
in the improvement and sale of lots.
As of April 1977, Ridgemark owned the following real
property:
1. Lot 82, Unit #2
2. Several lots in Unit #3
3. Golf course land
4. Clubhouse land
5. Miscellaneous parcels of land near the water tower
6. 27.9 acres at the end of George’s Drive
7. 8 acres near Ray’s Circle
8. 5.95 acres below Ridgemark Village
9. 7.3-acre parcel
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10. 37.34 acres at the northeast corner of Airline
Highway and Fairview Road
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11. 47.2 acres where the maintenance barn, the guest
cottage site, and the old Paullus residence are
located
12. 35.08-acre parcel
13. 7-acre parcel
On October 18, 1977, Ridgemark conveyed improved and
unsubdivided land to Construction for $175,000. The final
subdivision public report was issued to Construction on
February 1, 1979.
During 1980, Ridgemark expanded the golf course because the
existing facilities were becoming overcrowded. A $1 million
expansion increased the clubhouse facility from 6,600 to 22,600
square feet. Ridgemark also promoted a joint venture with
private investors to build 32 guest cottages for rental purposes
in order to increase its attraction and use as a destination golf
resort. The expansion had a positive effect on Ridgemark’s golf
and recreation business. Ultimately, Ridgemark acquired
ownership of the guest cottages.
As of April 1987, Ridgemark owned the following assets:
1. Lot 82, Unit #2
2. Several lots in Unit 3
3. Approximately 150 acres of golf course land
4. Approximately 5 acres of clubhouse land
5. Approximately 20 acres of land near a water tower
(Perry Hill)
6. 27.9 acres at the end of George’s Drive
7. 8 acres near Ray’s Circle
8. 5.95 acres below Ridgemark Village
9. 7.3-acre parcel near entrance to Ridgemark Village
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10. 37.34 acres at the northeast corner of Airline Highway
and Fairview Road
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11. 47.2 acres where the maintenance barn, guest cottage
site, and the old Paullus residence were located
12. 35.08 acres composed of three parcels located at
George’s Drive, Ray’s Circle, and the end of Ridgemark
Drive
13. 7-acre parcel located off Ridgemark Drive
Ridgemark acquired only two properties after April 1977:
(1) March 27, 1984, 1.89 acres at the corner of a major highway;
and (2) February 1985, 269 acres from Bushmont Properties
(Bushmont property). Ridgemark paid $1,825,379.90 for the
Bushmont property.
Ridgemark built a second 18-hole golf course, a tennis
center, and a new clubhouse facility on approximately 130 acres
of the Bushmont property. The new 18-hole golf course located on
the Bushmont property had a cost of about $1,600,000. The value
of the Bushmont property, after improvements, was estimated to be
$3 million. A lighted 10-court tennis facility and a new 5,000-
square-foot clubhouse located on the Bushmont property cost
approximately $492,000. Ridgemark also added 175 parking spaces.
The vast majority of Ridgemark’s real property holdings had
been acquired as of 1977. Between April 1977 and 1989, Ridgemark
sold the following properties to either Financial or
Construction:
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Acquisition Improvement Sale
Property Sold Sale Price Cost Cost Date
35 acres, Unit #4 $350,880 $153,732.00 $77,550.00
12/31/77
7 acres, Unit #5 175,000 58,670.00 80,901.72
10/18/77
7.3 acres, Unit #6 300,000 32,802.22 49,496.61
3/31/81
41 acres, Unit #7 2,460,000 369,583.00 249,550.00
4/12/85
13.43 acres,
Unit # 8,
phase one 1,347,000 121,060.00 137,123.96
11/18/85
10.53 acres,
Unit #8,
phase two 1,053,000 94,919.74 5,718.20
8/24/87
16.23 acres,
Unit # 9 1,054,950 146,300.79 63,122.23
6/30/87
On March 15, 1985, Ridgemark agreed to sell the units 7 and
8 properties to Financial and Construction, respectively. By
that time, Ridgemark had acquired tentative maps for units 7 and
8. The agreements provided that, concurrently with the recording
of the final maps for units 7 and 8, Ridgemark would sell the
properties to Financial and Construction. On April 12, 1985, and
November 18, 1985, the final maps for units 7 and 8,
respectively, were granted and the transactions concluded.
On February 24, 1987, Ridgemark agreed to sell the unit 9
property to Financial. By that time, Ridgemark had obtained
approval for a tentative map. The agreement contains a clause
providing that within 90 days of the recording of the final map
for unit 9, Ridgemark would sell the property to Financial. The
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final map for unit 9 was recorded on May 19, 1987. Ridgemark’s
May 26, 1987, corporate minutes reflect that it intended to sell
the unit 9 property to Financial within 1 month. The property
was sold on June 30, 1987, and deeded July 10, 1987.
