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T.C. Memo. 1997-413
UNITED STATES TAX COURT
SHARON LEE BARTLETT, F.K.A. HEITZMAN, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 33938-84.
Filed September 17, 1997.
William R. Harper, for petitioner.
Russell F. Kurdys, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
BEGHE, Judge:
Respondent determined a deficiency of $55,263
in petitioner’s 1979 Federal income tax.
The sole issue is
whether petitioner is entitled to innocent spouse relief under
section 6013(e).1
1
We hold that she is so entitled.
All section references are to the Internal Revenue Code in
effect for the year in issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure, unless otherwise
indicated.
- 2 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.
Petitioner was a resident
of Woodbridge, New Jersey, when she filed her petition.
The parties stipulated to the inclusion in the record of
this case of the opinions of this Court and of the Court of
Appeals for the Ninth Circuit in Heitzman v. Commissioner, T.C.
Memo. 1987-109, affd. 859 F.2d 783 (9th Cir. 1988), and of the
parties’ briefs in this Court, but not to the truth of any
matters asserted therein.
On September 9, 1986, prior to this
Court’s granting summary judgment in favor of respondent in
Heitzman v. Commissioner, supra, the parties stipulated that if
petitioner’s former husband, Charles J. Heitzman, paid the entire
tax liability at issue in Heitzman v. Commissioner, supra, plus
interest, then petitioner would be discharged from that
liability.
Petitioner also agreed to be bound by the outcome of
that case regarding substantive tax liability but reserved the
right to claim innocent spouse status under section 6013(e).
1.
Background
When petitioner married for the first time at age 17, she
had completed the 11th grade.
Petitioner had two children from
her first marriage, which ended in divorce.
In June 1973,
petitioner married Mr. Heitzman, a widower with one child.
Petitioner and Mr. Heitzman were residents of Hawaii throughout
- 3 their marriage, from 1973 until 1982.
In 1982, Mr. Heitzman
moved to Phoenix, Arizona, to pursue a business development
opportunity with a startup company called Autocast, which had
been formed to manufacture concrete products for the housing
industry.
In 1983, petitioner and Mr. Heitzman were divorced.
They had no children together.
In 1975, Mr. Heitzman and petitioner bought a house in
Honolulu, which served as their residence.
joint investment during their marriage.
It was their only
Mr. Heitzman made all
his other investment decisions without input from petitioner.
Although petitioner worked part time as a model and received
residuals from the Screen Actors Guild in 1979 for a television
commercial, Mr. Heitzman was the primary breadwinner.
In 1979,
Mr. Heitzman was employed by TSI Corporation as a real estate
developer.
He was also general partner in DMA Heitzman, which
developed condominium projects.
Petitioner made no independent investments during her
marriage.
In 1975, petitioner completed her high school
education by obtaining her General Education Diploma.
Petitioner
never took any accounting or bookkeeping courses.2
2
Petitioner’s only other training was two real estate sales
workshops she took in preparation for an attempt to become a real
estate agent. Petitioner failed the licensing examination the
first time partly because of her inadequate arithmetic skills.
On her second attempt, she passed the exam. Aside from the sale
of a condominium, the listing for which was given to her at Mr.
Heitzman’s behest, petitioner never participated in the sale of
any real estate as a real estate agent. Petitioner did not find
(continued...)
- 4 Petitioner was the homemaker and primary caregiver for her
two sons and Mr. Heitzman’s son.
Mr. Heitzman provided her a
monthly allowance for household expenses that grew over the years
to approximately $1,500 per month.
allowance was less than $1,500.
In 1979, the monthly
Mr. Heitzman also bought
petitioner gifts throughout their marriage in a pattern that did
not change until they separated in 1982.
On September 5, 1979, Mr. Heitzman contracted with Frank S.
H. Kwon Home Builders to remodel the kitchen and master bedroom
of the family residence.
Work was completed on October 16, 1979.
Costs rose to $41,191 from the original estimate of $29,224.
The
bulk of funds used to pay for remodeling the residence came from
a loan from the Bank of Hawaii.
The record does not reflect the
source of funds used to repay the loan or whether the loan was
ever repaid.
There were loans outstanding to the Bank of Hawaii
when petitioner and Mr. Heitzman were divorced in April 1983.
Mr. Heitzman assumed the obligation to repay these loans as part
of the divorce settlement.
In 1979, petitioner used her
separately earned income to make other improvements to the house,
including installing a parquet floor in the bedroom of
Mr. Heitzman’s son.
The remodeling had little or no long-term effect on the
value of the house.
2
In the early 1980's, and continuing through
(...continued)
the buyer for the condominium. Her role in the sale was
restricted merely to observing the contract negotiations.
- 5 the time of trial, the Hawaii housing market was driven by two
major factors:
structure.
Location and the underlying quality of the
The prime location of the house and its high quality
workmanship caused its value to rise throughout this period until
Mr. Heitzman and petitioner sold it in 1982.
Since 1983, petitioner has been employed as a flight
attendant.
2.
Stonehurst Energy Partners
Ronald Freemond, president and sole shareholder of Wind
River Energy, Inc. (Wind River), a Nevada corporation, formed
Stonehurst Energy Partners (Stonehurst) on December 10, 1979, to
engage in the
development, drilling, and operation of oil wells.
Wind River was the general partner, and Freemond was the initial
limited partner.
Freemond had organized Wind River to be general
partner of Stonehurst.
Although Freemond had “substantial
experience in financial planning and tax advantaged investment”,
he and Wind River had “no experience in drilling for oil and
gas.”
Between December 10 and December 29, 1979, Mr. Heitzman and
34 other individuals purchased a total of 175 limited partnership
units in Stonehurst at a cost of $6,200 per unit and a total
investment of $1,085,000.
Investors paid $3,100 in cash on the
purchase of each unit and $3,100 with a recourse promissory note
due April 1, 1980.
- 6 Wind River was to receive 12 percent of the capital invested
in Stonehurst as an “Initial Management Fee”, and an overriding
production royalty of 6.9 percent of gross revenues from Craig
Natural Resources, Inc. (Craig), the sublessor of the land and
named obligee of the minimum annual royalties, described infra
pp. 6-8.
Craig also was to receive 8 percent of the initial
capital invested in Stonehurst as a “consulting fee”.
a.
The Stonehurst Private Placement Memorandum
The Stonehurst Energy Partners Private Placement Memorandum
(the Memorandum) represented that the partnership “intends to
engage in acquiring, drilling and possibly completing twenty-five
(25) or more shallow Developmental Oil Wells in northeastern
Oklahoma.”
The Memorandum characterized these wells as having
more limited prospects of discovering and exploiting “significant
reserves of oil and gas in relation to the capital committed
* * * although bearing less risk” than the drilling of
exploratory wells in a relatively unproven area or formation.
The Memorandum stated that the partnership “does not presently
intend to engage in the drilling of any Exploratory Wells”, while
on another page, it emphasized the “high degree of risk of loss”
involved in “exploration” for oil and gas, and offered no
assurances that investors would recover their capital
contributions.
The Memorandum stated that the offering would be
restricted to individuals who had annual income sufficient to
incur Federal income tax liability at the rate of 50 percent.
- 7 b.
Minimum Annual Royalties
On December 29, 1979, Stonehurst entered into a sublease
agreement with Craig for a 100-percent working interest in oil,
gas, and mineral rights to 340 acres in Nowata County, Oklahoma.
The working interest was restricted to the “Bartlesville Sands
formation, the principal producing zone in the area” and “no
other oil, gas or mineral rights in the subject property”.
R.H.
Energy, Ltd. (“R.H. Energy”), the driller/operator under the
turnkey contract, see infra p. 8, concurrently was to assign its
mineral rights in this land to Craig.
Stonehurst, as sublessee, agreed to pay Craig, as sublessor,
a production royalty of 67 percent of gross revenue from the sale
of oil and gas.
Stonehurst was obligated to pay a lease bonus of
$10,000, and minimum annual royalties of $2,278,000 for 1979, and
$2,006,000 for each year thereafter through 1994, for a total of
$30,362,000, accruing on December 29 of each year, to be recouped
from the production royalty prior to any expenses’ being paid by
Stonehurst.
In the absence of production, payment of all
royalties was deferred until December 29, 1994.
All minimum
annual royalties accrued but unpaid on that date were then to be
paid in cash by Stonehurst to Craig.
Minimum annual royalties
accruing thereafter were to be paid within 1 year of accrual.
Both the general and limited partners of Stonehurst were relieved
of any liability associated with the accrued but unpaid royalties
- 8 unless they had assumed personal liability for them.
No interest
was payable on the unpaid accruals.
