James H. Swanson and Josephine A. Swanson v. Commissioner , 106 T.C. No. 3 ( 1996 )

106 T.C. No. 3UNITED STATES TAX COURT
JAMES H. SWANSON AND JOSEPHINE A. SWANSON, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 21203-92. Filed February 14, 1996.
Ps filed a motion for reasonable litigation costs
pursuant to Rule 231, Tax Court Rules of Practice and
Procedure, and sec. 7430, I.R.C., claiming that R was
not substantially justified in determining that: (1)
Prohibited transactions had occurred under sec. 4975,
I.R.C., with respect to a domestic international sales
corporation, a foreign sales corporation, and two
individual retirement accounts; and (2) the sale of Ps'
Illinois residence to P's closely held corporation was
a sham transaction.
1. Held: R was not substantially justified with
respect to the first issue, but was substantially
justified with respect to the second issue.
2. Held, further, net worth, for purposes of the
Equal Access to Justice Act, 28 U.S.C. sec.
2412(d)(2)(B) (1994), as incorporated by sec.
7430(c)(4)(A)(iii), is determined based upon the cost
of acquisition rather than the fair market value of
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assets, and was less than $2 million each with respect
to Ps on the date their petition was filed.
3. Held, further, Ps' failure to request an Appeals
Office conference did not constitute a "[refusal] * * *
to participate in an Appeals office conference" within the
meaning of sec. 301.7430-1(e)(2)(ii), Proced. & Admin.
Regs., and, because no 30-day letter was issued to
Ps prior to the mailing of their notice of deficiency,
Ps are deemed to have per se exhausted their
administrative remedies for purposes of sec.
7430(b)(1).
4. Held, further, Ps have not unreasonably
protracted the proceedings within the meaning of sec.
7430(b)(4).
5. Held, further, the amount sought by Ps for
litigation costs in this matter is not reasonable and
must be adjusted to comport with the record.
Neal J. Block and Maura Ann McBreen, for petitioners.
Gregory J. Stull, for respondent.
OPINION
DAWSON, Judge: This case was assigned to Special Trial
Judge John F. Dean pursuant to the provisions of section
7443A(b)(4) and Rules 180, 181, and 183.1 The Court agrees with
and adopts the Special Trial Judge's opinion, which is set forth
below.
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code. All Rule references are to the Tax
Court Rules of Practice and Procedure.
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OPINION OF THE SPECIAL TRIAL JUDGE
DEAN, Special Trial Judge: This matter is before the Court
pursuant to petitioners' motion for award of reasonable
litigation costs under section 7430 and Rule 231.
References to petitioner are to James H. Swanson.
The matter before us involves petitioners' combined use of a
domestic international sales corporation, a foreign sales
corporation, and two separate individual retirement accounts as a
means of deferring the recognition of income. Respondent
zealously strove to characterize this arrangement, as well as an
unrelated sale by petitioners of their Illinois residence, as tax
avoidance schemes. A protracted period of entrenchment ensued,
during which the parties firmly established their respective
positions, neither side wavering from its conviction that it was
in the right. Ultimately, however, these issues were resolved by
respondent's notice of no objection to petitioners' motion for
partial summary judgment as well as the entry of an agreed
decision document, which was later set aside and filed as a
stipulation of settlement. As a consequence, petitioners now
seek redress for what they claim were unreasonable positions
taken by respondent.
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A. Factual Background
Petitioners resided in Florida at the time the petition was
filed. At all times relevant to the following discussion,
petitioner was the sole shareholder of H & S Swansons' Tool
Company (hereinafter, Swansons' Tool), which has operated as a
Florida corporation since 1983.2 Swansons' Tool elected to be
taxed as a subchapter S corporation effective in 1987.
Swansons' Tool is in the business of building and painting
component parts for various equipment manufacturers. As a part
of these activities, Swansons' Tool manufactures and exports
property for use outside the United States.
1. The DISC and IRA #1
Following the advice of experienced counsel, petitioner
arranged in the early part of January 1985 for the organization
of Swansons' Worldwide, Inc., a domestic international sales
corporation (hereinafter the DISC or Worldwide). During this
period, petitioner also arranged for the formation of an
individual retirement account (hereinafter IRA #1).
The articles of incorporation for Worldwide were filed on
January 9, 1985, and under the terms thereof petitioner was
named the corporation's initial director. Shortly thereafter,
2
Initially organized as a corporation in the State of
Illinois, Swansons' Tool was subsequently merged into a newly
formed Florida corporation of the same name on Dec. 30, 1983.
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Worldwide filed a Form 4876A, Election to be Treated as an
Interest Charge DISC.
A Form 5305, Individual Retirement Trust Account, was filed
on January 28, 1985, establishing Florida National Bank
(hereinafter Florida National) as trustee of IRA #1, and
petitioner as the grantor for whose benefit the IRA was
established. Under the terms of the IRA agreement, petitioner
retained the power to direct IRA #1's investments.
On the same day that the Form 5305 was filed, petitioner
directed Florida National to execute a subscription agreement for
2,500 shares of Worldwide original issue stock. The shares were
subsequently issued to IRA #1, which became the sole shareholder
of Worldwide.
For the taxable years 1985 to 1988, Swansons' Tool paid
commissions to Worldwide with respect to the sale by Swansons'
Tool of export property, as defined by section 993(c). In those
same years, petitioner, who had been named president of
Worldwide, directed, with Florida National's consent, that
Worldwide pay dividends to IRA #1.3 Commissions paid to
3
The following dividends were paid by Worldwide to IRA #1
during the taxable years 1986 through 1988:
Paid Date Fiscal Year Amount
4/8/86 12/31/86 $244,576
2/10/87 12/31/87 126,155
12/29/87 12/31/87 100,519
(continued...)
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Worldwide received preferential treatment,4 and the dividends
paid to IRA #1 were tax deferred pursuant to section 408. Thus,
the net effect of these transactions was to defer recognition of
dividend income that otherwise would have flowed through to any
shareholders of the DISC.
In 1988, IRA #1 was transferred from Florida National Bank
to First Florida Bank, N.A. (hereinafter First Florida), as
custodian. Swansons' Tool stopped paying commissions to
Worldwide after December 31, 1988, as petitioners no longer
considered such payments to be advantageous from a tax planning
perspective.
2. The FSC and IRA #2
In January 1989, petitioner directed First Florida to
transfer $5,000 from IRA #1 to a new individual retirement
custodial account (hereinafter IRA #2). Under the terms of the
IRA agreement, First Florida was named custodian of IRA #2, and
petitioner was named as the grantor for whose benefit the IRA was
established. Under the terms of the IRA agreement, petitioner
3
(...continued)
12/30/88 12/31 88 122,352
Total 593,602
No distributions were made to petitioners from the trust during
the years at issue.
4
Under sec. 991, except for the taxes imposed by ch. 5, a
DISC is not subject to income tax.
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reserved the right to serve as the "Investment Manager" of
IRA #2.
Contemporaneous with the formation of IRA #2, petitioner
incorporated H & S Swansons' Trading Company (hereinafter
Swansons' Trading or the FSC). Petitioner directed First Florida
to execute a subscription agreement for 2,500 newly issued shares
of Swansons' Trading stock. The shares were subsequently issued
to IRA #2, which became the corporation's sole shareholder.
Swansons' Trading filed a Form 8279, Election To Be Treated as a
FSC or as a Small FSC, on March 31, 1989, and paid a dividend to
IRA #2 in the amount of $28,000 during the taxable year 1990.