When Ridgemark sold the units 4 through 9 properties to
Financial and Construction, Robert A. Prior (Prior), Ridgemark’s
attorney, did the preliminary filing of the applications with the
State of California Department of Real Estate (DRE). These lots
were developed and sold by Construction or Financial, although
the preliminary approval for subdividing was obtained in
Ridgemark’s name. The final report, however, was issued in the
name of the subdivider, either Financial or Construction. The
lots herein were zoned for the highest possible use (residential)
in order to maximize possible loans by third parties.
On February 24, 1987, in an effort to “increase the
marketability of lots and townhomes”, Ridgemark’s board of
directors voted to restrict the sales of new golf memberships to
people who owned property in and resided in Ridgemark Estates.
On May 26, 1987, Ridgemark’s board of directors met to discuss
Ridgemark’s financial status, and the board reversed its decision
of February 24, 1987:
[Ridgemark] will market a golf subscription to persons
who are not owners of a lot or a unit and a resident of
Ridgemark Estates. The subscription price will be
$4,000.00. The subscription will have a term of five
years, and will not be transferable and will have no
golf cart use privileges, and can be converted to a
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class A golf, tennis and social membership or class A
golf and social membership if the subscriber becomes
the owner of a lot or unit and a resident of Ridgemark
Estates within the five year term and pays the excess
of the membership initiation fee over the $4,000.00
subscription price.
The corporate minutes reflect that the board of directors
considered the further expansion of the golf facility and other
related activities, such as the purchase of 10 gasoline-powered
golf carts. The board also explored the possibility of future
development of all the remaining land south of Airline Highway.
Ridgemark’s engineer estimated that approximately 300 lots would
be produced at an average net sale price of $60,000, which would
produce gross profits of $18 million. An additional $9 million
could be produced by selling the lots improved with houses.
In the same meeting, the board of directors also authorized
Paullus to have preliminary discussions with representatives of
potential purchasers regarding the sale of Ridgemark. By that
time, certain Ridgemark shareholders sought to dispose of their
shares. Paullus desired to be relieved of the responsibilities
involved in the management of Ridgemark Golf and Country Club.
He also sought to liquidate Ridgemark’s assets in order to expand
into a new venture, the proposed Paicines project.
On February 23, 1988, the corporate minutes reflected the
fact that the tentative map for the unit 10 property, comprising
164 lots, had been filed with the San Benito County Planning
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Department. The tentative map for the unit 10 property was
approved on April 6, 1988.
On May 5, 1988, the board investigated the advantages
inherent in having Ridgemark perform as the subdivider of unit 10
as compared with selling the property to Construction and having
it act as the subdivider. The board determined that the
development of unit 10 by Construction would be preferable.
On August 2, 1988, Joseph Drosihn (Drosihn), a
representative of Y.L. Shen (Shen), contacted Ridgemark regarding
the purchase of all the developable land owned by Ridgemark.
Drosihn and Paullus agreed that land that had been formerly
conveyed to Financial would be reconveyed to Ridgemark and
included within its assets upon sale.
On August 8, 1988, Ridgemark represented that it intended to
subdivide land that was covered under prior agreements with the
local water utility. Consequently, the unit 10 property needed
sewer and water service installed. Ridgemark was referred to as
“Subdivider” in the agreement and agreed to pay $290,465 for
installation of water facilities and $282,559 for the
installation of sewerage facilities.
On August 12, 1988, Ridgemark’s board of directors met to
discuss the offer by Shen. The minutes of the meeting state:
The President [Paullus] advised the meeting that his
legal and tax advisors are developing a transaction
structure to include a tax free exchange in the sale of
the Corporation and the purchase of the Paicines Ranch,
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for the benefit of him and his associates in the
Paicines Ranch project and, in order to implement such
structure, he and his associates are willing to
purchase the shares of the capital stock of the
Corporation from the other shareholders at the same
price per share as that paid by the purchaser, less a
prorata [sic] share of the brokers’ commission, and
with an interest rate of 10% per year on the deferred
portion of the purchase price and providing each
selling shareholder the security given by the
purchaser.
On August 23, 1988, the board further discussed the Drosihn
proposal. Paullus reported that he had reached an agreement with
Drosihn that once approval of the final map for unit 10 was
obtained, the sales of lots in unit 10 would commence. The
minutes contain the notation that there were 97 people interested
in purchasing lots in unit 10.
In an August 27, 1988, letter, Shen’s representative was
informed that Ridgemark’s board had authorized its corporate
officers to engage in negotiations to sell Ridgemark. The letter
provides that neither the assets nor the stock of Construction or
Financial were involved in any proposed sale. Initially,
negotiations contemplated a straightforward sale of all of
Ridgemark’s stock to Shen.
An agreement with San Benito County recorded on
September 22, 1988, reflects that Ridgemark was “in the process
of developing or improving” the unit 10 property. Ridgemark was
required to make improvements, including the necessary paving,
curbs, gutters, catch basins, pipes, culverts, water mains, storm
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drainage systems, and sanitary sewers. Ridgemark and San Benito
County agreed that Ridgemark would be contractually liable to
complete the enumerated improvements after the issuance of the
final map. On September 23, 1988, Ridgemark notified DRE that as
subdivider of unit 10, it would grant nonexclusive easements to
certain streets to the owners of the lots in unit 10.