Recoupment from the 67-percent production royalties of full
payment of the $30,362,000 of minimum annual royalties projected
to be accrued by Stonehurst through 1994 would have required an
average price per barrel of oil between $58.93 and $86.11 over
the course of the lease at the levels of production assumed by
the economic projections in the Memorandum.
Stonehurst could
avoid liability for all or a proportionate part of the minimum
annual royalties not yet accrued by surrendering its rights under
the sublease to the entire leased property or to any parcel of 6
contiguous acres or more prior to the beginning of the next lease
year.
c.
Turnkey Contract
On December 29, 1979, Stonehurst also entered into a
“turnkey and drilling completion contract” with R.H. Energy for
25 wells to be completed by June 30, 1980.
The Memorandum
described R.H. Energy as a joint venture between H.H. Oil & Gas
Co., a Colorado based corporation, and Synergistics Equities,
Ltd.
The Memorandum indicated that there was a relationship
between R.H. Energy and Craig that gave rise to a possible
conflict of interest between R.H. Energy and Wind River
concerning R.H. Energy’s recommendations to Craig about whether
to complete drilling on any wells, inasmuch as incomplete wells
would eventually be forfeited back to R.H. Energy.
This possible
- 9 conflict relationship was also the subject of part of the legal
opinion rendered by the law firm of Meserve, Mumper & Hughes,
which was included as an exhibit in the Memorandum.
See infra
p. 14.
Under the turnkey contract, Stonehurst was obligated to pay
R.H. Energy $12,000 per dry well and $35,000 per well put into
production.
An initial payment of $12,000 per well was due to
R.H. Energy upon notice that drilling would commence within 5
days.
No such notice was given in 1979.
In March 1980, R.H.
Energy gave notice to Stonehurst that drilling of wells on the
property was about to commence.
d.
Economic Analysis and Predicted Tax Benefits of
Stonehurst
The Memorandum presented two economic projections that
purported to show significant tax losses in the early years of
Stonehurst’s operations and distributions of profits in the later
years.
Because no production or revenue was projected for the
initial year, 1979, the tax loss shown for that year was
identical under both projections, amounting to $2,788,000.3
3
The components of this figure are:
Item
Accrued minimum annual royalty
Amount
$2,278,000
Accrued intangible drilling costs
500,000
Operating costs
10,000
Total
2,788,000
The
- 10 beginning aggregate “at risk exposure” of the limited partners
for 1979 was $2,821,500.
Their 1979 ending aggregate “at risk
exposure” was $33,500, after deduction of the 1979 tax loss shown
for each limited partner.4
The Memorandum estimated aggregate
tax savings to the limited partners of $1,394,000 for 1979 based
upon a marginal tax rate for individuals of 50 percent.
The
Memorandum reported that the “tax loss” to be generated in 1979
was leveraged 5.09 times “with respect to the Initial Cash
Contribution”.
Each economic projection expressly relied upon the stated
assumption that 89 percent of a total of 55 wells drilled between
1980 and 1983 would produce oil in the quantities assumed in that
projection.
The cover letter to a geological report, discussed
below, and included as an exhibit to the Memorandum, stated that
“Realistically a 90% success ratio should be anticipated.”
Projection A assumed total production of 757,500 barrels of oil
from 1980 to 1994 at declining rates of production of 5, 4, and 3
barrels per day per well in the first 3 years and 3 barrels per
day thereafter.5
Projection B assumed production rates of half
those of projection A.
4
Mr. Heitzman’s claimed deduction of $110,170 on the 1979
return was derived from his share of the total losses (7 of 175
units), $2,788,000 less the remaining “at risk exposure”,
$33,500.
5
Compare with the Coburn report, infra p. 12, which makes a
somewhat different assumption: an initial production rate of 5
barrels per day, declining to 3 barrels per day within 24 months.
- 11 Both projections were also based upon a price per barrel of
oil of $32.50 in 1980 that would increase at a compounded annual
rate of 10 percent per year through 1994.
The Memorandum
projected that the price of oil in 1994 would be $123.44 per
barrel.
Operating costs were also projected to increase at 10
percent per year over the term of the lease.
e.
Coburn Geological Report
The Memorandum included a geological report, signed by R. W.
Coburn (hereinafter Coburn report), which identified Mr. Coburn
as a registered Oklahoma petroleum engineer.
The Coburn report
asserted that Stonehurst could expect 90 percent of its wells to
produce oil.
However, the report does not make clear whether
this likelihood pertained to developmental drilling of known
formations or exploratory drilling in new fields.6
The economic
projections described supra explicitly rested upon the 90-percent
success rate.
The Coburn report asserted that “commercial oil production
can be obtained from the Bartlesville Sand”, which it said was
“the principal producing zone” in Nowata County.
The assertion
about obtaining commercial oil production was uncorroborated by
any supporting geological data, such as log data, seismic data,
or gravity surveys.
6
The lack of any such data supporting the
One section of the report refers to “shallow oil
exploration” while another section refers to “proposed
development”. This same inconsistency is also found in the
Memorandum. See supra p. 6.
- 12 presence of Bartlesville Sand in the immediate area is critical
because the geological structure of Bartlesville reservoirs may
vary greatly in thickness and reservoir quality over short
distances.7
Because developmental drilling occurs only in known
formations, the drilling programs proposed by the Coburn report
and the Memorandum could only have been exploratory, inasmuch as
the nearest actual oil production in the preceding 40 years had
occurred some 8 miles away from the Stonehurst leasehold.
Exploratory drilling, in contrast to developmental drilling, has
an expected likelihood of success of about 10 percent.
The Coburn report projected reserves of 518,400 barrels
based on 30 notional wells if “water injection is commenced
immediately”.
The report based its projections on a notional
well producing 5 barrels of oil per day, declining thereafter to
3 barrels per day after 24 months.
Without confirmation of known
formations in the immediate vicinity of the leasehold, any
projection of reserves of 518,400 barrels was wildly overoptimistic.
The yield projection of a notional well over a 15-
year life also unrealistically postulated a constant yield over
the last 13 years of life of the well.
Such a projection curve
is inconsistent with typical oil well production yield curves,
7
Bartlesville Sand is fluvial sand deposited in ancient
riverbeds. The best Bartlesville production is found in the
meandering bends of the buried riverbeds in “ox-bow cut-offs”
that have a thick sand bar on the inside edge of the bend
containing large oil deposits.
- 13 irrespective of whether they are produced by natural reservoir
mechanisms or by waterflooding.
To obtain a waterflood, injection wells are drilled on an
approximately 1:1 ratio with producing wells.
This would mean up
to 30 (25 if only 25 producing wells were drilled--as the
Memorandum called for) additional wells.
Neither the Coburn
report nor the economic projections in the Stonehurst memorandum
accounted for the costs of drilling any such additional wells.
There was also no proposal for a water flood injection well
pattern.
The Coburn report also asserted that operating expenses for
a notional well would be $250 per month, which was too low in
1979 to include water flood operating costs required to support
the water injection required to obtain 518,400 barrels of
production over 15 years.
Even the $290 per well per month
projected in the economic projections, which were then inflated
at 10 percent per year over 15 years, was too low for operating a
water flood.
Even with the problems described supra, the projected
reserve of 518,400 barrels, based upon 30 notional wells, is less
than the 757,500 barrels assumed by the economic projection A
described supra.
The turnkey contract also only called for
drilling 25 wells in 1980, while the two economic projections
both assumed that a total of 55 wells would be drilled, of which
49 would be producers.
- 14 The Coburn report itself mentioned “Stonehurst Energy” once,
on the first page, in a typeface different from the remainder of
the report.
In the same paragraph, the last sentence, which
claimed that a projection of the future net revenue of a notional
well drilled in Bartlesville Sand was included in the report, was
also in a typeface different from the rest of the report.
The
report contained no projection of future revenue from a notional
well.
It included only a “pro-forma” projection of production
from a notional well from 1980 to 1994.
The typeface of the
address for Stonehurst on the cover letter signed by Coburn is
also different from the typeface of the rest of the letter.
f.
The Meserve Firm Federal Tax Opinion Letter
The Meserve firm wrote a letter to Freemond, which was
reproduced in the Memorandum (“opinion letter”), expressing legal
opinions on various tax issues.
The Meserve firm was counsel to
Craig, Wind River, and all their affiliates.
The Meserve firm
was to receive an overriding royalty of an undisclosed percentage
of production as its fee for legal services.
Additionally,
certain partners and associates of the Meserve firm purchased an
additional overriding royalty of “less than one half of one
percent.”
The opinion letter asserted that, based upon the
Coburn report, Stonehurst had economic substance because the
economic projections showed that the:
oil and gas reserves expected to be produced are
adequate to fully pay any Minimum Annual Royalties
incurred and to return a profit to investors. The
Partnership therefore anticipates a profit independent
- 15 of any favorable tax considerations and it is the
objective of the General Partner to realize such a
profit.
