The opinion
T.C. Memo. 2001-144
UNITED STATES TAX COURT
GREG McINTOSH AND SHEILA R. McINTOSH, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 15076-99. Filed June 19, 2001.
Greg McIntosh and Sheila R. McIntosh, pro sese.
Paul L. Dixon, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
DEAN, Special Trial Judge: This case is before the Court on
petitioners' Motion for Award of Administrative and Litigation
Costs filed pursuant to section 7430 and Rule 231. All
references to section 7430 are to that section as in effect at
the time the petition was filed. Unless otherwise stated, all
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other section references are to the Internal Revenue Code in
effect for the years in issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure.
Respondent has filed a response to petitioners' motion.
Respondent agrees that petitioners: (a) Have substantially
prevailed with respect to the amount in controversy, (b) meet the
net worth requirements as provided by law, (c) have exhausted
their administrative remedies, (d) have not unreasonably
protracted the administrative or Court proceedings, and (e) have
claimed a reasonable amount of costs.
Respondent does not agree, however, that his positions in
the administrative or Court proceedings were not substantially
justified. The issue for decision, therefore, is whether
respondent's positions in the underlying proceedings were
substantially justified.
Although petitioners initially requested a hearing in this
case, the parties have agreed upon a stipulation of facts. We
conclude that a hearing is not necessary to decide this motion.
See Rule 232(a)(2). Accordingly, we rule on petitioners' motion
for administrative and litigation costs on the basis of the
parties' submissions and the record in this case.
Petitioners resided in Shasta Lake, California, at the time
they filed their petition.
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FINDINGS OF FACT
Petitioners were notified by letter dated October 20, 1997,
addressed to their accountant, William Brown, that their Federal
income tax returns for 1995 and 1996 were to be examined by the
Internal Revenue Service (IRS). At the same time, the IRS issued
a Form 4564, Information Document Request (IDR), related to those
years' returns. Petitioners' Federal income tax return for 1994
was already under examination by the IRS, and some of the
information listed in the IDR of October 20, 1997, relates to tax
year 1994.
The IDR was directed at obtaining books and records
concerning petitioners' home-building income and expenses for
1994 through 1996 reported on Schedules C, Profit or Loss From
Business; underlying documentation of various Schedule C items;
business and personal bank statements and canceled checks for
1993 through January 31, 1997; and documentation for the sale of
a personal residence and for real estate taxes for 1996.
On April 16, 1998, the IRS issued another IDR requesting
essentially the same information except with more specificity for
certain Schedule C items.
On June 4, 1998, the examining agent met with Mr. Brown and
Greg McIntosh (petitioner). At the meeting petitioner discussed
his wage activities and his Schedules C activity. Petitioner was
employed as a dispatcher from March 1993 through July 1995 and
was unemployed between July 1995 and May 1996. Between May and
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October 1996, petitioner was a firefighter. In December 1996
petitioner worked "at Saint Elizabeth's in Red Bluff".
Petitioner told the examiner that he was also in the
business of building and selling houses. Before 1994 petitioners
had not been involved in building houses. It was determined that
petitioners did not have a contractor's license and performed no
contracting work personally; they worked through subcontractors.
Petitioners maintained no set of books and failed to provide an
accounting of the expenses associated with their home-building
activity. Petitioner, however, did present some folders
containing receipts and canceled checks related to the building
of a house on Montana Avenue in Shasta Lake, California, and to
the construction of a house on Vallecito Street in Shasta Lake,
California. Among the items in the folders was a canceled check
in the amount of $11,104.67 payable to the "US Bank".
In 1994, petitioners, in a part sale and part gift
transaction, acquired land located at 4511 Vallecito Street in
Shasta Lake, California (Vallecito property), from Sheila
McIntosh's parents. They had a house built on the property that
they sold in 1996. Petitioners reported on Schedule C the income
and expenses from the Vallecito property. They acquired another
piece of property, the "Oasis Road" property, from "a
grandmother" on which they built a house they intended to sell
but had not sold at the time of the income tax examination.