On September 26, 1988, Ridgemark entered into a Subdivision
Services Agreement with Bill Vierra & Associates, Inc. (Vierra).
In this agreement, Ridgemark agreed to be represented by Vierra
in filing the Preliminary and Final Public Report applications
with DRE in connection with “Ridgemark Estates No. 10".
On the same date, Vierra filed an application for a Final
Public Report for Ridgemark Estates, unit 10. Ridgemark is
reflected as the subdivider, with Paullus as its representative.
The Notice of Intention for unit 10 reflects that it would be
used solely for single family residential homes. However, the
lots in unit 10 would be sold as vacant lots. The ultimate
purchaser would be responsible for special fees charged to the
lot, such as school impact fees, fire and police department
impact fees, and traffic mitigation impact fees, either when the
purchaser obtained a building permit or prior to occupancy.
Finally, it was indicated that membership in Ridgemark Golf and
Country Club would be utilized as an inducement for the unit 10
lots. On November 14, 1988, Ridgemark’s board of directors
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determined that Shen’s proposal was unacceptable, and Paullus was
authorized to terminate negotiations and “proceed with the sales
of lots in the Unit 10 subdivision.” On December 6, 1988, Shen’s
representative, Drosihn, and Paullus, however, signed a letter of
intent delineating the terms and conditions for Shen’s purchase
of Ridgemark’s outstanding shares. Ridgemark reserved the right
to structure a tax-free or tax-deferred exchange without any
added cost or risk to the buyer.
On December 7, 1988, Shen rejected the proposed stock sale
because of “an adverse unresolved tax problem”. Drosihn,
however, advised Paullus that Shen was still interested in
purchasing Ridgemark and sought a meeting of tax specialists to
structure the transaction in a mutually acceptable manner to
resolve the tax problem. It became evident that Shen was not
interested in purchasing the Ridgemark Golf and Country Club
unless Paullus agreed to manage the operation for a period of 10
years. Paullus was unwilling to continue the management of the
golf course and resort facilities. On December 13, 1988,
Ridgemark’s board of directors met to discuss Shen’s new offer to
purchase the 120 lots in the unit 10 subdivision.3 The tax
consequences of the proposed purchase were discussed in the
minutes.
3
The minutes for Aug. 23, 1988, reflect that due to a
boundary dispute, Ridgemark decided to exclude the disputed strip
of land and reduced the land in question from 164 to 120 lots.
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Paullus counteroffered in a December 15, 1988, letter, which
proposed a restructured transaction under which Shen would
acquire Ridgemark’s assets except the land, facilities, and
equipment of Ridgemark Golf and Country Club. Specifically,
Ridgemark offered to sell the unit 10 property for a price of $10
million, with Shen assuming the responsibility of completing the
improvements related to the subdivision of the property into
buildable lots. An alternative offer for $11,500,000 was made
under which Ridgemark would complete the improvements. The
letter offered the unit 10 property for sale upon the terms and
conditions specified, which included Ridgemark’s tax-free
exchange requirement. The schematics associated with the offer
included the statement that the proposed transaction appeared to
qualify for a section 1031 exchange. On December 21, 1988,
Paullus sent a completed draft of the letter and schematic of the
proposed transaction. Ridgemark obtained the approval of the
final subdivision map and constructed certain offsite
improvements for the unit 10 property because Shen, through
assignees, wanted to be able to build houses and sell lots as
soon as possible after closing.
On January 9, 1989, Ridgemark’s board of directors removed
the restriction that preferred4 memberships in Ridgemark Golf and
4
The preferred memberships (class A) entitled those members
to full privileges of the recreational facility.
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Country Club be sold only to owners of lots who resided in
Ridgemark Estates. At the same time, Paullus offered to purchase
the shares of Ridgemark’s shareholders who did not wish to
participate in the development of the Paicines area properties.
On January 23, 1989, the Loan, Option and Purchase Agreement
(Purchase Agreement) was approved by the board of directors. The
Purchase Agreement provided that Ridgemark, as the seller, would
diligently complete, at its expense, all offsite improvements for
unit 10. Ridgemark completed the offsite improvements after the
Purchase Agreement execution at a cost of about $1,600,000. The
Purchase Agreement provided that Ridgemark had the right to
structure a tax-deferred exchange, and Shen was required to
cooperate to effectuate such an exchange. Moreover, Ridgemark
agreed to make golf and country club memberships available to
purchasers of homes in the unit 10 property on the same terms and
conditions as to the preferred members.
The Purchase Agreement also provided that Shen had two
options to purchase, in increments, any remaining developable
land owned by Ridgemark. The first option was exercisable in
1991, and the second in 1993. Each option was worth
approximately $7 million. Neither option was exercised.