The opinion letter claimed that the Coburn report provided a
basis for concluding that Stonehurst had the requisite profit
motive under section 183 to support the deduction of trade or
business expenses.
The opinion letter concluded that the limited partners would
have sufficient amounts “at risk” under section 465 to be
entitled to the deductions projected for 1979 when Stonehurst
incurred liability upon execution of the turnkey contract with
R.H. Energy and execution of the sublease with Craig.
The
opinion letter analyzed various aspects of the minimum annual
royalties, concluding that they met the requirements of “Rev.
Rul. 77-789”,8 because they were nonrefundable, and were
deductible under sec. 1.612-3(b), Income Tax Regs., as
“substantially uniform payments” because the accruals were
properly considered “payments”.
The opinion letter also
concluded, provided drilling was completed within 12 months of
Stonehurst’s incurring liability under the turnkey contract, that
the entire intangible drilling cost accrued in 1979 would be
deductible by the partnership.
Despite the air of certitude of
the opinion letter, the Memorandum warned that the tax returns of
8
This was a typographical error in the opinion letter. The
Internal Revenue Service had issued Rev. Rul. 77-489, 1977-2 C.B.
177.
- 16 investors may be subject to an increased “likelihood that a
Partner’s return will be subject to audit.”
g.
Mr. Heitzman’s Purchase of Interest in Stonehurst
Sometime during 1979, Mr. Heitzman’s personal attorney had
told Gil Sherman, who was selling interests in Stonehurst, about
Mr. Heitzman’s possible interest in a tax shelter.
During
December 1979, Sherman asked Mr. Heitzman if he would be
interested in purchasing an interest in Stonehurst in light of
his large income that year.
Sherman was entitled to receive a
0.5-percent overriding production royalty as compensation for his
efforts in selling the partnership units.
Mr. Heitzman had heard from other purchasers of interests in
Stonehurst, including his personal attorney and “other
substantial business people”, that Stonehurst “was a good
investment”.
He read the Stonehurst Memorandum, including the
statement in the Coburn report that there was an expected “90%
success ratio to be anticipated”.
Sherman told Mr. Heitzman that
other investors in similar limited partnerships had “done well
and this one should be great”.
going to make some money”.
Sherman said that they “were
Mr. Heitzman concluded that
Stonehurst was a “good investment” with a “big write-off”.
Mr. Heitzman was favorably impressed because “it had been
researched by a large law firm out of Los Angeles”.
On December 17, 1979, Mr. Heitzman purchased 7 limited
partnership units in Stonehurst, at the stated price of $6,200
- 17 per unit, for a total price of $43,400.
Mr. Heitzman paid half
in cash on or about that date, with the remainder due on a
recourse promissory note on April 1, 1980, which was acknowledged
by Stonehurst as having been paid on April 18, 1980.
Mr.
Heitzman signed a subscription agreement, by which he
acknowledged that there was substantial risk that he would lose
his entire investment.
He also acknowledged that he had been
advised of the general nature of the probable tax consequences
discussed in the opinion letter, and that he had been further
advised by that same letter to “consult with independent tax
counsel regarding the tax consequences of participating in the
Partnership”--which he did not do.
Mr. Heitzman elected to hold
his interest in Stonehurst as separate property rather than
tenancy in common or joint tenancy with right of survivorship,
both of which were offered as alternatives in the subscription
agreement.
On or about December 17, 1989, Mr. Heitzman also executed
two assumption agreements.
In the first assumption agreement,
Mr. Heitzman purported to assume personal liability for his
$63,364 pro rata share of $1,600,000 of the minimum annual royalty
that was to accrue on December 29, 1979.
He also purported to
assume personal liability for his pro rata share of a portion of
the minimum annual royalties to accrue in 1980, 1981, 1982, and
1983.
Under the assumption agreement, the limited partners were
to incur total additional liability beyond $1,600,000--up to
- 18 $3,300,000--only if production for all wells drilled and completed
by November 1, 1980, exceeded 30 barrels per day or 2 barrels per
day per completed well.
Mr. Heitzman would have personally
assumed $130,683 of total liability of $3,300,000 had those
production goals been met.
Nothing in the record indicates that
any oil was ever produced from the leased acreage.
In the second assumption agreement, Mr. Heitzman purported
to assume personal liability of up to $3,779 per unit (for a
maximum of $26,453) for payment of drilling and completion costs
incurred under the turnkey contract.
3.
Petitioner’s Knowledge of Mr. Heitzman’s Purchase of an
Interest in Stonehurst
Mr. Heitzman decided to purchase an interest in Stonehurst
without any input from petitioner about the merits of the
investment.
It is unclear from the record precisely when
Mr. Heitzman apprised petitioner about the Stonehurst purchase.
Petitioner was aware of the purchase prior to filing the 1979
joint income tax return.
Regardless of when Mr. Heitzman told
petitioner about the transaction, he told her only that
Stonehurst “was in oil and gas”, would make some money, and was
a “tax shelter” that would be reflected in the 1979 return.
Mr. Heitzman never explained to petitioner any other aspects of
the Stonehurst investment as he then understood them.
He did not
explain to her any attributes of Stonehurst as a tax shelter,
such as what minimum annual royalties or intangible drilling
costs were, nor give her any further information on Stonehurst as
- 19 an economic investment.
Petitioner never saw the subscription
agreement or either of the assumption agreements or any other
documents, including the Memorandum, relating to the Stonehurst
investment, either prior to Mr. Heitzman’s purchasing the
interest or at any time thereafter.
Mr. Heitzman kept the
Stonehurst documents at his office and signed the subscription
and assumption agreements there without ever bringing them home.
4.
The 1979 Joint Income Tax Return
In each of the taxable years from 1973 to 1981, including
1979, petitioner and Mr. Heitzman filed joint Federal income tax
returns that were prepared by a prominent accounting firm,
Alexander Grant, Inc. (Alexander Grant).
Each year, when Mr.
Heitzman asked, petitioner would give him her Forms W-2,
receipts, and other information pertaining to her employment.
He
would then pass that information to their accountant at Alexander
Grant, along with the other information required to complete the
return.
For taxable year 1979, Mr. Heitzman helped petitioner
determine the expenses for her modeling activities by going
through the checkbook and other receipts.
Petitioner’s 1979 gross income amounted to $3,700, derived
entirely from residuals from a television commercial.
Petitioner
had $3,058 in total deductions, including agency fees and
modeling expenses, that were attributable directly to her
business activities that year.
Her net contribution to taxable
income shown on the return was $642.
- 20 In 1979, Mr. Heitzman had $145,311 of business income
related to his role in the development of a large condominium
project by DMA Heitzman.
Additionally, Mr. Heitzman earned
$33,948 in compensation from TSI Corporation.
The 1979 joint
income tax return claimed deductions of $110,170 derived from
Stonehurst.
On June 14, 1980, petitioner and Mr. Heitzman filed their
joint return after obtaining an appropriate extension.
5.
Events Subsequent to the Filing of the 1979 Return
On June 22, 1981, Mr. Heitzman and petitioner gave a power
of attorney to two accountants employed by Alexander Grant to
represent them before the Service for tax year 1979.
In June 1982, petitioner and Mr. Heitzman separated, and he
moved to Phoenix, Arizona.
On April 11, 1983, the Family Court
of the First Circuit of Hawaii granted a final divorce decree to
petitioner and Mr. Heitzman.
The “Agreement Incident to and in
Contemplation of Divorce”, dated March 11, 1983, provided that
Mr. Heitzman would indemnify petitioner for all deficiencies in
State and Federal income tax arising from income tax returns that
they filed jointly during their marriage, specifically mentioning
a $1,281 assessment by the State of Hawaii for 1979.
The
agreement also entitled Mr. Heitzman to any refunds due from
those taxable years.
- 21 Mr. Heitzman and petitioner each signed separate Forms 872C,
“Consent to Extend Time to Assess Tax”, extending the period of
limitations for taxable year 1979 until June 30, 1984.
In May 1983, Mr. Heitzman traveled to Nowata County,
Oklahoma, to investigate the Stonehurst lease.
Mr. Heitzman
found several abandoned wells and associated piping and machinery
at the sites of the leaseholds.
The surrounding area was also
littered with abandoned oil wells.
Petitioner reported $2,374 in adjusted gross income for
1983.
Petitioner may have had up to $4,461 in additional
adjusted gross income for 1983, although that additional income
may have been reported in other taxable years.9
In June 1984, Mr. Heitzman filed for bankruptcy after the
failures of his businesses, DMA Heitzman and Autocast.
These
failures were precipitated by the death of Mr. Heitzman’s partner
9
For taxable year 1983, petitioner reported $2,374 in
adjusted gross income. Petitioner received an additional $2,250
in support payments during 1983 that were not reported on her
1983 tax return. She also received a check for $1,000, written
on Dec. 27, 1982, for the January 1982 support payment. The
record does not reflect whether that check was reported on
petitioner’s 1982 return.