3. The Algonquin Property
In anticipation of Swansons' Tool's transferring its
operations to Florida, petitioners moved during 1981 from their
Algonquin, Illinois, residence (hereinafter, the Algonquin
property or the property) to a condominium in St. Petersburg,
Florida. The Algonquin property was not advertised for sale
until sometime during 1983.
Conscious of a change in the Internal Revenue Code which
would eliminate preferential treatment of capital gain recognized
on the sale of their home, petitioners sought to sell the
Algonquin property prior to December 31, 1986.5 As time was
5
The Tax Reform Act of 1986 (TRA), Pub. L. 99-514, sec.
301(a), 100 Stat. 2085, 2216, eliminated the deduction under sec.
(continued...)
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clearly a factor, petitioners arranged to sell the property to a
trust of which Swansons' Tool was the beneficiary. Accordingly,
on December 19, 1986, petitioners conveyed the Algonquin property
to "Trust No. 234, Barry D. Elman, trustee," (hereinafter Trust
No. 234) under a Deed in Trust, which was received and filed by
the Recorder for the city of McHenry, Illinois. As a consequence
of this transaction, petitioners reported a long-term capital
gain of $141,120.78 on Schedule D, Capital Gains and Losses, of
their 1986 Federal income tax return, reflecting a $225,000 sale
price and an $83,879 basis.
Petitioners continued paying the electric bills, heating,
exterior maintenance, and house sitting expenses of the Algonquin
property through May or June of 1987. In March of 1988,
Swansons' Tool reimbursed petitioners for maintenance and repair
expenses incurred during the time period December 1986 through
May 1987, as well as the expense of moving petitioners' personal
belongings in September 1987. Swansons' Tool capitalized these
expenditures as part of its basis in the Algonquin property.
Subsequent to the signing of a "Real Estate Sales Contract"
during March of 1988, the Algonquin property was sold by
Swansons' Tool to an unrelated third party on June 23, 1988.
5
(...continued)
1202 for 60 percent of net long-term capital gains. The repeal
was effective for tax years beginning after Dec. 31, 1986.
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Petitioners' daughter, Jill, resided at the Algonquin
residence from May of 1987 through June of 1988. Although the
record is not clear as to the extent of usage, it appears that
petitioners also periodically stayed at the residence subsequent
to its sale on December 19, 1986.
4. The Notice of Deficiency
Despite petitioners' agreement to extend the period of
limitations in their case until June 30, 1992, petitioners did
not receive a 30-day letter prior to the notice of deficiency.
Petitioners agreed to the extension in the hope of resolving the
case at the administrative level.
In the notice of deficiency, dated June 29, 1992, respondent
set forth one primary and three alternative positions for
determining deficiencies in petitioners' Federal income taxes and
additions to tax for negligence with respect to petitioners'
1986, 1988, 1989, and 1990 taxable years. Of relevance to the
present matter were respondent's determinations that: (1)
"Prohibited transactions" had occurred which resulted in the
termination of IRA's #1 and #2; and (2) the sale of the Algonquin
property to a trust in 1986 was a "sham" transaction which could
not be recognized for tax purposes.
a. "Prohibited Transactions"
Because the notice of deficiency failed to adequately
explain respondent's bases for determining deficiencies
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and additions to tax with respect to the years at issue,
petitioners requested and received the revenue agent's report in
their case. As demonstrated by the revenue agent's report,
respondent identified, as alternative positions, two "prohibited
transactions" which resulted in the loss of IRA #1's status as a
trust under section 408. First, respondent concluded that:
Mr. Swanson is a disqualified person within the meaning
of section 4975(e)(2)(A) of the Code as a fiduciary
because he has the express authority to control the
investments of * * * [IRA #1].
Mr. Swanson is also an Officer and Director of
Swansons' Worldwide. Therefore, direct or indirect
transactions described by section 4975(c)(1) between
Swansons' Worldwide and * * * [IRA #1] constitute
prohibited transactions.
Mr. Swanson, as an Officer and Director of Worldwide
directed the payment of dividends from Worldwide to
* * * [IRA #1] * * * * The payment of dividends is a
prohibited transaction within the meaning of section
4975(c)(1)(E) of the Code as an act of self-dealing
where a disqualified person who is a fiduciary deals
with the assets of the plan in his own interest. The
dividend paid to * * * [IRA #1] December 30, 1988 will
cause the IRA to cease to be an IRA effective January
1, 1988 by reason of section 408(e)(1). Therefore, by
operation of section 408(d)(1), the fair market value
of the IRA is deemed distributed January 1, 1988.
[Emphasis added.]
As further demonstrated by the revenue agent's report,
respondent's second basis for disqualifying IRA #1 under section
408 was that:
In his capacity as fiduciary of * * * [IRA #1], Mr.
Swanson directed the bank custodian, Florida National
Bank, to purchase all of the stock of Swansons'
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Worldwide. At the time of the purchase, Mr. Swanson
was the sole director of Swansons' Worldwide.
The sale of stock by Swansons' Worldwide to
Mr. Swanson's Individual Retirement Account
constitutes a prohibited transaction within the meaning
of section 4975(c)(1)(A) of the Code. The sale
occurred February 15, 1985. By operation of section
408(e)(2)(A) of the Code, the Individual Retirement
Account ceases to be an Individual Retirement Account
effective January 1, 1985.
Effective January 1, 1985 the Individual Retirement
Account is not exempt from tax under section 408(e)(1)
of the Code. The fair market value of the account,
including the 2500 shares of Swansons' Worldwide, is
deemed to have been distributed to Mr. Swanson in
accordance with section 408(e)(2)(B) of the Code.
Therefore, Mr. Swanson effectively became the sole
shareholder of Swansons' Worldwide, Inc. with the loss
of the IRA's tax exemption. [Emphasis added.]
Although the record is not entirely clear on the matter, it
appears that respondent imputed to IRA #2 the prohibited
transactions found with respect to IRA #1 and used similar
reasoning to disqualify IRA #2 as a valid trust under section
408(a).
b. "Sham Transaction"
With respect to the Algonquin property, respondent concluded
in the notice of deficiency that:
the purported sale of your personal residence located
in Algonquin, Illinois by you in 1986 to Trust #234,
Barry D. Elman, Trustee, of which your corporation, H &
S Swansons' Tool Company, Inc. is the beneficiary, can
not be recognized for tax purposes. The purported sale
in 1986 was no more than a sham transaction which was
entered into for tax avoidance purposes. It is
determined that the purported sale served no other
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purpose than to enable you to obtain the tax benefit of
a long term capital gain deduction of 60 percent that
would not have been available had the sale occurred in
tax years subsequent to 1986. * * * [Emphasis added.6]
5. The Petition, Answer, Motion for Summary Judgment, and
Settlement Agreement
In their petition, filed September 21, 1992, petitioners
stated with respect to respondent's determination of "prohibited
transactions" that: (1) At all pertinent times IRA #1 was the
sole shareholder of Worldwide; (2) since the 2,500 shares of
Worldwide issued to IRA #1 were original issue, no sale or
exchange of the stock occurred; (3) from and after the dates of
his appointment as director and president of Worldwide,
Mr. Swanson engaged in no activities on behalf of Worldwide which
benefited him other than as a beneficiary of IRA #1; (4) IRA #1
was not maintained, sponsored, or contributed to by Worldwide
during the years at issue; (5) at no time did Worldwide have any
active employees; and (6) Mr. Swanson engaged in no activities on
behalf of Swansons' Trading which benefited him other than as a
beneficiary of IRA #2.
With respect to the Algonquin residence, petitioners stated,
in pertinent part, that: (1) On December 19, 1986, petitioners
conveyed the Algonquin property by a Deed in Trust to a trust of
6
Respondent used substantially similar language in setting
forth one primary and two alternative positions on this issue.