Ultimately, the optioned land reverted to Ridgemark.
Shen was expected to complete the purchase of the unit 10
lots by March 27, 1989. If Shen did not complete the purchase of
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the unit 10 lots, Paullus outlined a plan to the board for a
joint venture with outside investors. Ridgemark would contribute
the unit 10 lots that would be utilized for the venture. The
purchase and transfer of the unit 10 property was completed on
March 27, 1989, for a final gross selling price of $11,250,000.
On April 7, 1989, Paullus exercised his option to purchase
the outstanding shares of his fellow shareholders in Ridgemark.
After the transaction, petitioners personally owned 36.32 percent
of Ridgemark's outstanding shares. Paullus, along with his wife,
were also the trustees of the Loren and Donna Paullus Family
Trust, which owned 35.02 percent of Ridgemark’s outstanding
shares. In 1990, Ridgemark sold its golf courses, clubhouses,
and recreational facilities for $12 million to the members of
Ridgemark Golf and Country Club.
The property acquired by Ridgemark as an exchange consisted
of approximately 2,261 acres (the Paicines property). The
Paicines property was acquired with the intention of developing a
new and expanded golf course and resort facility. Approximately
1,000 acres were contemplated for five or six golf courses,
clubhouses, and appurtenant buildings. To obtain a better
financing note, the Paicines property was zoned for residential
purposes.
From 1980 to 1993, Ridgemark filed statements with the State
of California, and in the space for the “type of business”, the
following was reflected:
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Year Business
1980 Golf and Country Club
1981 Golf and Country Club
1982 Golf and Country Club
1983 No record
1984 Golf and Country Club
1985 Left blank
1986 Left blank
1987 Left blank
1989 Golf and Country Club
1990 Ranch Properties
1991 Left blank
1992 Left blank
1993 Left blank
At the time the petition was filed in this case, Ridgemark
owned the following property:
1. Approximately 20 acres of land near a water tower (Perry
Hill)
2. 27.9 acres at the end of George’s Drive
3. 8 acres near Ray’s Circle
4. 5.95 acres below Ridgemark Village
5. 37.34 acres at the northeast corner of Airline Highway
and Fairview Road
6. 47.2 acres where the maintenance barn, the guest cottage
site, and the old Paullus residence were located
Ridgemark’s operating revenue, costs of sales, and gross
income for its golf operations were:
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Golf Golf
Fiscal Operating Operating Golf
Yearend Revenue Cost of Sales Gross Income
1977 $433,052 $460,242 ($27,190)
1978 465,827 404,665 61,162
1979 461,287 500,717 (39,430)
1980 758,853 708,625 50,228
1981 1,263,595 1,101,881 161,714
1982 1,386,201 1,154,674 231,527
1983 1,813,201 1,446,022 367,179
1984 2,189,645 2,133,112 56,533
1985 2,419,178 2,279,223 139,955
1986 2,520,139 2,253,109 267,030
1987 3,131,939 2,535,181 596,758
1988 3,239,153 2,737,566 501,587
1989 3,149,241 2,885,885 263,356
Total 23,231,311 20,600,902 2,630,409
Ridgemark’s operating revenue, costs of sales, and gross income
for its real estate operations were:
Real Estate
Fiscal Operating Real Estate Real Estate
Yearend Revenue Cost of Sales Gross Income
1977 $1,015,183 $493,010 $522,173
1978 344,291 220,121 124,170
1979 257,506 169,666 87,840
1980 -0- -0- -0-
1981 -0- -0- -0-
1982 305,409 21,656 283,753
1983 363,350 107,592 255,758
1984 16,504 14,187 2,317
1985 1,043,797 273,270 770,527
1986 1,747,094 386,014 1,361,080
1987 2,194,609 432,086 1,762,523
1988 1,743,924 319,629 1,424,295
1989 1,502,664 307,855 1,194,809
Total 10,534,331 2,745,086 7,789,245
Ridgemark’s total gross operating revenue, cost of sales,
and gross income were $33,765,642, $23,345,988, and $10,419,654,
respectively, for the years between 1977 and 1989.
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The membership fees for Ridgemark Golf and Country Club
increased from $700 in 1971, when Ridgemark was formed, to
approximately $14,000 in 1990, when it was sold to the members.
Petitioners deducted $292,773 for depreciation on Schedule F
of their 1989 Federal income tax return with respect to certain
farm property. Respondent determined that the depreciation
deduction claimed by petitioners exceeded the allowable amount by
$191,637. The parties agreed that the proposed adjusted capital
gain of $213,993 would be reduced to $174,030. Petitioners have
conceded the remaining adjustments.
OPINION
The parties agree that Ridgemark “exchanged” the unit 10
property for the Paicines property. The disagreement concerns
whether the unit 10 property was held primarily for sale in the
ordinary course of Ridgemark’s business. Respondent contends
that Ridgemark was a real property dealer and that the exchange
of the unit 10 property was merely a continuation of established
subdivision activities. Ridgemark contends that the unit 10
property was sold to liquidate its assets, and that the offsite
improvements were merely a condition of the sale. Petitioners
bear the burden of establishing that respondent’s determination
is erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115
(1933).