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Petitioners bought no property from unrelated third parties on
which to build houses for sale.
After the June 4, 1998, meeting with petitioner and
Mr. Brown, the examining agent made no further request for the
items included in the previously issued IDR's but did make
certain third parties contacts.
On January 15, 1999, the IRS issued to petitioners a report
of proposed adjustments to their Federal income taxes for 1995
and 1996. The examining agent's letter enclosing the report
states that she obtained information indicating that petitioners
had lived on the Vallecito property and concludes that "I have
not received adequate information to justify that you are in a
business." The letter further informs petitioners that the loss
for 1995 has been disallowed, and the small profit for 1996 has
been "reversed out". Mr. Brown met with the examining agent to
discuss the proposed adjustments and later provided the agent
some additional information.
The additional information was in the form of a letter, with
enclosures, dated February 11, 1999. The letter primarily
addresses the issue of whether the Vallecito property was
petitioners' personal residence or was held for sale in the
ordinary course of business. The letter recites petitioners'
position that it was not their personal residence. Petitioners
admit in the letter, however, that they used the Vallecito
property as an office from February to October 1995, that they
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stored their furniture in the house, that the property was
occupied by petitioners' cousin from December 1995 through March
1996, and that the house was covered by a homeowner's insurance
policy in their names. The letter, however, enclosed other
letters written by third parties that were intended to show that
petitioners had not used the house as a personal residence.
Respondent, on the other hand, had obtained third party
information suggesting that petitioners had resided in the
Vallecito property. Respondent also obtained a "Real Estate
Transfer Disclosure Statement" signed by petitioners on July 19,
1995, indicating that the sellers, petitioners, were occupying
the property.
On May 5, 1999, the examining agent asked petitioners to
agree to extend the period for the assessment of income tax.
Through Mr. Brown, in a letter dated May 10, 1999, petitioners
declined to extend the period for assessment.
A statutory notice of deficiency for the years 1995 and
1996, along with a very detailed explanation of the items of
adjustment to petitioners' income, was issued on July 21, 1999.
Mr. Brown sent to the IRS a letter dated September 2, 1999,
with enclosures. The enclosures were intended to be
"documentation for two issues that were raised in the Notice of
Deficiency and one issue being raised by the taxpayers". Among
the enclosures was documentation showing that petitioners had in
March 1996 contracted to sell the Vallecito property to
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petitioners's cousin and his wife, Keith and Renee McIntosh. In
addition, petitioners provided verification for property taxes
paid in 1995 and legal and professional fees paid in 1996.
The enclosures further included a copy of an escrow
statement dated August 30, 1994, from the Fidelity National Title
Insurance Company of California (Fidelity National) for "PROPERTY
ADDRESS: AP #007-060-04" crediting petitioners with a deposit of
$11,104.67 (the same amount as the "US Bank" check mentioned
above). Petitioners also enclosed a copy of a handwritten
receipt to petitioners from Fidelity National dated August 29,
1994, in the amount of $11,104.67, naming "US Bank" as "maker".
The items were submitted as verification of a portion of the cost
of goods sold claimed on the Schedules C for 1996.
The petition in this case was filed on September 16, 1999.
The Court filed respondent's answer on October 26, 1999.
Mr. Brown faxed additional information to the IRS Office of
Appeals (Appeals) on November 11, 1999. The information was
related to petitioners' 1994 tax year. Mr. Brown settled the
1994 tax issues with the IRS, and he considered the "auto,
property taxes, and insurance" issues to be "carryover" issues
from the settlement to 1996.
In a letter to Mr. Brown dated November 17, 1999, Appeals
requested additional information about the settlement of the
1994 "carryover" adjustments and additional information to verify
insurance and interest expenses. Appeals also requested
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additional information on the Vallecito property, including
verification that the escrow statement referencing the $11,104.67
deposit related to the Vallecito property and not to another.
The letter also states that "there appears to be conflicting
evidence as to whether the taxpayers resided in the Vallecito
property."