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which Swansons' Tool was the beneficiary; (2) the transfer
documents conveyed full legal and beneficial ownership from
petitioners to this trust; (3) at no time did petitioners act in
any manner that was inconsistent with their transfer of all their
right, title, and interest in the Algonquin property; and (4)
subsequent to the sale, petitioners had no rights as tenants of
the property other than as tenants at will.
Respondent filed an answer on November 13, 1992, denying, or
denying for lack of knowledge, each of the allegations listed
above.
Petitioners filed a motion for partial summary judgment on
March 22, 1993. In their motion, petitioners restated their
position, as set forth in their petition, that no prohibited
transactions had occurred with respect to IRA's #1 and #2.
On July 12, 1993, respondent filed a notice of no objection
to petitioners' motion for partial summary judgment, thereby
ending the controversy on the DISC and FSC issues.
Respondent conceded the Algonquin property issue in a
settlement agreement entered into on January 24, 1994. The
parties agreed at that time to a total deficiency of $11,372.40,
which reflected an amount conceded by petitioners in their
petition as capital gain inadvertently omitted from their 1988
Federal income tax. A stipulated decision (hereinafter the
decision) was submitted by the parties and entered on February 9,
1994.
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6. Motion for Award of Reasonable Litigation Costs
On March 14, 1994, this Court received petitioner Josephine
Swanson's motion for award of reasonable litigation costs
(hereinafter also referred to as the motion). Finding that it
was not petitioner Josephine Swanson's intent that the decision
entered on February 9, 1994, be conclusive as to the issue of
attorney's fees, the Court ordered on April 29, 1994, that the
decision be vacated and set aside. The Court further ordered
that the decision of February 9, 1994, be filed as a stipulation
of settlement, that petitioner Josephine Swanson's motion for
award of reasonable litigation costs be filed, and that
respondent file a response to petitioner Josephine Swanson's
motion in accordance with Rule 232(c).
Respondent's objection to petitioner Josephine Swanson's
motion for award of reasonable litigation costs was filed on June
29, 1994. Petitioners sought leave to file a response to
respondent's objection by a motion filed August 3, 1994, which
was granted.
Petitioners filed an amendment to the motion for award of
reasonable litigation costs (hereinafter amendment to motion) on
August 1, 1994, pursuant to which petitioner James Swanson joined
petitioner Josephine Swanson as a party to the motion.
Petitioners filed their response to respondent's objection
to petitioners' motion for award of reasonable litigation costs
on September 15, 1994.
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Following a conference call with the parties on March 20,
1995, the parties were ordered to file a stipulation of facts
with respect to items of net worth reported by petitioners on
attachment II of their amendment to motion. They were further
ordered to file a stipulation of facts regarding the issue of
attorney's fees paid or incurred by petitioners. If the parties
could not stipulate facts with respect to either issue, they were
ordered to file a status report with the Court on or before
May 1, 1995.
On May 1, 1995, the parties participated in a conference
call, during which they agreed to stipulate certain items of net
worth reported on attachment II of petitioners' amendment to
motion. The parties also agreed to stipulate that petitioners
paid or incurred fees in this matter. The parties disagreed,
however, as to the proper method for determining the acquisition
cost of specific items on attachment II of petitioners' amendment
to motion. With respect to these items, the parties were ordered
to file, on or before June 1, 1995, simultaneous memoranda of
law, and, on or before July 3, 1995, answering memoranda of law.
B. Discussion
As an initial matter, we reject respondent's argument that
it was improper for us to have vacated the decision of
February 9, 1994, thereby allowing petitioners to file their
motion for award of reasonable litigation costs. This Court may,
in its sound discretion, set aside a decision that has not yet
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become final. See, e.g., Cassuto v. Commissioner, 93 T.C. 256,
260 (1989), affd. in part, revd. in part, and remanded on another
issue 936 F.2d 736 (2d. Cir. 1991). Having so held, we turn to
the merits of petitioners' motion.
Section 7430 provides that, in any court proceeding brought
by or against the United States, the "prevailing party" may be
awarded reasonable litigation costs. Sec. 7430(a). To qualify
as a "prevailing party" for purposes of section 7430,
petitioners must establish that: (1) The position of the United
States in the proceeding was not substantially justified; (2)
they substantially prevailed with respect to the amount in
controversy, or with respect to the most significant issue
presented; and (3) they met the net worth requirements of 28
U.S.C. sec. 2412(d)(2)(B) (1994), on the date the petition was
filed. Sec. 7430(c)(4)(A). Petitioners must also establish that
they exhausted the administrative remedies available to them
within the Internal Revenue Service and that they did not
unreasonably protract the proceedings. Sec. 7430(b)(1), (4).
Petitioners bear the burden of proof with respect to each of the
preceding requirements. Rule 232(e).
Although it is conceded that petitioners substantially
prevailed in this case, respondent does not agree that her
litigation position was not substantially justified.7
7
Respondent argues that our consideration of whether she was
(continued...)
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Furthermore, respondent asserts that petitioners: (1) Have not
satisfied the net worth requirements, (2) failed to exhaust the
administrative remedies available to them within the Internal
Revenue Service, (3) unreasonably protracted the proceedings, and
(4) have not shown that the costs they have claimed are
reasonable. We will address each contested point in turn.
1. Whether Respondent's Litigation Position Was
Substantially Justified
In 1986, Congress amended section 7430 to conform that
provision more closely to the Equal Access to Justice Act
(EAJA). Tax Reform Act of 1986, Pub. L. 99-514, sec. 1551, 100
Stat. 2085, 2752. Where the prior statute required taxpayers to
prove that the Government's position in a proceeding was
"unreasonable," the statute as amended now requires a showing
that the position of the United States was "not substantially
justified." Sec. 7430(c)(4)(A)(i). This Court has concluded
that the substantially justified standard is essentially a
continuation of the prior law's reasonableness standard. Sher v.
7
(...continued)
substantially justified in this matter should be based, in part,
on the outcome of a related case involving IRA #1. In docket No.
21109-92, respondent determined, and IRA #1 ultimately conceded,
that IRA #1 had unrelated business income for the taxable year
1988. IRA #1's concession in docket No. 21109-92, however,
appears to have been a direct result of respondent's filing her
notice of no objection to petitioners' motion for summary
judgment in this case. In any event, we give no weight to the
outcome of docket No. 21109-92 because it resulted from an
agreement between the parties to that docket rather than a
judicial determination.
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Commissioner, 89 T.C. 79, 84 (1987), affd. 861 F.2d 131 (5th Cir.
1988). Thus, a position that is "substantially justified" is one
that is "justified to a degree that could satisfy a reasonable
person" or that has a "reasonable basis both in law and fact."
Pierce v. Underwood, 487 U.S. 552, 565 (1988) (internal quote
marks omitted) (defining "substantially justified" in the context
of the EAJA).
Petitioners have not sought an award of administrative costs
in this matter. Accordingly, we need only examine the question
of whether respondent's litigation position was substantially
justified.8
Respondent argues that we may not consider positions she
took prior to the filing of the answer in determining whether her
litigation position was substantially justified. In support,
respondent cites, among other cases,9 Huffman v. Commissioner,
978 F.2d 1139 (9th Cir. 1992), affg. in part and revg. in part
T.C. Memo. 1991-144.
8
Respondent's litigation position for purposes of this matter
is that taken on Nov. 13, 1992, the date the answer was filed.
See Han v. Commissioner, T.C. Memo. 1993-386.
9
To the extent respondent has cited for support cases which
discuss sec. 7430 prior to its amendment in 1986 by TRA sec.