Petitioner also received a check for $16,000, dated Dec. 27,
1983, as the final installment payment from the sale of the
house, of which 18.92 percent was taxable income, or $3,027.
Using the Schedule D attached to petitioner’s 1983 tax return, 40
percent of that amount, or $1,211, would have been reported as
gross income on petitioner’s Form 1040 in 1983 if it was to be
included in her 1983 gross income. The record does not reflect
whether that amount was reported on petitioner’s 1984 return.
- 22 in DMA Heitzman, who had been backing him in both businesses, and
the financial failure of another financial backer of Autocast.
On June 28, 1984, respondent timely issued a statutory
notice of deficiency to Mr. Heitzman and petitioner, determining
a deficiency of $55,263 for calendar year 1979.
On September 20,
1984, Mr. Heitzman filed a petition with this Court in the names
of himself and petitioner, under docket No. 33436-84.
On
September 26, 1984, petitioner filed a separate petition, docket
No. 33938-84, in response to the same notice.
In her petition,
petitioner disputed the same factual matters as Mr. Heitzman’s
petition and raised additional issues of the period of
limitations and relief as an innocent spouse.
On August 9, 1985,
Mr. Heitzman filed a motion to dismiss petitioner from the case
under docket No. 33436-84.
On September 10, 1985, that motion
was granted.
On October 10, 1985, the State of Hawaii mailed Mr. Heitzman
a notice of assessment based on an increased Hawaii State income
tax liability of $11,727 that was based upon disallowance of the
deduction with respect to Stonehurst by the Internal Revenue
Service.
On December 29, 1986, Wind River sent a letter to the
Stonehurst limited partners inviting them to sign an “Agreement,
Release, Consent and Vote to Dissolve” that would terminate
Stonehurst and provide a means to “reduce” the recourse
liabilities that the limited partners had purported to assume in
- 23 the assumption agreements.
The letter explained that the limited
partners were required to sign this agreement in order to reduce
their liabilities.
In return, the principal payment date would
be extended until December 31, 2001, and the recourse liabilities
reduced by a consolidation of operations with another
partnership, Consolidated Petroleum Equities, Ltd. (CPE).
The
revenues of this new entity were to be applied at a rate of 0.01
percent of “the value of CPE’s share of production from its wells
before deducting royalties or expenses” for every “$1,000 of
outstanding assumed liabilities”.
The letter contained no
financial projections to illuminate how this would be done.
The
proffered documents also purported to release Wind River,
Freemond, and other principals from any liability arising from
Stonehurst.
On the advice of counsel, Mr. Heitzman did not sign
this agreement.
On March 23, 1987, Freemond sent a note to the limited
partners, exhorting them to execute the documents described
above.
Freemond’s note also said that the enclosed partnership
Form K-1 would be the last one sent because Stonehurst was being
dissolved.
On February 24, 1987, on cross-motions for partial summary
judgment in the case under docket No. 33436-84, this Court
granted respondent’s motion and denied Mr. Heitzman’s motion.
Heitzman v. Commissioner, T.C. Memo. 1987-109.
We held that, as
a matter of law, Mr. Heitzman was not entitled to deduct his
- 24 share of the 1979 minimum annual royalty or intangible drilling
costs attributable to Stonehurst.
Id.
On October 18, 1988, the
Court of Appeals for the Ninth Circuit affirmed.
Heitzman v.
Commissioner, 859 F.2d 783 (9th Cir. 1988).
On May 29, 1990, Mr. Heitzman filed for bankruptcy for a
second time.
As part of the bankruptcy proceedings, Mr. Heitzman
was discharged from any liability resulting from the decision
against him in Heitzman v. Commissioner, T.C. Memo. 1987-109.
OPINION
The Code permits married persons to make “a single return
jointly of income taxes”.
Sec. 6013(a).
Spouses who file a
joint return are jointly and severally liable for any tax due on
their aggregate income, including interest.
Sec. 6013(d)(3).
The sole issue for decision is whether petitioner is entitled to
innocent spouse relief from joint liability on her and Mr.
Heitzman’s 1979 income tax return.
To qualify for statutory relief from joint and several
liability under section 6013(e),10 a putative innocent spouse
must establish:
(1) A joint return was made under section 6013;
10
We apply the statute as amended by Congress in 1984 even
though the year before us is 1979. The Deficit Reduction Act of
1984, Pub. L. 98-369, sec. 424(a), 98 Stat. 494, 801-802, amended
sec. 6013(e) retroactively to all open tax years to which the
1954 Code applies.
Petitioner argued in the alternative that she met the
requirements of sec. 6004 of the Technical and Miscellaneous
Revenue Act of 1988, Pub. L. 100-647, 102 Stat. 3342, 3685-3686.
We need not consider this alternative argument.
- 25 sec. 6013(e)(1)(A); (2) there was a substantial understatement of
tax attributable to grossly erroneous items of one spouse; sec.
6013(e)(1)(B); (3) at the time of signing the return, the other
spouse did not know and had no reason to know that there was such
an understatement; sec. 6013(e)(1)(C); (4) taking into account
all the facts and circumstances, it would be inequitable to hold
the other spouse liable for the deficiency in tax for such
taxable year attributable to the understatement.
Sec.
6013(e)(1)(D).
For purposes of section 6013(e), an understatement of tax is
substantial if it exceeds $500.
Sec. 6013(e)(3).
With respect
to grossly erroneous deductions, the understatement must exceed a
specified percentage of the putative innocent spouse’s gross
income for the “preadjustment year”, which is the taxable year
immediately preceding the year in which the statutory notice of
deficiency was issued.
Sec. 6013(e)(4).
The taxpayer has the burden of proving each element by a
preponderance of the evidence.
Rule 142(a); Stevens v.
Commissioner, 872 F.2d 1499, 1504 (11th Cir. 1989), affg. T.C.
Memo. 1988-63; Purcell v. Commissioner, 826 F.2d 470, 473 (6th
Cir. 1987), affg. 86 T.C. 228 (1986); Sonnenborn v. Commissioner,
57 T.C. 373, 382 (1971).
Failure to carry that burden on any one
of the elements will prevent a taxpayer from qualifying for
innocent spouse relief.
Purificato v. Commissioner, 9 F.3d 290,
293 (3d Cir. 1993), affg. T.C. Memo. 1992-580; Stevens v.
- 26 Commissioner, supra at 1504; Purcell v. Commissioner, supra at
473.
The parties agree that a joint return was filed.
The record
also compels the conclusion that the understatement of $55,263
attributable to the items in question was substantial, sec.
6013(e)(3), and we so find.
Respondent has contested each of the remaining issues,
including whether the deficiency exceeds the specified percentage
of petitioner’s adjusted gross income for 1983, her preadjustment
year.
Sec. 6013(e)(4)(C).
Section 6013(e)(4)(A) requires that
the substantial understatement exceed 10 percent of the claimant
spouse’s adjusted gross income (AGI) for the preadjustment year
if the AGI is $20,000 or less.
We find that petitioner’s
adjusted gross income for 1983 could not have exceeded $6,835
even if additional items of income described in the record, which
may well have been reported in other taxable years, are added to
petitioner’s reported 1983 adjusted gross income.
The
understatement of $55,263 exceeds 10 percent of petitioner’s 1983
adjusted gross income.
We consider each of the remaining contested elements.
1.
“Grossly Erroneous Items of One Spouse”
a.
Attributable to Other Spouse
Respondent does not argue that the disallowed Stonehurst
deductions claimed on the 1979 return were not attributable to
Mr. Heitzman.
The record shows that petitioner had no ownership
- 27 interest in Stonehurst.
Mr. Heitzman deliberately held his
interest in Stonehurst as separate property when he had the
opportunity to elect to hold his interest as a joint survivorship
tenency or tenancy in common.
If petitioner and Mr. Heitzman had
filed separate returns, Mr. Heitzman would have claimed the
deduction on his return, and petitioner would not have been
liable for the resulting understatement.
Therefore the
disallowed deductions were items attributable to Mr. Heitzman.
b.
Grossly Erroneous Deduction
The Code defines a “grossly erroneous” deduction as one
having no basis in fact or law.
Sec. 6013(e)(2).
Neither the
Code nor the applicable regulations define “basis in fact or
law”.
However, Congress did not intend that the innocent spouse
defense would allow the putative innocent spouse to escape
liability for apparently legitimate claims that are later
disallowed.
Friedman v. Commissioner, 53 F.3d 523, 529 (2d. Cir.
1995), affg. in part, revg. and remanding in part T.C. Memo.
1993-549.