Generally, section 1001(c) requires that gain or loss on the
sale or exchange of property shall be recognized. Section
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1031(a) provides for the nonrecognition or deferral of gain or
loss when “property held for productive use in a trade or
business or for investment * * * is exchanged solely for property
of like kind which is to be held either for productive use in a
trade or business or for investment.”
Section 1031(a) treatment, however, does not apply to any
exchange of “property held primarily for sale”. See sec.
1031(a)(2). Section 1221(1) provides that a capital asset does
not include by definition “property held by the taxpayer
primarily for sale to customers in the ordinary course of his
trade or business”.
In Malat v. Riddell, 383 U.S. 569, 572 (1966) (quoting Corn
Prods. Refining Co. v. Commissioner, 350 U.S. 46, 52 (1955), and
Commissioner v. Gillette Motor Transp., Inc., 364 U.S. 130, 134
(1960)), the Supreme Court explained the function of the section
1221(1) definition as differentiating “between the ‘profits and
losses arising from the everyday operation of a business’ * * *
and ‘the realization of appreciation in value accrued over a
substantial period of time’”. The Court also defined
“primarily”, as utilized in section 1221(1), as “‘of first
importance’” or “‘principally.’” Whether property is held by a
taxpayer primarily for sale to customers in the ordinary course
of a trade or business is essentially a factual question.
Guardian Indus. Corp. v. Commissioner, 97 T.C. 308, 316 (1991).
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Other cases have developed a framework for determining
whether sales of land are considered sales of a capital asset or
sales of property held primarily for sale to customers in the
ordinary course of a taxpayer’s trade or business. See Major
Realty Corp. & Subs. v. Commissioner, 749 F.2d 1483 (11th Cir.
1985), affg. in part and revg. in part T.C. Memo. 1981-361; Byram
v. United States, 705 F.2d 1418 (5th Cir. 1983); Suburban Realty
Co. v. United States, 615 F.2d 171 (5th Cir. 1980); Parkside,
Inc. v. Commissioner, 571 F.2d 1092, 1096 (9th Cir. 1977), revg.
T.C. Memo. 1975-14; Biedenharn Realty Co. v. United States, 526
F.2d 409 (5th Cir. 1976); United States v. Winthrop, 417 F.2d 905
(5th Cir. 1969); Estate of Freeland v. Commissioner, 393 F.2d
573 (9th Cir. 1968), affg. T.C. Memo. 1966-283; Los Angeles
Extension Co. v. United States, 315 F.2d 1 (9th Cir. 1963).
In Suburban Realty Co. v. United States, supra at 178, the
Court of Appeals stated that the definition of “capital asset”
gave rise to three questions:
1) was taxpayer engaged in a trade or business, and,
if so, what business?
2) was taxpayer holding the property primarily for
sale in that business?
3) were the sales contemplated by taxpayer “ordinary”
in the course of that business?
In United States v. Winthrop, supra, and Biedenharn Realty
Co. v. United States, supra, various factors were considered in
answering the three questions:
(1) the nature and purpose of the acquisition of the
property and the duration of the ownership; (2) the
extent and nature of the taxpayer’s efforts to sell the
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property; (3) the number, extent, continuity and
substantiality of the sales; (4) the extent of
subdividing, developing and advertising to increase
sales; (5) the use of a business office for the sale of
the property; (6) the character and degree of
supervision or control exercised by the taxpayer over
any representative selling the property; and (7) the
time and effort the taxpayer habitually devoted to the
sales. [United States v. Winthrop, supra at 910;
citation omitted.]
See English v. Commissioner, T.C. Memo. 1993-111; Dunwoody v.
Commissioner, T.C. Memo. 1992-721; see also Parkside, Inc. v.
Commissioner, supra at 1096; Estate of Freeland v. Commissioner,
supra at 582; Los Angeles Extension Co. v. United States, supra
at 3.
The frequency and substantiality of sales over an extended
period of time are integral indicia to be considered. The
juxtaposition of the two aforementioned factors, therefore,
“‘will usually conclude the capital gains issue against [the]
taxpayer.’” Suburban Realty Co. v. United States, supra at 176-
178 (quoting Biedenharn Realty Co. v. United States, supra at
418).
At the same time, the courts have held that these factors
are not exclusive. United States v. Winthrop, supra at 911.
Rather, each case must be decided on its own peculiar facts.
Specific factors, or a combination thereof, are not necessarily
controlling. Biedenharn Realty Co. v. United States, supra at
415.
Respondent contends that Ridgemark was a dealer in real
property, and intended to sell the unit 10 property in the
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ordinary course of its business. Essentially, respondent asserts
that the unit 10 property was inventory, and did not qualify for
the nonrecognition provision of section 1031. Ridgemark argues
that it held the unit 10 property for investment purposes.