On January 11, 2000, Appeals faxed to Mr. Brown an offer in
settlement of the disputed items for the 1995 and 1996 tax years.
A number of items were included in the settlement. Among those
agreed upon was the cost of goods sold adjustment for 1996 of
$8,412. It was reduced by $9,097, the US Bank check amount of
$11,104.67 less $2,008.06 of expenditures previously allowed as
capital items that for settlement purposes were to be allowed as
expense deductions in 1995. Under the proposed settlement, the
1996 adjustment for legal and professional fees of $625 would be
conceded by the IRS as well as the utilities adjustment of $547
for 1995. The letter makes an inquiry as to: "What is the
additional $153 of utilities (700-547)?" That same day the
parties participated in a telephone conference regarding the
settlement offer.
A revised settlement offer was accepted on January 19, 2000.
On February 10, 2000, the Court issued its notice setting
petitioners' case for trial at the May 4, 2000, trial calendar in
Reno, Nevada. The documents embodying the settlement agreement
were signed by petitioners on February 22, returned to
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respondent's counsel March 28, and signed by respondent's counsel
and sent to the Tax Court on April 10, 2000.
Under the settlement agreement between the parties, the
amounts proposed in the Appeals letter of January 11, 2000, for
cost of goods sold and legal and professional fees for 1996 were
accepted. The utilities expense adjustment for 1995 of $547 was
reduced by $700 under the agreement.
The parties have stipulated that petitioners take the
position that respondent was not substantially justified in
making adjustments to petitioners': (a) Deduction of certain
utilities expenses for 1995; (b) deduction of a portion of car
and truck, insurance, office, and utilities expenses for 1995;
(c) claim of a portion of cost of goods sold for 1996; and (d)
deduction of legal and professional fees for 1996.
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OPINION
We apply section 7430 as most recently amended by Congress
in the Internal Revenue Service Restructuring and Reform Act of
1998 (RRA 1998), Pub. L. 105-206, sec. 3101, 112 Stat. 685, 727.
However, the amendments made by RRA 1998 to section 7430 apply
only to costs incurred or services performed after January 18,
1999. See id. sec. 3101(g), 112 Stat. 729. To the extent the
claimed costs were incurred on or before January 18, 1999, we
shall apply section 7430 as amended by the Taxpayer Relief Act of
1997, Pub. L. 105-34, secs. 1285, 1453, 111 Stat. 1038, 1055.
Requirements Under Section 7430
Under section 7430(a), a judgment for litigation costs
incurred in connection with a court proceeding may be awarded
only if a taxpayer: (1) Is the "prevailing party"; (2) has
exhausted his or her administrative remedies within the IRS;
and (3) did not unreasonably protract the court proceeding.
Sec. 7430(a) and (b)(1), (3). Similarly, a judgment for
administrative costs incurred in connection with an
administrative proceeding may be awarded under section 7430(a)
only if a taxpayer: (1) Is the "prevailing party"; and (2) did
not unreasonably protract the administrative proceeding. Sec.
7430(a) and (b)(3).
A taxpayer must satisfy each of the respective requirements
in order to be entitled to an award of litigation or
administrative costs under section 7430. See Rule 232(e). Upon
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satisfaction of these requirements, a taxpayer may be entitled to
reasonable costs incurred in connection with the administrative
or court proceeding. See sec. 7430(a)(1) and (2), (c)(1) and (2).
To be a prevailing party, the taxpayer must substantially
prevail with respect to either the amount in controversy or the
most significant issue or set of issues presented and satisfy the
applicable net worth requirement. See sec. 7430(c)(4)(A).
Respondent concedes that petitioners have satisfied the
requirements of section 7430(c)(4)(A). Petitioners have
nevertheless failed to qualify as the prevailing party if
respondent can establish that respondent's position in the
administrative and court proceedings was substantially justified.
See sec. 7430(c)(4)(B).