Addressing this issue, we have stated that
A deduction has no basis in fact when the expense for
which the deduction is claimed was never, in fact,
made. A deduction has no basis in law when the
expense, even if made, does not qualify as a deductible
expense under well-settled legal principles or when no
substantial legal argument can be made to support its
deductibility. Ordinarily, a deduction having no basis
in fact or in law may be described as frivolous,
fraudulent, or * * * phony. [Belk v. Commissioner, 93
T.C. 434, 442 (1989); Douglas v. Commissioner, 86 T.C.
758, 762-763 (1986).]
- 28 We inquire first whether the minimum annual royalty and the
intangible drilling expense deductions are grossly erroneous as
having no basis in fact or law because they arose from a sham
transaction entered into solely for the purpose of obtaining
favorable tax consequences.
Sham transactions are not given
effect for Federal income tax purposes, Frank Lyon Co. v. United
States, 435 U.S. 561, 573 (1978); Ferrell v. Commissioner, 90
T.C. 1154, 1199 (1988), and
the claimed deductions arising
therefrom are “phony” or “frivolous”, without basis in fact or
law, and therefore grossly erroneous under section 6013(e)(2),
even if an expense or loss is actually incurred.
See, e.g.,
Bouskos v. Commissioner, T.C. Memo. 1987-574 (deductions arising
from coal-mining lease that was “a mere tax shelter designed to
enrich the general partners and provide sizable tax deductions to
the limited partners” were phony and had no basis in law or fact)
(quoting Tallal v. Commissioner, T.C. Memo. 1984-486, affd. 778
F.2d 275 (5th Cir. 1985)); cf. Somervill v. Commissioner, T.C.
Memo. 1996-165 (claimed deductions in tax shelter that was a sham
were not grossly erroneous because they were “not without some
support in the case law”) (quoting Finkelman v. Commissioner,
T.C. Memo. 1989-72, affd. without published opinion 937 F.2d 612
(9th Cir. 1991)).
The putative innocent spouse must carry the burden of
producing evidence of the sham nature of the underlying
transaction and the lack of profit motive on the part of the
- 29 entity and its principals.
Here, petitioner must establish that,
at the partnership level, Stonehurst was a sham transaction
without profit motive.
Hulter v. Commissioner, 91 T.C. 371, 393
(1988); Fox v. Commissioner, 80 T.C. 972, 1006-1008 (1983), affd.
without published opinion 742 F.2d 1441 (2d Cir. 1984), affd. sub
nom. Barnard v. Commissioner, 731 F.2d 230 (4th Cir. 1984), affd.
without published opinions sub nom. Hook v. Commissioner, Kratsa
v. Commissioner, Leffel v. Commissioner, Rosenblatt v.
Commissioner, Zemel v. Commissioner, 734 F.2d 5-7, 9 (3d Cir.
1984); see also Bealor v. Commissioner, T.C. Memo. 1996-435.
This was an issue that was not litigated in Heitzman v.
Commissioner, T.C. Memo. 1987-109, and the record in the case at
hand lacks any direct reference to the economic motives of the
general partner.
Wind River had been organized to act as general
partner in Stonehurst, and Freemond had no previous experience in
oil and gas exploration.
For purposes of our inquiry, Freemond
and Wind River are shadowy figures, present only in the
Memorandum and later letters chronicling Stonehurst’s dwindling
prospects of finding oil or natural gas and its ultimate demise.
The evidence in the record that Stonehurst was a sham
transaction is circumstantial, and comes from the following
sources:
(1) The Stonehurst documentation, (2) the testimony and
report of petitioner’s expert, Charles M. Bowers, and (3) the
testimony of Mr. Heitzman.
Our analysis of Stonehurst is also
informed by our report in Osterhout v. Commissioner, T.C. Memo.
- 30 1993-251, affd. on this issue and revd. in part without published
opinion sub nom. Balboa Energy Fund 1981 v. Commissioner, 85 F.3d
634 (9th Cir. 1996), which held similarly structured oil and gas
partnerships--which used up-front accruals of minimum advance
royalties to generate claims for large tax deductions that were
never paid for--to be sham transactions.
In Osterhout, we found
that “the objective of the * * * [partnerships at issue in that
case] was to help investors avoid taxes and to enrich the coffers
of the promoters”, including Meserve, a partner in the law firm
rendering the tax opinion for Stonehurst.
There are striking
parallels between Osterhout and the case at hand.
In Osterhout, as in the case at hand, the promotional
material emphasized the tax benefits available to investors who
would benefit regardless of whether oil and gas were actually
discovered.
An investor in Stonehurst could seemingly “win” by
receiving tax deductions far in excess of the amount paid for the
partnership interest even if no oil or gas was produced.
See
Ferrell v. Commissioner, 90 T.C. at 1183; Osterhout v.
Commissioner, supra (citing Barnard v. Commissioner, 731 F.2d 230
(4th Cir. 1984), affg. Fox v. Commissioner, 80 T.C. 972 (1983)).
In cases such as Osterhout, where “the promised tax benefits
are suspiciously excessive and the transaction is carried out
with complete indifference to profit, it is clear the parties
intended to structure the transaction for the tax benefits.”
Osterhout v. Commissioner, supra (citing Flowers v. Commissioner,
- 31 80 T.C. 914, 941 (1983)).
The record in the case at hand is
replete with similar indicia of indifference to profits on the
part of Stonehurst and its principals.
Petitioner’s expert, Charles M. Bowers (Bowers), a petroleum
engineer registered in Oklahoma, concluded that the Coburn report
was egregiously flawed in several ways.
In Bowers’ view, the
most egregious flaw in the Coburn report was the assertion that
“commercial oil production can be obtained from the Bartlesville
Sand”.
Because of the unique characteristics of Bartlesville
Sand,11 there would have had to have been previous oil production
in commercial quantities on the lease in order for the Coburn
report to make such an assertion without its being a gross
misrepresentation.
The Coburn report referred to no evidence to
support its contentions about the likelihood of discovering oil
in commercial quantities.
Furthermore, Mr. Heitzman testified at
trial that the maps he was shown indicated that the closest
proven Bartlesville Sand was 8 miles from the leasehold.12
Another egregious flaw in the Coburn report was its claim of
a 90-percent success rate for exploratory drilling.
Likelihoods
of success on the order of 90 percent are associated with
developmental drilling, which the Memorandum itself defined as
11
12
See supra n.7.
Now repealed sec. 56(h)(6)(B), providing energy based
preference adjustments to the alternative minimum tax, defined
the minimum distance of an exploratory well from other wells as
1.25 miles or 800 feet in depth (the exploratory well being
deeper).
- 32 drilling wells in “the presently proven productive area of an oil
or gas reservoir.”
Despite the representation in the Memorandum
that Stonehurst was planning to engage in a developmental
drilling program, there were, as discussed supra, no “proven
productive areas” on the Stonehurst leasehold.
Bowers testified
that a 10-percent likelihood of success in exploratory drilling
would be relatively generous under the best of conditions.
Consistent with Bowers’ opinion that the Coburn report was
“disturbingly generic”, was the different typeface used in the
report whenever it referred to Stonehurst.
We believe, based
upon Bowers’ evaluation and the record as a whole, that the
Coburn report could not have been relied upon to support the
assumptions in the economic projections.
The Coburn report is a
strong indication of the lack of profit motive of the Stonehurst
partnership and its principals.
See Hulter v. Commissioner, 91
T.C. at 393; Fox v. Commissioner, 80 T.C. at 1006-1008.
In Osterhout v. Commissioner, supra, we found that the
“promotional valuations pertaining to the prospective oil and gas
production of * * * [the partnerships in issue] were inflated.”
Those inflated valuations were supported by inaccurate geology
reports and world oil price projections that were significantly
inflated in comparison to actual downward market movements
occurring as the leases were entered into in 1981, 1982, and
1983.
Id.
The economic projections in the Stonehurst Memorandum
were similarly unrealistic.
See Krause v. Commissioner, 99 T.C.
- 33 132, 169-170 (1992), affd. sub nom. Hildebrand v. Commissioner,
28 F.3d 1024 (10th Cir. 1994); see also Tallal v. Commissioner,
T.C. Memo. 1984-486, affd. 778 F.2d 275 (5th Cir. 1985).
The Memorandum used three critically flawed assumptions to
support the economic projections of Stonehurst’s asserted
profitability after having paid a 67-percent production royalty.
The first was the assertion in the Coburn report of a 90-percent
chance of finding oil with the projected drilling program, which
as we have found, was completely unwarranted and invalidates the
economic projections.
The Memorandum projected as many as 23
wells producing 5 barrels a day in 1981 out of a total of 25
wells drilled.
A 10-percent likelihood of finding oil at all
renders virtually nil the possibility that Stonehurst could pay
the minimum annual royalty.
