T.C. Memo. 1995-477
UNITED STATES TAX COURT
JULIUS AND HANAN DIBSY, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 16466-93. Filed October 4, 1995.
Julius Dibsy, pro se.
Roy Wulf, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GERBER, Judge: Respondent determined a deficiency in
petitioners' 1989 Federal income tax of $34,079 and additions to
tax under sections 66541 and 6662(a) in the amounts of $191 and
$6,816, respectively. The issues for our consideration are: (1)
1
All section references are to the Internal Revenue Code in
effect for the taxable year under consideration, and all Rule
references are to this Court's Rules of Practice and Procedure,
unless otherwise indicated.
- 2 -
Whether petitioners are entitled to defer, as a like-kind
exchange, the income realized on the sale of their liquor store;
(2) whether petitioners are liable for the addition to tax for
failure to make estimated income tax payments; and (3) whether
petitioners are liable for the addition to tax for substantial
understatement of income tax.
FINDINGS OF FACT
Petitioners, at all pertinent times, were married, and they
resided in Westminster, California, at the time their petition in
this case was filed. Julius and Hanan Dibsy (petitioners) have
been in the business of owning and operating liquor stores. On
January 17, 1986, petitioners purchased a liquor store in
Huntington Beach, California, from William D. Hanshaw (Hanshaw).
Petitioners changed the name of the store from "Hoovs Hut Liquor
#4" to "Sunshine Liquor". Petitioners paid $210,000 for the
noninventory assets of Sunshine Liquor.
During 1988, petitioners entered into discussions with
Hanshaw about obtaining a store with a larger volume of sales.
Petitioners learned that Hanshaw might sell "Bayshore Liquor", a
liquor store located in Seal Beach, California. Consequently,
petitioners immediately listed Sunshine Liquor for sale. On or
about March 23, 1988, they entered into an agreement to sell the
noninventory assets of Sunshine Liquor to Sathit and Supin
Sathavoran. On March 31, 1988, petitioners agreed to purchase
Bayshore Liquor from Hanshaw, and they gave him $10,000 in
- 3 -
"earnest money". On or about August 16, 1988, the Sathavorans
notified petitioners that they would not purchase Sunshine
Liquor.
Petitioners requested that Hanshaw release them from the
purchase of Bayshore Liquor. Hanshaw refused to return the
$10,000 "earnest money" and also refused to purchase Sunshine
Liquor from petitioners. However, Hanshaw allowed petitioners to
defer payment of a portion of the purchase price for Bayshore
Liquor by petitioners' issuing a note to Hanshaw in the amount of
$150,000 plus interest, which was secured by the assets of
Sunshine Liquor.
On October 5, 1988, petitioners purchased Bayshore Liquor
from Hanshaw for $434,593.82. Petitioners financed the purchase
as follows:
Seller $50,861.94
Demand note 75,000.00
Note to Hanshaw1 150,000.00
Credits through escrow 1,863.81
Check 156,868.07
Total 434,593.82
1
The note was due in 1 year, or upon the earlier sale of
Sunshine Liquor.
On March 31, 1989, petitioners sold Sunshine Liquor to Mr.
and Mrs. Nam Kyun and Sun Cha Shin for $286,423.63. This price
was allocated as follows:
Inventory $39,827.71
Other store assets 242,500.00
Lease deposit adjustment 3,800.00
Other 295.92
Total 286,423.63
- 4 -
Petitioners then disbursed the funds from the sale as
follows:
Payment of note to W. Hanshaw $46,641.16
Interest on above note to Hanshaw1 108.83
Payment of note to W. Hanshaw 158,850.00
Interest on above note to Hanshaw 900.15
Note to petitioners from purchasers 43,150.00
Inventory service 249.14
Escrow and closing costs 1,639.55
Creditors' claims paid 8,843.38
State Board of Equalization 19,483.57
Payoffs of preexisting loans 6,557.85
Total 286,423.63
1
We assume that "W. Hanshaw" and "Hanshaw" are both one and
the same person discussed elsewhere.
In connection with Sunshine Liquor, petitioners claimed a
total of $100,547 as depreciation and amortization expenses
during 1986, 1987, and 1988. Their basis in the noninventory of
Sunshine Liquor was $109,453 on March 31, 1989. The selling
price of these assets was $242,500.
From October 5, 1988, until March 31, 1989, petitioners
operated both Sunshine Liquor and Bayshore Liquor, and they were
entitled to any profits earned by either store. The parties
agree that if section 1031 does not apply to the disposition of
Sunshine Liquor, then petitioners must recognize a long-term
capital gain of $133,047 on the transaction.
OPINION
Respondent concluded that the purchase of one liquor store
and subsequent sale of another by petitioners were two separate
taxable events. Accordingly, respondent determined that
- 5 -
petitioners should have reported a long-term capital gain from
the sale of Sunshine Liquor. Petitioners agree that, in form, a
separate sale and purchase occurred. They contend, however,
that, in substance and when considered together, the transactions
resulted in a section 1031 like-kind exchange. Petitioners'
failure to include the capital gain as income is justified if
section 1031 is applicable.
Section 1001(c) generally requires that the entire amount of
gain or loss on the sale or exchange of property shall be
recognized. Section 1031(a)(1), however, provides for the
nonrecognition of such gain or loss when "property held for
productive use in a trade or business or for investment * * * is
exchanged solely for property of like kind which is to be held
either for productive use in a trade or business or for
investment."
The parties disagree on whether petitioner "exchanged"
Sunshine Liquor for Bayshore Liquor.2 Petitioners bear the
burden of establishing that respondent's determination is
erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115
(1933).