Substantial Justification
The Commissioner's position is substantially justified if,
on the basis of all of the facts and circumstances and the legal
precedents relating to the case, the Commissioner acted
reasonably. See Pierce v. Underwood, 487 U.S. 552 (1988); Sher
v. Commissioner, 89 T.C. 79, 84 (1987), affd. 861 F.2d 131 (5th
Cir. 1988). In other words, to be substantially justified, the
Commissioner's position must have a reasonable basis in both law
and fact. See Pierce v. Underwood, supra; Rickel v.
Commissioner, 900 F.2d 655, 665 (3d Cir. 1990), affg. in part and
revg. in part on other grounds 92 T.C. 510 (1989). A position is
substantially justified if the position is "justified to a degree
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that could satisfy a reasonable person." Pierce v. Underwood,
supra at 565 (construing similar language in the Equal Access to
Justice Act). Thus, the Commissioner's position may be incorrect
but nevertheless be substantially justified "'if a reasonable
person could think it correct'." Maggie Management Co. v.
Commissioner, 108 T.C. 430, 443 (1997) (quoting Pierce v.
Underwood, supra at 566 n.2).
The relevant inquiry is "whether * * * [the Commissioner]
knew or should have known that * * * [his] position was invalid
at the onset". Nalle v. Commissioner, 55 F.3d 189, 191 (5th Cir.
1995), affg. T.C. Memo. 1994-182. We look to whether the
Commissioner's position was reasonable given the available facts
and circumstances at the time that the Commissioner took his
position. See Maggie Management Co. v. Commissioner, supra at
443; DeVenney v. Commissioner, 85 T.C. 927, 930 (1985).
The fact that the Commissioner eventually concedes, or even
loses, a case does not establish that his position was
unreasonable. See Estate of Perry v. Commissioner, 931 F.2d
1044, 1046 (5th Cir. 1991); Sokol v. Commissioner, 92 T.C. 760,
767 (1989). However, the Commissioner's concession remains a
factor to be considered. See Powers v. Commissioner, 100 T.C.
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457, 471 (1993), affd. in part, revd. in part and remanded on
another issue 43 F.3d 172 (5th Cir. 1995).
As relevant herein, the position of the United States that
must be examined against the substantial justification standard
with respect to the recovery of administrative costs is the
position taken by respondent as of the date of the notice of
deficiency. See sec. 7430(c)(7)(B). The position of the United
States that must be examined in light of the substantial
justification standard with respect to the recovery of litigation
costs is the position taken by respondent in the answer to the
petition. See Bertolino v. Commissioner, 930 F.2d 759, 761 (9th
Cir. 1991); Sher v. Commissioner, 861 F.2d 131, 134-135 (5th Cir.
1988). Ordinarily, we consider the reasonableness of each of
these positions separately. See Huffman v. Commissioner, 978
F.2d 1139, 1144-1147 (9th Cir. 1992), affg. in part, revg. in
part and remanding on other issues T.C. Memo. 1991-144. In the
present case, however, we need not consider two separate
positions because there is no indication that respondent's
position changed between the issuance of the notice of deficiency
(on July 21, 1999) and the filing of the answer to the petition
(on October 26, 1999). See Swanson v. Commissioner, 106 T.C. 76,
87 (1996).
In order to decide whether respondent's position was
substantially justified, we must review the substantive merits of
the case.
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Reasonable Basis in Fact
Petitioners do not suggest that respondent applied the wrong
legal standard in taking positions on their documentation of cost
of goods sold for 1995, capitalized costs from 1994, legal and
professional expenses for 1996, and utilities expenses for 1996.
Petitioners argue that respondent's positions on those
adjustments were not reasonable in fact based on the evidence
they presented.
As to that argument, respondent asserts that it was
incumbent upon petitioners to substantiate the amounts and
purposes of the items claimed. It is reasonable, according to
respondent, not to concede adjustments until he has received and
verified adequate substantiation for the items in question. He
therefore concludes that as to the four stated adjustments, his
position was reasonable when taken and appropriately conceded
when substantiation was provided to Appeals. The Court agrees.