This flawed assumption also
highlights internal inconsistencies in the Memorandum, which, on
one page, disavowed any intention to conduct exploratory
drilling, while on another page, warned of the risks involved in
“exploration” for oil.
The second flawed assumption was the projected size of the
reserves.
The Coburn report estimated that only 518,400 barrels
of oil would be produced over a 15-year period, while the
economic projections in the Memorandum projected, without any
additional support, that 757,700 barrels would be produced over a
similar period.
Neither the Coburn report nor the Memorandum
cited any justification for either estimate.
These projected
- 34 reserves were particularly unreasonable since the sublease
restricted Stonehurst’s mineral rights to oil produced from
Bartlesville Sand.
Furthermore, the Coburn report assumed that waterflooding
would be necessary to obtain 518,400 barrels of oil over 15
years.
Bowers testified that waterflooding would require
substantial additional capital to support additional drilling and
would result in increased operating costs.
See also Yates
Petroleum Corp. v. Commissioner, T.C. Memo. 1992-146 (discussing
economic feasibility of secondary and tertiary oil recovery
programs); In re Dept. of Energy Stripper Well Exemption
Litigation, 520 F. Supp. 1232, 1244-1247 (D. Kan. 1981), revd.
and remanded on other grounds 690 F.2d 1375 (Temp. Emer. Ct. App.
1982) (expert testimony describes waterflood process and expense
involved).
Neither the Coburn report nor the economic
projections in the Memorandum took such costs into account.
The Memorandum’s third critically flawed assumption was that
1980 oil prices of $32.50 per barrel would increase at 10-percent
per year, compounded annually, peaking at $123.44 per barrel in
1994.
Even though Stonehurst was marketed in December 1979, at a
time when world oil markets had been destabilized by war in the
Middle East, the Iranian revolution, and the resulting embargo,
Krause v. Commissioner, 99 T.C. at 134, the Memorandum contained
no support for the 10-percent price escalation.
Indeed, the
price of domestic oil never exceeded $40 in the 1980-81
- 35 timeframe.
In Krause v. Commissioner, supra, we noted that the
peak domestic price in March 1981 was $34.70 per barrel.13
In
Ferrell v. Commissioner, 90 T.C. at 1195 n.27, we took judicial
notice that the price of oil in the United States as a whole
peaked at $31.77 per barrel in 1981 and declined thereafter to
$24.08 per barrel in 1985.
Bowers testified at trial that by the
early 1990's, the market price of oil worldwide was less than $20
per barrel.
Although, as our analysis in cases like Krause v.
Commissioner, supra, and Ferrell v. Commissioner, supra, shows,
we are aware that such price declines were not forecast in
December 1979, the Stonehurst Memorandum provided no support for
its wildly over-inflated oil price projections.
The structure of the minimum annual royalty that Stonehurst
was to pay Craig was very similar to that described in Osterhout
v. Commissioner, supra, where we found such structures “foreign
to the oil and gas industry” because of the “speculative nature
of an oil well” in comparison to coal mining leases where such
royalties are used “due to the definitive quantity of coal that
can be mined”.14
In this case, Bowers characterized Stonehurst
13
The spot price of Saudi light crude oil peaked at $46 per
barrel in August 1980. Krause v. Commissioner, 99 T.C. 132, 134
(1992), affd. sub nom. Hildebrand v. Commissioner, 28 F.3d 1024
(10th Cir. 1994).
14
In Osterhout v. Commissioner, T.C. Memo. 1993-251, affd.
on this issue and revd. in part without published opinion sub
nom. Balboa Energy Fund 1981 v. Commissioner, 85 F.3d 634 (9th
Cir. 1996), we cited the expert testimony of Mr. John Teeple,
respondent’s expert witness, an attorney who had been involved in
(continued...)
- 36 as “a very unusual deal.
like this before.”
I’ve never quite seen one put together
Bowers’ conclusion is supported by the
extremely remote possibility that any oil production that could
pay the minimum annual royalty would result from the exploratory
drilling on the leasehold.
The fees paid to the promoters and the overriding production
royalty due to Craig, the sublessor, which were 67 percent of the
gross revenues before any expenses, are also unreasonable,
especially in light of Stonehurst’s highly restricted mineral
rights under the lease.
According to the Memorandum, Craig was
also to receive 8 percent of the initial capital contribution as
a “consulting fee”.
The Memorandum and the Meserve firm legal
opinion both disclosed interrelationships between the various
entities involved in Stonehurst, most notably that R.H. Energy
had assigned its rights in the sublease to Craig, and that the
Meserve firm was legal counsel to both Stonehurst and Craig.
While the record does not fully develop the scope of these
interrelationships, this unanswered question is yet another
indication of the indifference of Stonehurst and its principals
to the likelihood of any profit that would inure to the
investors.15
14
(...continued)
oil and gas matters since 1960.
15
We note in passing that the presence of the Meserve
firm’s legal opinion does not alter our finding that Stonehurst
was a sham transaction that rendered the claimed deductions
(continued...)
- 37 In Osterhout v. Commissioner, supra, we found that the
recourse notes issued by the limited partners to the sublessor of
the land leased to the partnerships in issue were “merely * * * a
facade to support the current deductibility of the amounts
accrued as MAR [minimum annual royalties]”.
The recourse notes
given to Craig and R.H. Energy and the assumption agreements
signed by the 35 individuals who bought partnership units in
Stonehurst served exactly the same purpose.
In Osterhout v. Commissioner, supra, the possibility of
payment of the notes was so remote as to be illusory.
The
likelihood of payment of the notes to Craig and R.H. Energy was
just as illusory.
On December 29, 1986, Wind River sent a letter
to the Stonehurst limited partners inviting them to sign an
agreement that would relieve the principals in Stonehurst of all
liabilities and “reduce” the liabilities of the limited partners
by providing a means to pay them down and by further delaying the
due date of the principal until December 31, 2001.
Such an
offer, completely unsupported by reference to any discernible
economic reality, suggests that Craig did not entertain any
realistic possibility of being paid in the absence of actual oil
15
(...continued)
grossly erroneous. Like the Martin law firm opinion letter in
Osterhout v. Commissioner, supra, with respect to additions to
tax for negligence and whether it was reasonable in the
circumstances of that case for the taxpayers to rely on it, the
Meserve firm’s opinion letter is germane in this case only as a
factor in determining whether petitioner had reason to know of
the grossly erroneous deductions.
- 38 or gas production--the remote likelihood of which in 1979 was
subsequently confirmed by the lack of any production from the
leasehold.
The form of the recourse notes indicates the remoteness of
any possibility of payment.
In Osterhout v. Commissioner, supra,
the principal was not due and payable for 12 years, and the notes
themselves were interest free, a form “foreign to the business
world.”
The principal on the Stonehurst note given to Craig was
not due for 15 years and was likewise interest free.
Stonehurst was formed solely to enrich the promoters and
provide claims to tax deductions for the limited partners.
The
activities of Stonehurst served no viable economic or commercial
profit objective.
While we realize that oil and gas exploration
is highly speculative and can yield large profits, that Congress
enacted certain tax measures to encourage oil and gas
exploration, and that the Stonehurst promotional materials
contained representations of profitability, the structure of
those materials, with their flawed assumptions, internal
inconsistencies, and the unbusinesslike structure of the socalled minimum advance royalty, all demonstrate that any
possibility of profits was so remote as to be negligible.
Compare United States v. Dean, 224 F.2d 26, 29 (1st Cir. 1955)
(for purposes of sec. 20.2055-2(b)(1), Estate Tax Regs., “so
remote as to be negligible” defined as the “chance which persons
generally would disregard as so highly improbable that it might
- 39 be ignored with reasonable safety in undertaking a serious
business transaction”); see also Estate of Clopton v.
Commissioner, 93 T.C. 275, 285-286 (1989); Briggs v.
Commissioner, 72 T.C. 646, 656-657 (1979), affd. without
published opinion 665 F.2d 1051 (9th Cir. 1981).
We find that Stonehurst, like the partnerships at issue in
Osterhout v. Commissioner, T.C. Memo. 1993-251, was a sham
transaction entered into for tax benefits without any objective
possibility of producing an economic profit independent of the
contemplated tax benefits that should not be given effect for
Federal income tax purposes.
Frank Lyon Co. v. United States,
435 U.S. at 573; Ferrell v. Commissioner, 90 T.C. at 1199.
We
find that the minimum annual royalty and the intangible drilling
costs accrued by Stonehurst in 1979 and claimed by Mr. Heitzman
on the 1979 joint return to be completely without basis in fact
or law, sec. 6013(e)(2)(B), Belk v. Commissioner, 93 T.C. at 442;
Bouskos v. Commissioner, T.C. Memo. 1987-574 citing Douglas v.