1551, 100 Stat. 2085, 2752, and in 1988 by the Technical and
Miscellaneous Revenue Act of 1988, Pub. L. 100-647, sec. 6239,
102 Stat. 3342, 3743, we find them to be inapposite. See Sansom
v. United States, 703 F. Supp. 1505 (N.D. Fla. 1988).
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Respondent is correct in stating that Huffman approves of a
bifurcated analysis under section 7430, pursuant to which the two
stages of a case, the administrative proceeding and the court
proceeding, are considered separately. This bifurcated analysis:
not only ensures that the prevailing taxpayer is
reimbursed for pre-litigation and litigation costs, but
also supports Congress's intent that before an award of
attorney's fees is made, the taxpayer must meet the
burden of proving that the Government's position was
not substantially justified. It affords another
opportunity for the United States to reconsider an
inappropriate position. [Id. at 1146.]
Respondent's arguments on this point appear moot, however, as we
find no discernible difference between the administrative and
litigation positions she took in this matter.10 See Lennox v.
Commissioner, 998 F.2d 244, 247-249 (5th Cir. 1993) (holding that
the Government's position must be analyzed in the context of the
circumstances that caused it to take that position), revg. in
part and remanding T.C. Memo. 1992-382.
a. The DISC Issue
Petitioners contend that respondent was not substantially
justified in maintaining throughout the proceedings that
prohibited transactions had occurred with respect to IRA #1, and
by implication, IRA #2. We agree.
10
Respondent's administrative position for purposes of this
matter is that taken on June 29, 1992, the date of the notice of
deficiency. Sec. 7430(c)(2).
- 20 -
As stated previously, respondent based her determination of
prohibited transactions on section 4975(c)(1)(A) and (E).
Section 4975(c)(1)(A) defines a prohibited transaction as
including any "sale or exchange, or leasing, of any property
between a plan[11] and a disqualified person".12 Section
11
A "plan" is defined by sec. 4975(e)(1) to encompass an
individual retirement account as described under sec. 408.
12
As applicable to the following discussion, sec. 4975(e)(2)
defines a disqualified person as:
(A) a fiduciary;
* * * * * * *
(C) an employer any of whose employees are covered
by the plan;
(D) an employee organization, any of whose members
are covered by the plan;
* * * * * * *
(G) a corporation, partnership, or trust or estate
of which (or in which) 50 percent or more of--
(i) the combined voting power of all
classes of stock entitled to vote or the
total value of shares of all classes of stock
of such corporation,
(ii) the capital interest or profits
interest of such partnership, or
(iii) the beneficial interest of such
trust or estate, is owned directly or
indirectly, or held by persons described in
subparagraph (A), (B), (C), (D), or (E);
* * * * * * *
(H) an officer, director (or an individual having
(continued...)
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4975(c)(1)(E) further defines a prohibited transaction as
including any "act by a disqualified person who is a fiduciary[13]
whereby he deals with the income or assets of a plan in his own
interest or for his own account".
We find that it was unreasonable for respondent to maintain
that a prohibited transaction occurred when Worldwide's stock was
acquired by IRA #1. The stock acquired in that transaction was
newly issued--prior to that point in time, Worldwide had no
shares or shareholders. A corporation without shares or
12
(...continued)
powers or responsibilities similar to those of officers
or directors), a 10 percent or more shareholder, or a
highly compensated employee (earning 10 percent or more
of the yearly wages of an employer) of a person
described in subparagraph (C), (D), (E), or (G)
* * * [Emphasis added.]
13
In pertinent part, a "fiduciary" is defined by sec.
4975(e)(3) as any person who:
(A) exercises any discretionary authority or
discretionary control respecting management of such
plan or exercises any authority or control respecting
management or disposition of its assets, [or]
* * * * * * *
(C) has any discretionary authority or
discretionary responsibility in the administration of
such plan.
At all relevant times, petitioner maintained and exercised
the right to direct IRA #1's investments. Petitioner, therefore,
was clearly a "fiduciary" with respect to IRA #1 and thereby a
"disqualified person" as defined under sec. 4975(e)(2)(A).
Furthermore, as petitioner was the sole individual for whose
benefit IRA #1 was established, IRA #1 itself was a disqualified
person pursuant to sec. 4975(e)(2)(G)(iii).
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shareholders does not fit within the definition of a disqualified
person under section 4975(e)(2)(G).14 It was only after
Worldwide issued its stock to IRA #1 that petitioner held a
beneficial interest in Worldwide's stock, thereby causing
Worldwide to become a disqualified person under section
4975(e)(2)(G).15 Accordingly, the issuance of stock to IRA #1
14
Furthermore, we find that at the time of the stock issuance,
Worldwide was not, within the meaning of sec. 4975(e)(2)(C), an
"employer", any of whose employees were beneficiaries of IRA #1.
Although sec. 4975 does not define the term "employer", we find
guidance in sec. 3(5) of the Employee Retirement Income Security
Act of 1974 (ERISA), Pub. L. 93-406, 88 Stat. 829, 834. In
pertinent part, ERISA sec. 3(5) provides that, for plans such as
an IRA, an "'employer' means any person acting directly as an
employer, or indirectly in the interest of an employer, in
relation to an employee benefit plan * * *." Because Worldwide
did not maintain, sponsor, or directly contribute to IRA #1, we
find that Worldwide was not acting as an "employer" in relation
to an employee plan, and was not, therefore, a disqualified
person under sec. 4975(e)(2)(C). As there is no evidence that
Worldwide was an "employee organization", any of whose members
were participants in IRA #1, we also find that Worldwide was not
a disqualified person under sec. 4975(e)(2)(D).
15
Sec. 4975(e)(4) incorporates the constructive ownership rule
of sec. 267(c)(1), which states that:
Stock owned, directly or indirectly, by or for a
corporation, partnership, estate, or trust shall be
considered as being owned proportionately by or for its
shareholders, partners, or beneficiaries * * *
Petitioner, as the sole individual for whose benefit IRA #1
was established, was therefore beneficial owner of all the
outstanding shares of Worldwide after they were issued. Because
petitioner, as the sole beneficial shareholder of Worldwide, was
also a "fiduciary" with respect to IRA #1, Worldwide thus met the
definition of a disqualified person under sec. 4975(e)(2)(G).
Contrary to respondent's representations, petitioner was not
a "disqualified person" as president and director of Worldwide
until after the stock was issued to IRA #1. Sec. 4975(e)(2)(H).
Furthermore, petitioner was not a disqualified person under sec.
(continued...)
- 23 -
did not, within the plain meaning of section 4975(c)(1)(A),
qualify as a "sale or exchange, or leasing, of any property
between a plan and a disqualified person".16 Therefore,
respondent's litigation position with respect to this issue was
unreasonable as a matter of both law and fact.
We also find that respondent was not substantially justified
in maintaining that the payments of dividends by Worldwide to IRA
#1 qualified as prohibited transactions under section
4975(c)(1)(E). There is no support in that section for
respondent's contention that such payments constituted acts of
self-dealing, whereby petitioner, a "fiduciary", was dealing with
15
(...continued)
4975(e)(2)(H) solely due to his "shareholding" in Worldwide as
the constructive attribution rules provided under sec. 267 are
applicable only to sec. 4975(e)(2)(E)(i) and (G)(i). Sec.
4975(e)(4).
16
Ordinarily, controlling effect will be given to the plain
language of a statute unless to do so would produce absurd or
futile results. Rath v. Commissioner, 101 T.C. 196, 200 (1993)
(citing United States v. American Trucking Associations, 310 U.S.
534, 543-544 (1940)). As the Supreme Court has stated:
in the absence of a clearly expressed legislative
intention to the contrary, the language of the statute
itself must ordinarily be regarded as conclusive.