Taxpayers are required to maintain books and records in
accordance with rules and regulations prescribed by the
Secretary. See sec. 6001. Generally, taxpayers must "keep such
permanent books of account or records, including inventories"
sufficient to establish gross income, deductions, or other
matters required to be shown on the return. Sec. 1.6001-1(a),
Income Tax Regs. Accounting records include the taxpayer's
regular books and other records and data necessary to support
entries on books and returns. See sec. 1.446-1(a)(4), Income Tax
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Regs. Such books and records should properly classify
expenditures as between capital and expense. See sec. 1.446-
1(a)(4)(ii), Income Tax Regs.
Petitioners did not maintain a set of books and failed to
provide an accounting of the expenses associated with their home-
building activity. Although petitioners presented some folders
containing receipts and canceled checks related to the building
of the Vallecito property, they were intermingled with those from
the construction of a personal home on Montana Avenue, Shasta
Lake, California. In an attempt to verify the amounts shown on
petitioners' returns, respondent's agent had to reconstruct the
costs incurred in acquiring and constructing the Vallecito
property.
Cost of Goods Sold
Any amount claimed as cost of goods sold must be
substantiated. See sec. 6001; Ranciato v. Commissioner, T.C.
Memo. 1993-536. Among the items in the folders presented by
petitioners during the examination was a canceled check in the
amount of $11,104.67 payable to the "US Bank". It was not
readily apparent that the US Bank check represented an amount
associated with the cost of acquiring or constructing the
Vallecito property. It was only after the notice of deficiency
was issued on July 21, 1999, that petitioners supplied on
September 2, 1999, a copy of an escrow statement indicating that
petitioners had made a deposit for an unnamed property in the
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amount of $11,104.67. The property for which the escrow deposit
was made was not identified in a way that was understandable to
the examining Internal Revenue agent ("PROPERTY ADDRESS: AP
#007-060-04").
Appeals later requested on November 17, 1999, identifying
information for the purchase and sale of the Vallecito property.
The identifying information must therefore have been received
sometime after that date, and after the October 26, 1999, filing
of respondent's answer in the case.
Capitalized Costs From 1994
During the examination of petitioners' 1994 Federal income
tax return, respondent disallowed Schedule C deductions for
automobile expenses, property taxes, and insurance. Petitioners
allege that there was an "informal agreement" to allow them to
capitalize a portion of the costs and to allow "deduction" of
them in 1996. The notice of deficiency for 1996 does not reflect
such an informal agreement.
There is but scant evidence in the record of an informal
agreement as alleged by petitioners. It is not apparent what the
terms of such an agreement may have been. And it was, by
petitioners' own description, an "informal" agreement. After
reviewing documents submitted by petitioners on November 11,
1999, Appeals agreed to allow petitioners to capitalize as part
of the cost of the Vallecito property a portion of the 1994
expenditures for automobile expenses and property taxes.
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Legal and Professional Expenses
Respondent disallowed a deduction for a legal fee expense
and a tax preparation fee expense for 1996. After consideration
of information sent in by petitioners on September 2, 1999,
respondent conceded most of the adjustment.
Utilities Expenses
On Schedules C of their 1995 return, petitioners claimed
$547 as an expense for utilities at the Vallecito property.
Because respondent had evidence that petitioners had resided at
the Vallecito property, he took the position that the utilities
expense was a nondeductible personal living expense. Petitioners
had submitted statements from individuals indicating that
petitioners did not reside at the property. As late as
November 17, 1999, Appeals requested additional information
concerning the occupation of the Vallecito property. For
settlement purposes, respondent conceded his position although
the evidence remained ambiguous. See Creske v. Commissioner,
T.C. Memo. 1990-318, affd. 946 F.2d 43 (7th Cir. 1991).