Consequently, the issue is clearly drawn, and we focus on
the characterization of the unit 10 property held by Ridgemark.
1. Nature and Purpose of the Acquisition of the Property and the
Duration of Ownership
Ridgemark segregated its business of operating Ridgemark
Golf and Country Club from the development and sales of lots.
Development and sales were placed in separate corporate entities.
After the creation of the new corporations, Ridgemark had seven
sales of property, excluding the unit 10 property. The sales
were made over a 12-year period exclusively to Financial or
Construction, the new corporate entities, which developed and
sold real property.
The one significant acquisition (the Bushmont property) was
used to expand Ridgemark Golf and Country Club. Ridgemark also
found it necessary to sell some of its real property holdings to
finance a new 18-hole golf course and other facilities on the
Bushmont property. Ridgemark’s primary activity was the
development and operation of golf courses. To that end, it was
successful, thereby increasing the value of the facility,
including the adjacent real property. Specifically, demand for
the lots and residences in Ridgemark Estates was increased by
coupling them to the golf and country club memberships.
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Ridgemark’s success can be seen in the price increases for
golf and country club membership from $700 in 1971 to
approximately $14,000 in 1990, when the golf and country club was
sold to its members. As significant, Ridgemark did not intend to
sell the unit 10 property on an individual basis. In early 1987,
a number of Ridgemark’s shareholders decided to disassociate
themselves from the business of owning and operating Ridgemark
Golf and Country Club. This was to be accomplished by selling
all of Ridgemark’s assets, including the real property holdings.
Originally, it was to be accomplished by a cash sale of
Ridgemark’s outstanding shares. Shen was the ostensible
purchaser until the adverse tax consequences deterred him. Shen
then became interested in the business of Ridgemark Golf and
Country Club until Paullus advised him that he would not manage
the facility after its sale. Shen thereafter developed an
interest in the developable real property held by Ridgemark,
including the unit 10 property.
Throughout the period, 1980 through 1989, Ridgemark
consistently reported its business activity as the operator of a
golf and country club. We find this to be probative evidence of
Ridgemark’s primary involvement in the golf and country club
business. See Malinowski v. Commissioner, 71 T.C. 1120, 1125
(1979).
Appreciation in value of the unit 10 property stems from its
proximity to the facilities extant in the Ridgemark Golf and
- 28 -
Country Club, as well as the existing residential developments
that Construction and Financial developed and sold. By itself,
property sold as undeveloped land, with development to be done
under contract for the purchasers, does not automatically reflect
that the land is held for sale to customers in the ordinary
course of a taxpayer’s trade or business. Reithmeyer v.
Commissioner, 26 T.C. 804, 813 (1956).
Finally, we note that Ridgemark held the unit 10 property
for approximately 4 years prior to the transaction in question.
This relatively long holding period also tends to support the
conclusion that Ridgemark held the property for investment
purposes. Ridgemark held a relatively significant amount of real
estate from 1977 and 1987 with only limited sales to related
companies. This is more indicative of an investment motive in
Ridgemark.
We note that a sale of a large tract in a single transaction
does not necessarily mean that the property was not held for sale
in the ordinary course of a taxpayer’s trade or business. See
Major Realty Corp. v. Commissioner, 749 F.2d 1483, 1489 (11th
Cir. 1985), affg. in part and revg. in part on another issue T.C.
Memo. 1981-361; Williams v. United States, 329 F.2d 430 (5th Cir.
1964); Lawrie v. Commissioner, 36 T.C. 1117, 1121 (1961).
However, Ridgemark does not have a history of continuously and
regularly purchasing raw land that was later sold for
development.
- 29 -
The relative paucity of purchases and sales, coupled with
the other factors discussed herewith, suggests that the real
property was peripheral to the business of operating Ridgemark
Golf and Country Club. Pritchett v. Commissioner, 63 T.C. 149,
164 (1974).
Accordingly, unit 10 was held for a relatively long period
of time and was acquired for investment purposes.
2. The Extent and Nature of the Taxpayer’s Efforts To Sell the
Property
Ridgemark and Paullus sought to sell assets in order to
concentrate on developing a golf resort in Paicines. The
question is whether there were any acts of sales promotion on the
part of Ridgemark or its agents. For example, improving and
developing the land is a possible avenue to promote sales. See
Reithmeyer v. Commissioner, supra at 813 ("The obvious reason for
the platting and subdividing was to attract buyers."). The Fifth
Circuit Court of Appeals in Estate of Barrios v. Commissioner,
265 F.2d 517 (5th Cir. 1959), revg. 29 T.C. 378, 383 (1957),
while reversing the Tax Court for other reasons, agreed with the
general principle that improvement and development of land was an
avenue to promote sales. The Court of Appeals stated:
The idea of selling a large tract of land in lots
embraces necessarily the construction of streets for
access to them, the provision of drainage and the
furnishing of access to such a necessity as water. It
is hardly conceivable that taxpayer could have sold a
lot without doing these things. To contend that
reasonable expenditures and efforts, in such necessary
undertakings are not entitled to capital gains
treatment is to reject entirely the established
- 30 -
principle that a person holding lands under such
circumstances may subdivide it for advantageous sale.