Unless exceptional circumstances dictate otherwise,
when we find the terms of a statute unambiguous,
judicial inquiry is complete. [Burlington No. R. v.
Oklahoma Tax Commn., 481 U.S. 454, 461 (1987);
citations and internal quotation marks omitted.]
Accordingly, when, as here, a statute is clear on its face, we
require unequivocal evidence of a contrary purpose before
construing it in a manner that overrides the plain meaning of the
statutory words. Rath v. Commissioner, supra at 200-201 (citing
Halpern v. Commissioner, 96 T.C. 895, 899 (1991); Huntsberry v.
Commissioner, 83 T.C. 742, 747-748 (1984)).
- 24 -
the assets of IRA #1 in his own interest. Section 4975(c)(1)(E)
addresses itself only to acts of disqualified persons who, as
fiduciaries, deal directly or indirectly with the income or
assets of a plan for their own benefit or account. Here, there
was no such direct or indirect dealing with the income or assets
of a plan, as the dividends paid by Worldwide did not become
income of IRA #1 until unqualifiedly made subject to the demand
of IRA #1. Sec. 1.301-1(b), Income Tax Regs. Furthermore,
respondent has never suggested that petitioner, acting as a
"fiduciary" or otherwise, ever dealt with the corpus of IRA #1
for his own benefit.
Based on the record, the only direct or indirect benefit
that petitioner realized from the payments of dividends by
Worldwide related solely to his status as a participant of IRA
#1. In this regard, petitioner benefited only insofar as IRA #1
accumulated assets for future distribution. Section 4975(d)(9)
states that section 4975(c) shall not apply to:
receipt by a disqualified person of any benefit to
which he may be entitled as a participant or
beneficiary in the plan, so long as the benefit is
computed and paid on a basis which is consistent with
the terms of the plan as applied to all other
participants and beneficiaries.
Thus, we find that under the plain meaning17 of section
4975(c)(1)(E), respondent was not substantially justified in
17
See the discussion supra note 16 regarding application of a
statute's plain meaning.
- 25 -
maintaining that the payments of dividends to IRA #1 constituted
prohibited transactions. Respondent's litigation position with
respect to this issue was unreasonable as a matter of both law
and fact.18
Respondent would have us believe that the delay in settling
the DISC issue was due to a statement in petitioners' motion for
partial summary judgment that IRA #1 was exempt from tax at all
times. In her memorandum in objection to petitioners' motion for
litigation costs, respondent contends that this was a "new and
overriding issue" that required her to determine whether "any
other" prohibited transactions had occurred during the period
covered by the notice of deficiency. We disagree.
We need look no further than respondent's own memorandum to
divine that the true reason for her delay in conceding the DISC
18
In a letter accompanying the revenue agent's report,
respondent stated that:
We believe the statutory Notice of Deficiency
adequately describes the adjustments asserted therein.
Moreover, during the course of the examination your
client became fully cognizant of the transactions under
scrutiny. However, as a convenience to you, enclosed
is a copy of the revenue agent's report. Naturally, it
is not the Service's intent by this letter to in any
way limit the general language of the statutory notice.
The Commissioner will stand on any ground fairly raised
by the statutory notice as a basis for her
determination.
In finding that respondent was not substantially justified with
respect to the DISC issue, we have considered all grounds upon
which respondent could fairly raise a question of prohibited
transactions under sec. 4975.
- 26 -
issue was her desire to discover new facts with which to
resuscitate her meritless litigation position. The following
statements from respondent's memorandum are illuminating in this
regard:
due to the complexity of the prohibited transaction
rules and the many ways in which disqualified person
status can be achieved through specific relationships
described in I.R.C. § 4975(e)(2), it was imperative
that respondent explore other possible violations
before conceding that the facts (as represented by
petitioner's counsel) demonstrated no violation.
* * * * * * *
Petitioner husband established the IRA and created
a DISC inside of his IRA to shelter from current income
inclusion dividend payments made by an international
trading company in which he was the sole shareholder.
But for the existence of the IRA, such dividends would
be currently taxable to him. If he had created the
DISC outside of the IRA, and then sold some or all of
the stock in the DISC to the IRA, the sale of stock in
the DISC to his IRA would clearly violate the
prohibited transactions rules under I.R.C. § 4975.
Similarly, the payment of any dividends from his wholly
owned corporation to his IRA that effectively allows
him to avoid current income inclusion because he
assigned his interest in the DISC to his IRA arguably
represents an indirect benefit to him personally.
For example, both petitioner husband and
petitioner wife indirectly received a significant
current tax benefit derived from the payment of DISC
dividends into his IRA, rather than to the husband as a
direct shareholder. But for the creation and
maintenance of the IRA, petitioner husband (and, by
virtue of her election to file a joint return, the
petitioner wife) would have current income inclusion
for payments from the trading corporation to the DISC.
Accordingly, the transactions between his wholly-owned
trading corporation to such entity are arguably
indirect prohibited transactions between disqualified
persons and the IRA. Also, since one slight variation
in the structure or operation of the petitioner's
transactions could have resulted in noncompliance with
- 27 -
the prohibited transactions rules, it was clearly
reasonable for respondent not to concede her position
on answer and to analyze thoroughly all positions
presented by petitioner's counsel during the litigation
stage of the case. [Emphasis added.]
We read the preceding statements as an acknowledgment by
respondent that her litigation position, as developed in the
administrative proceedings and adopted in her answer, was without
a foundation in fact or law. This case is distinguishable from
those in which respondent promptly conceded an unreasonable
position taken in her answer, thereby avoiding an award of
litigation costs. Nothing occurred between the filing of
respondent's answer and her notice of no objection to alter the
fact that she had misapplied the prohibited transaction rules of
section 4975 to petitioners' case. Accordingly, we find that
respondent's litigation position with respect to IRA #1 was not
substantially justified. Petitioners are therefore entitled to
an award of litigation costs under section 7430.
As respondent's determination of deficiencies with respect
to IRA #2 was inexorably linked to the fate of IRA #1, the award
of litigation costs is also intended to cover respondent's
litigation position with respect to IRA #2.19
b. The House Issue
Petitioners contend that respondent was not substantially
justified in determining that the sale of the Algonquin property
19
See discussion of IRA #2 supra p. 11.
- 28 -
to Trust No. 234 was a sham transaction. Respondent, on the
other hand, argues that such a determination was reasonable,
particularly in light of the postsale use by petitioners and
their daughter.
A "sham" transaction is one which, though it may be proper
in form, lacks economic substance beyond the creation of tax
benefits. Karr v. Commissioner, 924 F.2d 1018, 1022-1023 (11th
Cir. 1991), affg. Smith v. Commissioner, 91 T.C. 733 (1988). In
the context of a sale transaction, as here, the inquiry is
whether the parties have in fact done what the form of their
agreement purports to do. Grodt & McKay Realty, Inc. v.
Commissioner, 77 T.C. 1221, 1237 (1981).
The term "sale" is given its ordinary meaning for Federal
income tax purposes and is generally defined as a transfer of
property for money or a promise to pay money. Commissioner v.
Brown, 380 U.S. 563, 570-571 (1965). In deciding whether a
particular transaction constitutes a sale, the question of
whether the benefits and burdens of ownership have passed from
seller to buyer must be answered. This is a question of fact
which is to be ascertained from the intention of the parties, as
evidenced by the written agreements read in light of the
attendant facts and circumstances. Haggard v. Commissioner, 24
T.C. 1124, 1129 (1955), affd. 241 F.2d 288 (9th Cir. 1956).