It was reasonable for respondent to make adjustments for
items and to refuse to concede the adjustments until he had
received and verified petitioners' substantiation for the amounts
adjusted. See Beecroft v. Commissioner, T.C. Memo. 1997-23;
Simpson Fin. Servs., Inc. v. Commissioner, T.C. Memo. 1996-317;
McDaniel v. Commissioner, T.C. Memo. 1993-148.
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We are persuaded that respondent's positions on the above
issues were reasonable. Respondent's positions were based on
petitioners' failure to fully substantiate or account for the
respective items. Further, the issues were settled within a
reasonable time after petitioners gave sufficient information to
respondent. See Harrison v. Commissioner, 854 F.2d 263, 265 (7th
Cir. 1988), affg. T.C. Memo. 1987-52; Wickert v. Commissioner,
842 F.2d 1005 (8th Cir. 1988), affg. T.C. Memo. 1986-277; Ashburn
v. United States, 740 F.2d 843 (11th Cir. 1984); McDaniel v.
Commissioner, supra.
Reasonable Basis in Law
According to petitioners, respondent unreasonably determined
that car and truck, insurance, office, and utilities expenses
totaling $2,008.06 incurred in 1995 were not deductible expenses
but instead must be capitalized into the cost of the Vallecito
property sold in 1996. Petitioners appear to argue that
respondent's position was legally infirm, although their argument
seems to be inconsistent with the "informal agreement" they urge
for the treatment of similar 1994 expenses as capital
expenditures.
Although petitioners did not maintain a set of books and
failed to provide an accounting of the expenses associated with
their home-building activity, they reported a reduction of
$77,462 of Schedule C gross receipts for "cost of goods sold" in
connection with their home-building activity for 1996. Because
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of their lack of an accounting for costs, respondent attempted to
reconstruct them from petitioners' receipts and canceled checks.
In the reconstruction, respondent included as cost of goods
sold $2,008.06 of indirect costs incurred in 1995 along with
other verified Vallecito costs of $61,353.99 to arrive at a cost
of goods sold of $69,049.98, an amount less than that reported on
the return. Had respondent allowed the $2,008.06 as expenses for
1995, the adjustment to cost of goods sold for 1996 would have
been larger by that amount.
The uniform capitalization rules of section 263A(a)(1)
require that all direct costs and certain indirect costs
allocable to certain property be included in inventory, or
capitalized if such property is not inventory. Items that would
not otherwise be taken into account1 in computing taxable income
may not be taken into account as costs allocable to property
under section 263A. See sec. 263A(a).
For settlement purposes, after verification of the purpose
of the $11,104.67 check to the US Bank, Appeals agreed that the
$2,008.06 in costs was associated with the construction or
acquisition of the Vallecito property sold in 1996 and is
deductible as expenses for 1995. Appeals cited as authority for
the agreement the de minimis rule of the simplified production
method of section 1.263A-2(b)(3)(iv), Income Tax Regs. The
1
If, for example, an item of indirect cost were not properly
substantiated under sec. 274, it would not be a proper cost under
sec. 263A. See sec. 1.263A-1(c)(2), Income Tax Regs.
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simplified production method may be elected for any trade or
business as a method for determining costs allocable to ending
inventories of produced and other eligible property on hand at
the end of the year. See sec. 1.263A-2(b)(1) and (2), Income Tax
Regs. The record in this case fails to show that petitioners
ever made any such election or that they made any argument to
respondent that they relied upon the above provision when
reporting the expenses on their return for 1995.
We find that respondent's position that the $2,008.06
represented an amount that had to be capitalized into the cost of
the Vallecito property was a reasonable application of the law
given the available facts and circumstances at the time that
respondent took his position.
Conclusion
We find that respondent's positions on the disputed issues
were reasonable positions sufficiently supported by the facts and
circumstances in petitioners' case and the existing legal
precedent. See Pierce v. Underwood, 487 U.S. 552 (1988).
Because we find respondent's positions to have been reasonable,
we cannot find petitioners to be "prevailing" parties, and their
motion will therefore be denied.
To reflect the foregoing,
An appropriate order will
be issued, and decision will be
entered under Rule 155.