[Id. at 520.]
Property sold as undeveloped land with development to be done by
the seller under contract for the purchasers does not
automatically cause the land to be held for sale to customers in
the ordinary course of the taxpayer’s trade or business.
Reithmeyer v. Commissioner, supra at 813. In the setting of this
case, we find that selling the unit 10 property with the offsite
improvements required by Shen did not convert it into a sale in
the ordinary course of a trade or business.
Respondent contends that Ridgemark’s property was zoned for
the highest use (residential), and that fact is dispositive of
Ridgemark’s intent. We believe the zoning classification was
necessary to maximize possible loans by third parties. Although
residential zoning is a necessary element for subdivision, it
does not, per se, convert property to inventory status.
The record does not demonstrate that Ridgemark utilized an
agent or broker. Although the August 12, 1988, minutes mention
brokers’ commissions, it appears that Ridgemark did not want an
agent to negotiate for it, but that it was willing to pay a
commission or a finder’s fee if a successful sale was finalized.
Finally, we find it troublesome that Ridgemark maintained a
sales office and that there was a list of 97 people interested in
purchasing lots in the unit 10 property. That is one factor that
is indicative of an intention to sell the unit 10 property in the
- 31 -
ordinary course of Ridgemark’s business. Paullus’ daughter also
had names of potential purchasers of lots in unit 10. There was
some connection between the unit 10 property and Ridgemark’s
sales office.
Additionally, Ridgemark concedes that before the sale of the
unit 10 property to Shen, it was taking steps to develop and sell
the property in the process of liquidating its holdings.
Respondent argues that this made Ridgemark a dealer in real
property when it engaged in preparations to sell the unit 10
property prior to its final sale to Shen. Ridgemark contends
that it should not be deprived of its investor status simply
because it prepared to sell the land to third parties.
Overall, we believe Ridgemark’s position is supported by the
facts. Ridgemark sought to liquidate its assets so it could
maximize the amount of cash and attention it could focus on the
proposed Paicines golf and resort facility. It was contemplated
that, if the transaction with Shen was not consummated, Ridgemark
would follow the same pattern it had followed in the past. In
other words, Ridgemark would sell the unit 10 property to either
Construction or Financial.
3. The Number, Extent, Continuity, and Substantiality of the
Sales
Courts have generally viewed frequent sales that generate
substantial income as tending to show that property was held for
sale rather than investment. Suburban Realty Co. v. United
States, 615 F.2d at 181; Biedenharn Realty Co. v. United States,
- 32 -
526 F.2d 409 (5th Cir. 1976). Conversely, infrequent sales
resulting in large profits tend to show that property was held
for investment. Bramblett v. Commissioner, 960 F.2d 526 (5th
Cir. 1992).
The unit 10 property was sold to Shen for $11,250,000.
Previously, Ridgemark was willing to sell the unit 10 property to
Shen for $10 million, which incorporated approximately $1,500,000
of offsite improvements, with a $2,563,454 basis. Consequently,
at the sale, Ridgemark received net proceeds of approximately $9
million. This is evidence of long-term appreciation as opposed
to normal inventory markup. We also recognize that Ridgemark’s
golf operating revenue is approximately twice the revenue from
real estate transactions. This factor quantitatively reflects
that Ridgemark’s primary source of income and business operation
was the management of a golf resort facility. The real estate
sales were, at best, peripheral.
There was a significant difference between the unit 10
property and prior property sales. Ridgemark incurred costs of
approximately $2 million in completing the unit 10 property,
compared to about $600,000 expended in connection with the seven
parcels that had been sold to Financial or Construction. Of the
$2 million, approximately $1,600,000 was spent for improvements
in satisfaction of the Agreement with Shen. We do not agree with
respondent that Ridgemark would have, in any event, made these
improvements irrespective of whether Shen completed the sale.
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Finally, Ridgemark sold eight parcels of land in a 12-year
period between 1977 and 1989. By comparison, only one
significant purchase of property was made subsequent to
Ridgemark’s 1971 formation (Bushmont property in 1985).
Accordingly, Ridgemark fits the pattern of infrequent but
substantial sales of property which indicates, generally, that it
was held for investment purposes. See Bramblett v. Commissioner,
supra.
4. The Extent of Subdividing, Developing, and Advertising To
Increase Sales
Respondent asserts that Ridgemark routinely subdivided and
incurred substantial improvement costs before selling the land to
either Construction or Financial. Also, respondent contends that
the fact that Ridgemark recorded final subdivision maps on
certain property before the sales were complete demonstrates that
it was involved in the business of dealing in real property.