- 29 -
Various factors to consider in making a determination as to
whether a sale has occurred were summarized in Grodt & McKay
Realty, Inc. v. Commissioner, supra at 1237-1238, as follows:
(1) Whether legal title passes; (2) how the parties
treat the transaction; (3) whether equity was acquired
in the property; (4) whether the contract creates a
present obligation on the seller to execute and deliver
a deed and a present obligation on the purchaser to
make payments; (5) whether the right of possession is
vested in the purchaser; (6) which party pays the
property taxes; (7) which party bears the risk of loss
or damage to the property; and (8) which party receives
the profits from the operation and sale of the
property. * * * [Citations omitted.]
An additional factor to be weighed is the presence or absence of
arm's-length dealing. Falsetti v. Commissioner, 85 T.C. 332, 348
(1985) (citing Estate of Franklin v. Commissioner, 64 T.C. 752(1975), affd. 544 F.2d 1045 (9th Cir. 1976)).
We recognize that a number of the factors listed above favor
petitioners' contention that the sale of the Algonquin property
was not a "sham" transaction. Nevertheless, the fact remains
that petitioners continued paying the heating, electricity,
security, and maintenance expenses incurred for the property
until sometime in June 1987; i.e., over 5 months after their sale
of the property to Trust No. 234. Petitioners also paid for a
number of repairs to the property prior to its sale to a third
party in 1988. Although petitioners were ultimately reimbursed
for all or part of these expenses, it appears that such
reimbursement did not occur until proximate to the time a
contract of sale was signed between Trust No. 234 and the third
- 30 -
party. Finally, we cannot discount the fact that petitioners and
their daughter occupied the property at various times between the
time of its sale to the trust and its ultimate sale to a third
party. In the case of the daughter, this period of occupancy
lasted just over 1 year and ended shortly before the property was
sold to the third party in June of 1988. The foregoing takes on
added significance in light of the fact that petitioner was on
"both sides" of the initial sale--both as owner of the property
and as the sole shareholder of Swansons' Tool. Combined with the
questionable business purpose behind a manufacturing
corporation's purchase of a personal residence, we do not find it
unreasonable that respondent would challenge the sale as not
being at arm's-length.
Based on the record as a whole, we cannot say that
respondent's position with respect to the house issue was
unreasonable, as a matter of either law or fact. We recognize
that petitioners have cited a number of cases supporting the
proposition that sales to close corporations by shareholders are
not "sham" transactions per se. We further note that petitioners
cited cases supporting the permissible occupancy of a residence
subsequent to its sale. A careful reading of each, however, does
not persuade us that, based on the facts of this case,
respondent's litigation position was not substantially justified.
- 31 -
Accordingly, we find that petitioners have failed to meet their
burden of proof on this issue.20
Our conclusion is not diminished by the fact that respondent
ultimately conceded this matter in petitioners' favor prior to
trial. The determination of whether respondent's position was
substantially justified is based on all the facts and
circumstances surrounding a proceeding; the fact that respondent
ultimately concedes or loses a case is not determinative. See
Wasie v. Commissioner, 86 T.C. 962, 968-969 (1986); DeVenney v.
Commissioner, 85 T.C. 927, 930 (1985).
2. Net Worth
Respondent contends that petitioners have failed to
demonstrate that they satisfied the net worth requirement of
section 7430(c)(4)(A)(iii).
To qualify as a prevailing party eligible for an award of
litigation costs, a taxpayer must establish that he or she has a
net worth that did not exceed $2 million "at the time the civil
action was filed".21 In the case of a husband and wife seeking
20
For similar reasons, we find that it was not unreasonable as
a matter of fact or law for respondent to contend in alternative
positions that the proceeds from the sale of the Algonquin
property should be adjusted between petitioners and Swansons'
Tool. Having carefully considered petitioners' arguments, we
find that they have not met their burden of proving that
respondent was not substantially justified on this point.
21
This requirement is set forth by implication in sec.
7430(c)(4), which states in pertinent part that:
(A) In general.--The term "prevailing party" means
any party in any proceeding to which subsection (a)
(continued...)
- 32 -
an award of litigation costs, the net worth test is applied to
each separately. Hong v. Commissioner, 100 T.C. 88, 91 (1993).
Although the term "net worth" is not statutorily defined,
the legislative history to the EAJA states: "In determining the
value of assets, the cost of acquisition rather than fair market
value should be used." H. Rept. 96-1418, at 15 (1980); see also
United States v. 88.88 Acres of Land, 907 F.2d 106, 107 (9th Cir.
1990); American Pacific Concrete Pipe Co., Inc. v. NLRB, 788 F.2d
586, 590 (9th Cir. 1986); Continental Web Press, Inc. v. NLRB,
767 F.2d 321, 322-323 (7th Cir. 1985).
To demonstrate that they each had a net worth of less than
$2,000,000 on the date their petition was filed, petitioners
submitted, on August 1, 1994, a "STATEMENT OF NET WORTH AT
ACQUISITION COST AS OF SEPTEMBER 21, 1992".22 Petitioners'
separate net worths were reported on this statement as follows:
21
(...continued)
applies
* * * * * * *
(iii) which meets the requirements of
* * * section 2412(d)(2)(B) of title 28,
United States Code (as in effect on October
22, 1986) * * *.
As applicable to this case, 28 U.S.C. sec. 2412(d)(2)(B)
provides that a "party" means "an individual whose net worth did
not exceed $2,000,000 at the time the civil action was filed."
22
This statement of net worth was submitted as "attachment II"
to petitioners' amendment to motion for award of reasonable
litigation costs. As noted by petitioners, the figures presented
therein are unadjusted for depreciation.
- 33 -
Asset Acq. Cost James Josephine
Cash/Checking $48,375 $24,188 $24,188
Money Fund 188,657 188,657 -
Repo Account 184,155 184,155 -
Mortgage 76,225 38,113 38,113
Mortgage 40,000 40,000 -
Contract 34,433 34,433 -
Note-1 26,815 26,815 -
Note-2 2,300 2,300 -
Note-3 80,000 80,000 -
Note-4 17,500 17,500 -
IRA-Kemper 9,000 9,000 -
IRA-Kemper 8,250 - 8,250
IRA-1st Fla. 2,500 2,500 -
IRA-1st Fla. 5,000 5,000 -
401-K Plan 45,000 45,000 -
Condo 185,000 - 185,000
Industrial Bldg. 107,500 - 107,500
Industrial Bldg. 260,000 - 260,000
Industrial Vacant 65,000 65,000 -
Stock - HSSTC 59,200 59,200 -
Prestige 23,500 - 23,500
Breck 25,000 25,000 -
West Coast 25,000 25,000 -
Sunshine 20,910 20,910 -
FSCC 5,000 5,000 -
Sailboat 85,000 85,000 -
Motorboat 8,000 8,000 -
Auto 17,000 20,000 [sic]
Art, etc. 40,000 20,000 20,000
Totals 1,694,322 [sic] 1,010,771 683,551
With an exception for the four IRA's, the 401(k) plan, and
the stock of the six listed corporations, the parties stipulated
on May 16, 1995, to the accuracy of the preceding statement.23
23
We note that petitioners omitted the asset identified as
"Florida Bonds" from their Aug. 1, 1994, statement of net worth
in the amount of $60,000 to be allocated half to each petitioner.
Petitioners have explained, and we accept, that this was an
(continued...)
- 34 -
Pursuant to our Order of May 1, 1995, the parties submitted
simultaneous and answering memoranda of law, addressing the
proper method for determining the acquisition cost of those
assets for which there had been no stipulation. As set forth in
these memoranda, petitioners argue for an approach whereby the
amount paid for an asset, adjusted for depreciation, establishes
the acquisition cost of an asset for purposes of the net worth
computation. Respondent, on the other hand, argues that the
acquisition cost of an asset should constantly be adjusted to
reflect realized (if not recognized) income. To quote
respondent:
In summary, acquisition costs of an asset are generated
not only from external contributions but also from
realized gains, the internal reinvestment of which
acquires an increase, improvement, or enhancement in
such asset.