Commissioner, 86 T.C. at 762-763, and therefore grossly erroneous
for purposes of section 6013(e)(1)(B).16
16
Because we held in Heitzman v. Commissioner, T.C. Memo.
1987-109, affd. 859 F.2d 783 (9th Cir. 1988), that neither the
minimum annual royalty nor the intangible drilling costs could
have been claimed as deductions in 1979, as a matter of law, we
also find them to be grossly erroneous as being without basis in
law. Reser v. Commissioner, 112 F.3d 1258, 1265 (5th Cir. 1997),
affg. in part and revg. in part T.C. Memo. 1995-572.
- 40 2.
Knowledge or Reason to Know
Petitioner must establish “that * * * she did not know, and
had no reason to know, that there was * * * [a] substantial
understatement” on the 1979 joint return.
Sec. 6013(e)(1)(C).
Respondent does not contend that petitioner had actual knowledge
of the understatements on the 1979 return nor would the record
support a contention to that effect.
Petitioner did not have
actual knowledge of the understatement at the time the 1979
return was signed.
We now turn to whether petitioner had reason to know of the
substantial understatement of income tax on the 1979 joint
return.
know.
Respondent contends that petitioner did have reason to
We disagree.17
17
Respondent relies heavily on a letter dated Nov. 25,
1985, that Mr. Heitzman wrote to the Atlanta Appeals Office in
response to a request for information from him concerning
petitioner. In that letter, Mr. Heitzman stated that he and
petitioner “reviewed very carefully any investment either one of
us made during our marriage”. At trial in the case at hand,
Mr. Heitzman recanted what he wrote in the letter.
Mr. Heitzman wrote that letter less than 2 years after he
and petitioner were divorced. In 1985, Mr. Heitzman was still
very bitter over the failure of his marriage with petitioner.
Compounding Mr. Heitzman’s bitterness was the bankruptcy of both
of his businesses because of the death of his partner, who was
also one of his major financial backers, and the financial
failure of his other major financial backer. To make matters
worse, Mr. Heitzman was also in the early stages of litigation
concerning the deficiency arising from the Stonehurst deductions
that eventually culminated in the decision in Heitzman v.
Commissioner, supra. He also had not yet been discharged from
bankruptcy and may well have hoped for contribution from
petitioner irrespective of the “hold harmless” clause in the
divorce settlement agreement.
(continued...)
- 41 In Bokum v. Commissioner, 94 T.C. 126 (1990), affd. on
another ground 999 F.2d 1132 (11th Cir. 1993), we held that “the
taxpayer claiming innocent spouse status must establish that he
or she is unaware of the circumstances that give rise to error on
the tax return and not merely to be unaware of the tax
consequences”.
Id. at 145-146 (citing Purcell v. Commissioner,
86 T.C. 228, 238 (1986), affd. 826 F.2d 470 (6th Cir. 1987)).
In
Bokum v. Commissioner, supra at 146, we held that a putative
innocent spouse’s knowledge of the relevant underlying
transaction incident to the grossly erroneous deduction and the
appearance of a large, unexplained deduction on the face of the
income tax return, id. at 148, are both independently sufficient
to cause the putative innocent spouse either to have a reason to
know of the substantial understatement of tax incident to a
grossly erroneous deduction or to impose upon her a duty to
inquire.
17
(...continued)
At trial, Mr. Heitzman explained his state of mind:
you put all that together, and it was pretty * * *
devastating. And so, you know, I felt my world has
fallen apart. I was bitter because of the marriage
that didn’t work. I’m sorry. * * * I take full
responsibility * * * [for] the letter I wrote * * *
[which] doesn’t reflect the facts * * * when I now can
look at it later.
Based upon Mr. Heitzman’s testimony at trial and the
evidence in the record directly contradicting allegations in the
letter, we give the letter no credence.
- 42 With respect to petitioner’s knowledge of the underlying
transaction, which in this case was Mr. Heitzman’s purchase of
the Stonehurst interest in December 1979, petitioner knew of the
bare existence of the transaction, but little more.
Both
Mr. Heitzman’s testimony and that of petitioner herself show that
he informed her of his purchase either shortly before it was made
or at some point thereafter, prior to the filing of the 1979
return.
In considering whether this bare knowledge of the
transaction is sufficient to hold petitioner to have had reason
to know of the understatement, we must consider several factors
used by this Court and others:
(1) The putative innocent
spouse’s level of education; (2) her involvement in the family’s
financial affairs; (3) the putative guilty spouse’s evasiveness
or deceit concerning the family’s finances, and; (4) the presence
of lavish or unusual expenditures or any large unexplained
increase in the family’s standard of living.
Flynn v.
Commissioner, 93 T.C. 355, 365-366 (1989); see also Silverman v.
Commissioner, T.C. Memo. 1996-69, revd. on other grounds 116 F.3d
172 (6th Cir. 1997).
Petitioner was a woman of limited education and no financial
sophistication who trusted Mr. Heitzman and deferred to him on
all business matters.
Mr. Heitzman told petitioner that the
Stonehurst partnership was a tax shelter “in oil and gas” that
would make some money, facts that, to petitioner, were consistent
- 43 with a legitimate investment in light of contemporaneous
instability in oil prices and supplies.
Given petitioner’s lack
of financial sophistication, the minimal explanation that she
received from Mr. Heitzman was sufficient to apprise her of the
existence of the transaction and to allay any questions she might
have had under the circumstances, while leaving her effectively
without any substantive knowledge of the transaction.
Petitioner’s awareness that Stonehurst was a “tax shelter”
is not particularly probative, in the context of her limited
financial sophistication, of whether she substantively knew of
the underlying transaction.
As we have observed in similar
cases, in the late 1970's and early 1980's, a person such as
petitioner who did not understand tax matters could quite
reasonably interpret the term “tax shelter” as legitimately
sheltering income from tax, see, e.g., Foley v. Commissioner,
T.C. Memo. 1995-16, especially in light of Mr. Heitzman’s comment
that Stonehurst would “make a lot of money”.
It was common
knowledge in the 1980's and earlier that “wily investors could
find legal ways and means of attaining spectacular tax benefits
through cunning investment strategies.”
Commissioner, 53 F.3d at 531.
Friedman v.
The fact that Stonehurst “was in
oil and gas” in 1979, a time when oil prices were rising, only
lent further credence to its potential value as a legitimate and
possibly quite lucrative investment.
- 44 That petitioner was satisfied by Mr. Heitzman’s superficial
explanation of the Stonehurst transaction precisely captures how
uninvolved she was in the family’s financial affairs.
The only
joint investment that Mr. Heitzman and petitioner made together
was their home.
Mr. Heitzman routinely made investment decisions
during their marriage with no participation by petitioner.
In
petitioner’s mind, the Stonehurst purchase was like every other
business transaction that Mr. Heitzman had made during their
marriage:
It was his property and his affair, and petitioner was
not privy to any meaningful information about it.
Petitioner did
not review any documentation such as the Stonehurst Memorandum or
the purchase contract or assumption agreements.
She knew nothing
of the substance of the transaction, nor did Mr. Heitzman discuss
with her any of its salient substantive aspects.
While Mr. Heitzman was neither evasive nor deceptive with
petitioner about his investment and other financial decisions, by
the same token, he brooked no intrusion by petitioner into what
he considered his affairs.
Mr. Heitzman regarded the Stonehurst
purchase and his other, legitimate investments to be his, funded
with his money.
Petitioner had no role in deciding whether to
purchase the Stonehurst interest.
She also remained uninvolved
in subsequently claiming the deductions incident to that
transaction on their 1979 joint income tax return.
In any case,
given the context of her and Mr. Heitzman’s marital relationship,
petitioner would never have expected to have had such a role.
- 45 Just as surely as if Mr. Heitzman had deliberately hidden the
transaction from petitioner, or had deliberately deceived her
about its existence or its tax consequences, the dynamics of
their marital relationship effectively walled petitioner off from
any substantive knowledge of the transaction.
The record also does not reflect any change in the family’s
standard of living during the 1979-80 timeframe.
Indeed, the
only change in standard of living was a precipitous decline in
petitioner’s standard of living in the aftermath of their 1983
divorce.
With respect to the appearance on the 1979 return of the
deductions related to Stonehurst, we find that, at the time the
return was signed, their appearance on the return would not have
caused petitioner to have reason to know of the understatement.
To all appearances, they were perfectly valid.
Any questions
that their size might have engendered had already been allayed
because Mr. Heitzman had already apprised petitioner of the
purchase in a way that fully legitimized it in her eyes.
Furthermore, the return had been prepared and signed by a
prominent accounting firm as income tax return preparer and was
without any apparent defect.
Compare Bokum v. Commissioner, 94
T.C. at 147-148 (taxpayer incurred a duty to inquire by signing a
return prepared, but not signed, by an income tax return
preparer, which contained a huge, unexplained deduction and an
obvious arithmetic error).