The seven sales of real property during the 12-year interval
between 1977 and 1989 can be divided into two categories:
(1) Three sales of large unsubdivided parcels, and (2) four sales
in which the title to the property could not be transferred
without a new map being recorded to create a separate legal
parcel.5 Ridgemark contends that the recordation of a final map
5
See Cal. Govt. Code sec. 66426 (West Supp. 1996), which
provides:
A tentative and final map shall be required for
all subdivisions creating five or more parcels, five or
(continued...)
- 34 -
was a condition precedent to Ridgemark’s ability to convey legal
title to the aforementioned parcels to Financial and
Construction.
Ridgemark notes that it sold three parcels of real property
between 1977 and 1984. Two were sold to Construction, and one
was sold to Financial. For example, on October 18, 1977,
Ridgemark deeded 7 acres of unsubdivided land to Construction for
$175,000.
All properties sold after 1977 were conveyed after the final
subdivision map was recorded. In particular, when Ridgemark
agreed to sell the unit 9 property to Financial, there was a
tentative map for the property. At the time of the sale on
June 30, 1987, the final map for unit 9 had been recorded. A
similar pattern occurred for units 7 and 8, which were sold to
both Financial and Construction, respectively.
5. The Use of a Business Office for the Sale of the Property
Respondent places heavy reliance on the fact that Ridgemark
compiled a list of names of people interested in purchasing lots
in the unit 10 property. Ridgemark points out that the list was
created several months after it had decided to proceed with a
5
(...continued)
more condominiums as defined in Section 783 of the
Civil Code, a community apartment project containing
five or more parcels, or for the conversion of a
dwelling to a stock cooperative containing five or more
dwelling units * * *
- 35 -
sale of all its assets, and therefore the list is not relevant to
its intention regarding the unit 10 property.
Ridgemark had explored the options available to it with the
intention of disposing of all its assets. Given that Shen had
backed out of an earlier deal, we find it credible that Ridgemark
sought alternatives in the event the transaction might not be
consummated. One of the options was selling to another buyer.
The possession of the names of potential buyers of the unit 10
property, by itself, is not dispositive of this issue.
The existence of a sales office is a weakness in Ridgemark’s
position, but not a fatal one. In this regard, the existence of
a sales office did not result in sales for Ridgemark.
6. The Time and Effort the Taxpayer Habitually Devoted to the
Sales
After the formation of the sister corporations, Construction
and Financial, Ridgemark was substantially involved in the
development and expansion of its golfing and recreational
business.
Ridgemark’s corporate minutes demonstrate that the board of
directors spent significant portions of its time discussing the
proposed transaction with Shen and various aspects of the golfing
business.
There was a symbiotic relationship between the operation of
Ridgemark Golf and Country Club and the sales of land. That
interrelationship generated the dispute concerning Ridgemark’s
trade or business. Although Ridgemark pursued the sale of the
- 36 -
unit 10 property, that activity did not rise to the level of a
trade or business. Instead, the real estate aspect was
incidental to the primary business (golf) and constituted an
investment so that the property was not part of Ridgemark’s
inventory.
Accordingly, we hold that Ridgemark was entitled to the
nonrecognition of income from the sale of the unit 10 property
under section 1031, and thus there is no underpayment to which
section 6662(a) would be applied.
Finally, we consider whether petitioners are liable for the
accuracy-related penalty for negligence under section 6662.
Respondent determined that they were negligent or intentionally
disregarded rules and regulations and that the section 6662(a)
20-percent penalty should apply. Sec. 6662(b)(1).
Negligence has been defined as the failure to make a
reasonable attempt to comply with the provisions of this title,
and the term “disregard” includes any careless, reckless, or
intentional disregard. Sec. 6662(c). Petitioners bear the
burden of showing that they were not negligent. Rule 142(a);
Bixby v. Commissioner, 58 T.C. 757, 791-792 (1972).
Respondent determined an accuracy-related penalty of $10,690
due to negligence or disregard of rules or regulations. Sec.
6662(b)(1) and (c). In the notice of deficiency, respondent
determined that the depreciation deduction claimed by petitioners
on their 1989 Schedule F exceeded the allowable amount by
- 37 -
$191,637. Petitioners have conceded $174,030 of the proposed
adjusted capital gain of $213,993. Petitioners have also
conceded the remaining adjustments. However, respondent contends
that petitioners were negligent with respect to the depreciation
deductions. Consequently, respondent asserts that the
underpayment due to negligence was $53,452, out of the total
underpayment of $124,324.6
Petitioners contend that they reasonably relied on the
advice, expertise, and knowledge of their accountant. However,
petitioners have not presented specific evidence that reliance on
their accountant, under the circumstances, was reasonable. Thus,
petitioners are liable for the accuracy-related penalty pursuant
to section 6662(a).
Decision will be entered under
Rule 155 in docket No. 6105-93.
Decision will be entered for
petitioner in docket No. 6106-93.
6
The issues related to the remaining underpayments of
$70,872 have been resolved.