Having carefully considered the parties' respective arguments, we
accept petitioners' computation of their net worth under section
7430(c)(4)(A)(iii). We find no basis in this case for
disregarding the separate legal status of entities in which
petitioners hold beneficial or legal interests. See, e.g.,
Moline Properties, Inc. v. Commissioner, 319 U.S. 436, 438-439
(1943); Webb v. United States, 15 F.3d 203, 207 (1st Cir. 1994);
23
(...continued)
accidental omission. The stipulation of facts contains other
nonmaterial modifications and corrections.
- 35 -
Bertoli v. Commissioner, 103 T.C. 501, 511-512 (1994); Allen v.
Commissioner, T.C. Memo. 1988-166.
Respondent argues that even if Congress originally intended
acquisition cost as the proper measure of net worth, relatively
recent trends in generally accepted accounting principles (GAAP)
require that such a measure be abandoned. We have considered
respondent's arguments on this point and find them off the mark.
While there has been a change in the rules regarding the method
by which individuals prepare their financial statements, there
has been no change in the definition of acquisition cost under
GAAP, and as that was the standard set forth in the legislative
history, it is the measure of net worth we apply to this case.24
After careful review of the record, we find that petitioners
have adequately set forth a statement of their net worth pursuant
to Rule 231(b)(5) and have met the burden of proving that their
separate net worths did not exceed $2 million on the date they
filed their petition.
We have considered all other arguments raised by respondent
regarding the net worth requirement and, to the extent not
24
As noted by the Courts of Appeals for the Ninth and Seventh
Circuits, "the cost of acquisition" under GAAP is arrived at by
subtracting accumulated depreciation from the original cost of an
asset. American Pacific Concrete Pipe Co., Inc. v. NLRB, 788
F.2d 586, 590-591 (9th Cir. 1986); Continental Web Press, Inc. v.
NLRB, 767 F.2d 321, 322-323 (7th Cir. 1985). We do not here
decide whether depreciation should be used in determining net
worth for purposes of sec. 7430(c)(4)(A), as petitioners'
separate net worths, whether computed using depreciation or not,
do not exceed $2 million.
- 36 -
discussed above, find them to be without merit. Before
continuing, however, we find it necessary to comment on some of
the arguments raised by respondent in her memoranda.
While there was colorable merit to some of the contentions
raised by respondent in her memoranda regarding the question of
net worth, others border on being frivolous and vexatious. As an
illustration, respondent set forth the following proposition in
arguing that additional amounts should be added to petitioner
Josephine Swanson's calculation of net worth:
Florida provides for the equitable distribution of
property between spouses upon divorce. Fla. Stat. ch.
61.075 (1994). * * *
Respondent notes that the record provides no indication
of marital disharmony between the petitioners and
presumes that Florida's equitable distribution statute
does not expressly apply to this case. However, this
significant expectancy to receive an equitable
distribution in the event of divorce may itself
constitute an asset of a spouse entitled to recognition
for purposes of the net worth computation.
Such transparent sophistry speaks for itself and comes perilously
close to meriting an award of fees to petitioners under section
6673(a)(2).
3. Exhaustion of Administrative Remedies
Notwithstanding our conclusion that respondent was not
substantially justified with respect to the DISC issue,
petitioners are not entitled to an award of litigation costs if
it is found that they failed to exhaust their administrative
remedies.
- 37 -
No "30-day letter" was issued to petitioners prior to the
issuance of the statutory notice of deficiency. Respondent
contends, however, that petitioners failed to exhaust their
administrative remedies by not seeking an Appeals Office
conference prior to the filing of their motion for summary
judgment. In support, respondent maintains that:
After commencing litigation, * * * [petitioners']
attorneys forged quickly ahead by filing a motion for
partial summary judgment without attempting to confer
with either Appeals or District Counsel to seek a
possible settlement--a conference which likely would
have eliminated the need for the parties to prepare a
prosecution and defense of the motion and its extensive
exhibits and attachments, perhaps resulting in reduced
litigation activities, saving time for the parties and
the Court.
In opposition, petitioners state that, pursuant to section
301.7430-1(e)(2), Proced. & Admin. Regs., they have per se
exhausted their administrative remedies.
In pertinent part, section 301.7430-1(e), Proced. & Admin.
Regs., sets forth the following exception to the general rule
that a party must participate25 in an Appeals Office conference
in order to exhaust its administrative remedies:
25
Sec. 301.7430-1(b)(2), Proced. & Admin. Regs., provides
that:
a party or qualified representative of the party * * *
participates in an Appeals office conference if the
party or qualified representative discloses to the
Appeals office all relevant information regarding the
party's tax matter to the extent such information and
its relevance were known or should have been known to
the party or qualified representative at the time of
such conference.
- 38 -
(e) Exception to requirement that party pursue
administrative remedies. If the conditions set forth
in paragraphs (e)(1), (e)(2), (e)(3), or (e)(4) of this
section are satisfied, a party's administrative
remedies within the Internal Revenue Service shall be
deemed to have been exhausted for purposes of section
7430.
* * * * * * *
(2) In the case of a petition in the Tax
Court--
(i) The party did not receive a notice
of proposed deficiency (30-day letter) prior
to the issuance of the statutory notice and
the failure to receive such notice was not
due to actions of the party (such as failure
to supply requested information or a current
mailing address to the district director or
service center having jurisdiction over the
tax matter); and
(ii) The party does not refuse to
participate in an Appeals office conference
while the case is in docketed status.
[Emphasis added.]
Section 301.7430-1, Proced. & Admin. Regs., fails to define the
phrase "does not refuse to participate".
Respondent's arguments suggest that section 301.7430-
1(e)(2), Proced. & Admin. Regs., is to be interpreted as
requiring an affirmative act by petitioners; i.e., a request for
an Appeals Office conference. Petitioners, on the other hand,
contend that the proper interpretation is one that puts the
burden on respondent, requiring that she act affirmatively.
Petitioners reason that they cannot "refuse to participate" in an
- 39 -
Appeals Office conference unless and until respondent makes an
offer of such a conference.26
We conclude that petitioners' reading of section 301.7430-
1(e)(2), Proced. & Admin. Regs., is correct. Section
601.106(d)(3), Statement of Procedural Rules, states that with
respect to cases docketed in the Tax Court:
(iii) If the deficiency notice in a case docketed in
the Tax Court was not issued by the Appeals office and no
recommendation for criminal prosecution is pending, the case
will be referred by the district counsel to the Appeals
office for settlement as soon as it is at issue in the Tax
Court. The settlement procedure shall be governed by the
following rules:
(a) The Appeals office will have exclusive
settlement jurisdiction for a period of 4 months over
certain cases docketed in the Tax Court. The 4 month
period will commence at the time Appeals receives the
case from Counsel, which will be after the case is at
issue. Appeals will arrange settlement conferences in
such cases within 45 days of receipt of the case. * * *
[Emphasis added.]
The notice of deficiency in this matter was issued by the
District Director for Jacksonville, Florida. There is no
suggestion that a recommendation for criminal prosecution was
ever pending against petitioners. Accordingly, pursuant to the
procedural rules, respondent's Appeals Office gained settlement
jurisdiction over petitioners' case after it was docketed in
this Court and maintained such jurisdiction for a period of
26
As we have not found any prior cases addressing this issue,
it appears that the correct interpretation of the meaning of the
regulation is one of first impression.