- 46 Alexander Grant, a prominent national accounting firm, had
prepared the 1979 return without raising any question about the
Stonehurst deductions.
Alexander Grant had prepared each of the
joint returns from 1973 to 1981 for Mr. Heitzman and petitioner.
Under the circumstances, petitioner was entitled to rely upon the
imprimatur of legitimacy that Alexander Grant lent to the joint
return.
To petitioner, cognizant of Mr. Heitzman’s explanation
and the manner in which the return was prepared, nothing was
amiss.18
Even if we were to find that the return should have alerted
a reasonable taxpayer to question the deduction as not being
legitimate--and we do not so find--to impose a duty to inquire on
petitioner under these circumstances would be to impose a duty to
perform a futile act.
Reser v. Commissioner, 112 F.3d 1258, 1269
(5th Cir. 1997), affg. in part and revg. in part T.C. Memo. 1995572.
She already knew that a qualified income tax return
preparer had prepared the return without question, and the duty
to inquire “does not extend so far as to impose on a spouse the
18
The lack of mention in the record that Alexander Grant
questioned the deductions claimed pursuant to Stonehurst when it
prepared petitioner’s and Mr. Heitzman’s 1979 joint return does
not change the analysis of whether those deductions were grossly
erroneous. We cannot determine from the record whether Alexander
Grant’s actions were reasonable or not in signing the return
based on the information available to them, nor need we answer
that question. It suffices for our purposes that the return was
signed by a respected income tax return preparer, and petitioner
acted reasonably in relying on that signature with respect to
whether petitioner should have questioned the validity of the
deductions claimed on the returns.
- 47 duty to seek advice from her own independent legal and financial
advisers”.
Friedman v. Commissioner, 53 F.3d at 531.
Even if
petitioner had asked any questions, her lack of financial
sophistication, her nonexistent role in Mr. Heitzman’s business
and investment activities, and Mr. Heitzman’s attitude toward
petitioner’s participation in those affairs, would have allowed
her to uncover no more than she already knew.
Had Mr. Heitzman
shown petitioner the pertinent documents, their aura of
verisimilitude would have provided her with little to question.
The fundamental mendacity of the documents could have been
uncovered only by a much more sophisticated and skeptical
investor--which, in 1980, petitioner was not.
Even the warning
to seek the opinion of independent tax counsel would not have
caused petitioner to question the deductions claimed on the
return because the return bore the imprimatur of an independent
and respected income tax return preparer.
For purposes of sec. 6013(e)(1)(C), we find that, under the
circumstances of this case, petitioner neither knew nor had
reason to know of the understatement on the 1979 joint income tax
return.
She had no effective knowledge of the relevant
underlying transaction nor did she have a duty to inquire into
the validity of the deductions arising from the transaction that
were claimed on the 1979 joint income tax return.
Bokum v.
Commissioner, 94 T.C. at 145-148; Flynn v. Commissioner, 93 T.C.
at 365-366.
- 48 3.
Equities
Petitioner must show, based on all the facts and
circumstances, that it would be inequitable to hold her liable
for the deficiency attributable to the substantial
understatement.
Regs.
Sec. 6013(e)(1)(D); sec. 1.6013-5(b), Income Tax
Relevant factors include:
(1) Whether the taxpayer
seeking relief significantly benefited, directly or indirectly;
(2) whether the spouse seeking relief has been deserted,
divorced, or separated from the other spouse, and; (3) the
probable hardships that would befall the spouse seeking relief if
she were not relieved of joint liability.
The record reveals that petitioner did not significantly
benefit from the grossly erroneous deduction attributable to Mr.
Heitzman’s interest in Stonehurst.
purchasing his interest.
Mr. Heitzman spent $43,400
His total claimed State and Federal
income tax savings were $66,990.
Mr. Heitzman netted no more
than $23,590 from the Stonehurst deductions.
show the disposition of these funds.
The record does not
However, money being
fungible, petitioner must show that she did not even indirectly
benefit.
Normal support does not constitute a “significant benefit”,
Flynn v. Commissioner, supra at 367, and is measured by the
circumstances in each case, id.
Petitioner’s and Mr. Heitzman’s
standard of living, while comfortable throughout this period, did
not appreciably change in 1979 or thereafter until they separated
- 49 in 1982, when petitioner’s disposable income dropped
precipitously.
The remodeling of the family residence was completed and
paid for prior to Mr. Heitzman’s ever having contemplated the
purchase of his interest in Stonehurst and was not funded in any
way by the tax savings.
Indeed, petitioner had used her own
limited resources in 1979 to make additional improvements to the
residence.
Even if the cost of remodeling could have been traced
indirectly to the tax savings, the remodeling contributed little
to any increase in the value of the residence between 1979 and
1982, when it was sold pursuant to their divorce settlement.
Such increases were entirely attributable to market forces and
the desirable location and quality of the house.
Another factor to be taken into account is the 1983 divorce
between petitioner and Mr. Heitzman.
Flynn v. Commissioner, 93
T.C. at 367; sec. 1.6013-5(b), Income Tax Regs.
There is nothing
in the record to indicate that petitioner received any more in
the divorce settlement, which primarily consisted of her share of
the proceeds from the sale of the residence and about $14,000 in
alimony, than she otherwise would have.
In view of
the standard
of living that petitioner and Mr. Heitzman enjoyed while married,
such a settlement is well within the bounds of normal support.
See, e.g., Foley v. Commissioner, T.C. Memo. 1995-16.
The
divorce also takes on added importance in light of the provision
in the settlement agreement whereby Mr. Heitzman agreed to
- 50 indemnify petitioner for all deficiencies arising from their
joint returns and of Mr. Heitzman’s subsequent bankruptcies in
1984 and 1990, which have apparently relieved him of his
obligations under the divorce settlement agreement.
Despite Mr. Heitzman’s agreement in the divorce settlement
that he was and would be responsible for any income tax
deficiencies, his 1990 bankruptcy discharged him from any
liability on the deficiency upheld against him in Heitzman v.
Commissioner, T.C. Memo. 1987-109, thus imposing on petitioner
the burden of paying the deficiency of $55,263 and more than 17
years of accrued interest of at least four times that amount if
she does not qualify for innocent spouse relief.
Finally, respondent argues, citing McCoy v. Commissioner, 57
T.C. 732, 734-735 (1972), that both Mr. Heitzman and petitioner
were equally ignorant of the income tax consequences of the
Stonehurst deduction and should therefore be held jointly liable.
Respondent’s reliance on McCoy v. Commissioner, supra, is
misplaced.
The case at hand is one that the innocent spouse
provisions were intended to reach--Mr. Heitzman and petitioner
were not equally ignorant of the income tax consequences of the
Stonehurst deduction.
Cf. Pewitt v. Commissioner, T.C. Memo.
1997-288 (wife and husband were equally knowledgeable--and
equally ignorant of Federal income tax consequences--wife
attended sales meeting where both she and husband were informed
of tax benefits and risks).
Mr. Heitzman was consciously trying
- 51 to shelter income from taxation in 1979.
While Mr. Heitzman was
not guilty of any wrongdoing in striving to minimize his tax
burden, he failed to ensure that he was not taking a frivolous
position in claiming the deductions.
By his own admission, he
did no research and did not seek an opinion from independent tax
counsel either prior to his purchase of the interest or prior to
claiming the deductions on the 1979 return.19
Furthermore, the Stonehurst interest was entirely Mr.
Heitzman’s.
He had all of the relevant information solely in his
possession--including the warning to seek the opinion of an
independent tax counsel--and he should have known that the
deductions were, to say the least, questionable.
Petitioner was
privy to none of that information, and, as we have already found,
she had no reason to know of the understatement because Mr.
Heitzman had given her sufficient information to dispel any
disquiet she might have had under the circumstances.
Friedman v.
Commissioner, 53 F.3d at 531; Foley v. Commissioner, supra.
Thus, we find that it would be inequitable, under the facts and
circumstances of this case, to hold petitioner liable for the
19
There is nothing in the record to indicate whether the
Alexander Grant income tax return preparers were apprised of
sufficient facts concerning Stonehurst to cause them to question
the deduction more closely. That issue is not relevant to this
case. What the record does reflect is that, as far as petitioner
was concerned, Alexander Grant had given the return its
imprimatur by preparing and signing it without comment. Cf.
Bokum v. Commissioner, 94 T.C. 126, 147-148, 156 (1990), affd. on
another ground 992 F.2d 1132 (11th Cir. 1993).
- 52 deficiency attributable to the understatement on the 1979 tax
return.
Petitioner has established every element of entitlement to
innocent spouse relief.
By reason of the foregoing,
Decision will be entered
for petitioner.
This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.