- 40 -
4 months. Contrary to the language of section
601.106(d)(3)(iii)(a), Statement of Procedural Rules, however,
Appeals in this case did not arrange a settlement conference
within 45 days of receipt of petitioners' case. Petitioners
could not, therefore, have refused to participate in an Appeals
Office conference, as none was ever offered.
We note that when a 30-day letter has been issued, the
procedural rules provide that, in general, the taxpayer is
entitled, as a matter of right, to an Appeals Office conference.
See sec. 601.106(b), Statement of Procedural Rules. No such
right exists, however, once the taxpayer's case is docketed in
the Tax Court. Furthermore, once the case is docketed, there is
no provision in the procedural rules for a taxpayer request for
an Appeals Office conference.
Based on the foregoing, we find that petitioners have
exhausted their administrative remedies within the meaning of
section 7430 and the regulations thereunder.
4. Whether Petitioners Unreasonably Protracted the
Proceedings
Based upon the record, we find that petitioners did not
protract the proceedings.
5. Whether the Fees Sought in This Matter Are Reasonable
As discussed below, we find that the amount sought by
petitioners in this matter for litigation costs is not reasonable
and must be adjusted to comport with the record.
- 41 -
C. Award of Litigation Costs
As an initial matter, we note that the parties disagree as
to whether the cost of living adjustment (COLA), which applies to
an award of attorney's fees under section 7430, should be
computed from October 1, 1981, or from January 1, 1986.27
Respectively, these are the two dates on which COLA's were first
provided under the EAJA and section 7430.
Our position on this issue was addressed in Bayer v.
Commissioner, 98 T.C. 19 (1992), where we concluded that
Congress, in providing for cost of living adjustments in section
7430, intended the computation to start on the same date the
COLA's were started under the EAJA; i.e., October 1, 1981. Id.
at 23. Citing Lawrence v. Commissioner, 27 T.C. 713 (1957),
revd. on other grounds 258 F.2d 562 (9th Cir. 1958), we stated
that we would continue to use 1981 as the correct year for making
the COLA calculation, unless, of course, the Court of Appeals to
which appeal lay had held otherwise. Golsen v. Commissioner, 54
T.C. 742, 756-757 (1970), affd. 445 F.2d 985 (10th Cir. 1971).
This case is appealable to the Court of Appeals for the 11th
Circuit, which has not addressed the question of whether 1981 or
1986 is the correct date for purposes of computing the COLA
27
Petitioners are seeking an award of fees based solely upon
the statutorily provided rate of $75 an hour, as adjusted by the
COLA. Sec. 7430(c)(1)(B)(iii). Petitioners have not argued that
there are "special factors" which would justify a higher rate in
this case. Id.- 42 -
adjustment under section 7430. Accordingly, we will follow our
holding in Bayer, and we find October 1, 1981, to be the
applicable date from which to make the adjustment.
1. Amount of Litigation Costs
Petitioners seek an award of litigation fees and expenses in
the total amount of $140,580.46. Petitioners have also asked
that they be awarded any additional costs incurred since March 1,
1994, to recover such fees and expenses. However, as explained
in the affidavit of petitioners' counsel filed as a supplement to
motion for litigation costs:
with counsel's acquiescence, Petitioners have paid to
date only $56,588 of the fees incurred on their behalf.
As a result of Baker & McKenzie's advisery role with
regard to the DISC Issue, Petitioners agreed after
Respondent fully conceded the case to pay only $40,000
of the unbilled fees incurred from December 1992 on
their behalf. The $40,000 amount was paid by the
Swansons from their Joint checking account. H.& S.
Swansons' Tool Co., Mr. Swanson's closely held
corporation and the client of record for bookkeeping
purposes, had previously paid $16,588 for services
rendered on petitioners' behalf between September and
November, 1992.
Petitioners agreed to allow Baker & McKenzie to recover
any remaining unbilled fees in excess of the $56,588
Petitioners have paid to date to the extent that
Petitioners prevail on * * * [their Motion for
Reasonable Litigation Costs.] [Emphasis added.]
Thus, beyond the $40,000 agreed to, there is no legal obligation
of petitioners to pay fees incurred on their behalf in the
judicial proceeding.28 Furthermore, based on the agreement
28
We find that to the extent of the $16,588 paid by Swansons'
Tool, petitioners did not "pay or incur" fees within the meaning
of sec. 7430. Although the nature of the agreement under which
(continued...)
- 43 -
detailed in the affidavits of petitioners' counsel, they incurred
no fees with respect to the preparation of their motion.
Petitioners did not, therefore, incur fees in this matter in an
amount greater than $40,000. See Marre v. United States, 38 F.3d
823, 828-829 (5th Cir. 1994); United States v. 122.00 Acres of
Land, 856 F.2d 56 (8th Cir. 1988) (applying sec. 304(a)(2) of the
Uniform Relocation Assistance and Real Property Acquisition
Policies Act of 1970, 42 U.S.C. sec. 4654(a); fees were not
actually "incurred" because the taxpayer had no legal obligation
to pay his attorney's fees); accord SEC v. Comserv Corp., 908
F.2d 1407, 1414 (8th Cir. 1990) (construing the EAJA, which
language the Court did not find to be significantly different
from that in United States v. 122.00 Acres of Land, supra); see
also Frisch v. Commissioner, 87 T.C. 858, 846 (1986) (lawyer
representing himself pro se was not entitled to fees for his own
services because such fees were not paid or incurred).
Because there is no mention in the affidavits of counsel
regarding the liability of petitioners for costs other than fees
incurred after December 1992, we find that petitioners are not
similarly restricted with respect to an award of "reasonable
court costs" under section 7430(c)(1)(A) or those items listed in
section 7430(c)(1)(B)(i) and (ii).
28
(...continued)
such payment was made is unclear, the ultimate effect was to
diminish the deterrent effect of the expense involved in seeking
review of, or defending against, unreasonable Government action.
See, e.g., SEC v. Comserv Corp., 908 F.2d 1407, 1413-1415 (8th
Cir. 1990).
- 44 -
We must apportion the award of fees sought by petitioners
between the DISC issue, for which respondent was not
substantially justified, and the Algonquin property issue, for
which respondent was substantially justified. Based on the
record, we find that for the period December 1992 until September
1993,29 a total of 312.9 hours was spent by counsel in connection
with the Court proceedings. Of this amount, 158.8 hours were
devoted to the DISC issue, 139.8 hours to the Algonquin property
issue, and 14.3 hours to general case management. Based upon the
$75-per-hour statutory rate, as adjusted by the COLA computed
from 1981, we find that petitioners are entitled to an award for
166.4 hours of fees paid to counsel.30
As for expenses other than fees, petitioners have asked for
total miscellaneous litigation costs in the amount of $6,512.33.
Based upon our evaluation of the total time spent on the DISC
issue, and our need to exclude miscellaneous expenses incurred
with respect to the Algonquin property issue, we find that
29
Pursuant to petitioners' agreement with counsel, December
1992 was the month from which they agreed to pay $40,000 of
unbilled fees incurred on their behalf. According to the
affidavits of counsel, September 1993 was the last month in which
fees were incurred to defend the DISC issue. Thus, this is the
only period for which petitioners may recover fees in this
matter.
30
We reach this figure based upon 158.8 hours devoted to the
DISC issue and 7.6 of general case management apportioned to the
DISC issue ((158.8 / (158.8 + 139.8) x 14.3 = 7.6).
- 45 -
petitioners are entitled to an award of miscellaneous expenses in
the amount of $3,300.
To reflect the foregoing,
An appropriate order will be
issued and decision will be entered
pursuant to Rule 155.