Essentially, section 1031 assumes that new property received
in an exchange is "'substantially a continuation of the old
2
For reasons that will become clear, we find it unnecessary
to address whether Bayshore Liquor and Sunshine Liquor were
property of like kind within the meaning of sec. 1031.
- 6 -
investment'". Commissioner v. P.G. Lake, Inc., 356 U.S. 260, 268
(1958) (quoting section 39.112(a)-1), Income Tax Regs.
(promulgated under the Internal Revenue Code of 1939), and
analyzing a tax-free exchange under section 112(b)(1) of the 1939
Code, a predecessor of section 1031). In an exchange of like-
kind property, "the taxpayer's economic situation after the
exchange is fundamentally the same as it was before the
transaction occurred." Koch v. Commissioner, 71 T.C. 54, 63
(1978). The U.S. Court of Appeals for the Fourth Circuit in
Coastal Terminals, Inc. v. United States, 320 F.2d 333, 337 (4th
Cir. 1963), stated:
The purpose of Section 1031(a), as shown by its
legislative history, is to defer recognition of gain or
loss when a direct exchange of property between the
taxpayer and another party takes place; a sale for cash
does not qualify as a nontaxable exchange even though
the cash is immediately reinvested in like property.
See also Magneson v. Commissioner, 753 F.2d 1490, 1494 (9th Cir.
1985), affg. 81 T.C. 767 (1983);3 Starker v. United States, 602
F.2d 1341, 1352 (9th Cir. 1979). In Barker v. Commissioner, 74
T.C. 555, 561 (1980), this Court noted:
The "exchange" requirement poses an analytical
problem because it runs headlong into the familiar tax
3
The case law, the regulations and the legislative history
are thus all in agreement that the basic reason for
nonrecognition of gain or loss on transfers of property under
sec. 1031 is that the taxpayer's economic situation after the
transfer is fundamentally the same as it was before the transfer:
his money is still tied up in investment in the same kind of
property. Magneson v. Commissioner, 753 F.2d 1490, 1494 (9th
Cir. 1985); affg. 81 T.C. 767 (1983).
- 7 -
law maxim that the substance of a transaction controls
over form. In a sense, the substance of a transaction
in which the taxpayer sells property and immediately
reinvests the proceeds in like-kind property is not
much different from the substance of a transaction in
which two parcels are exchanged without cash. Bell
Lines, Inc. v. United States, 480 F.2d 710, 711 (4th
Cir. 1973). Yet, if the exchange requirement is to
have any significance at all, the perhaps formalistic
difference between the two types of transactions must,
at least on occasion, engender different results.
Accord, Starker v. United States, 602 F.2d, 1341, 1352
(9th Cir. 1979).
Courts have afforded some latitude in structuring exchange
transactions. See, e.g., Magneson v. Commissioner, supra (change
in mechanism of ownership which does not significantly affect
amount of control or nature of underlying investment does not
preclude a tax-free exchange); Starker v. United States, supra at
1354-1355 (the transfers need not occur simultaneously);4
Alderson v. Commissioner, 317 F.2d 790, 793 (9th Cir. 1963),
revg. 38 T.C. 215 (1962) (parties can amend previously executed
sales agreement to provide for an exchange); Barker v.
Commissioner, supra at 562 (a party can hold transitory ownership
solely for the purpose of effectuating an exchange); Biggs v.
Commissioner, 69 T.C. 905, 913-914 (1978); affd. 632 F.2d 1171
(5th Cir. 1980) (multiple parties can be involved in an exchange
with parties not owning any property at the time of entering into
4
In 1984, sec. 1031 was amended by the enactment of sec.
1031(a)(3) to permit nonsimultaneous exchanges under certain
limited circumstances. This provision is more restrictive in
that regard than the decision in Starker v. United States, 602
F.2d 1341, 1352 (9th Cir. 1979).
- 8 -
an agreement to exchange); 124 Front Street, Inc. v.
Commissioner, 65 T.C. 6, 17-18 (1975) (taxpayer can advance money
toward purchase price of property to be exchanged); Coupe v.
Commissioner, 52 T.C. 394, 405, 409 (1969) (the taxpayer can
locate and negotiate for the property to be acquired); J.H. Baird
Publishing Co. v. Commissioner, 39 T.C. 608, 615 (1962) (the
taxpayer can oversee improvements on the land to be acquired);
Mercantile Trust Co. v. Commissioner, 32 B.T.A. 82, 87 (1935)
(alternative sales possibilities are ignored where conditions for
an exchange are manifest and an exchange actually occurs).
Provided the final result is an exchange of property for other
property of a like kind, the transaction may qualify under
section 1031.5
However, courts have discerned boundaries in the
interpretation and application of section 1031. In Barker v.
Commissioner, 74 T.C. at 563-564, we recognized that
at some point the confluence of some sufficient number
of deviations will bring about a taxable result.
Whether the cause be economic and business reality or
poor tax planning, prior cases make clear that
taxpayers who stray too far run the risk of having
their transactions characterized as a sale and
reinvestment.
Other courts have acknowledged that transactions that take
the form of a cash sale and reinvestment cannot, in substance,
constitute an exchange for purposes of section 1031, even though
5
Biggs v. Commissioner, 69 T.C. 905, 914 (1978); affd. 632
F.2d 1171 (5th Cir. 1980).
- 9 -
the end result is the same as a reciprocal exchange of
properties. Bell Lines, Inc. v. United States, 480 F.2d 710, 714
(4th Cir. 1973); Carlton v. United States, 385 F.2d 238, 241 (5th
Cir. 1967). Thus, our inquiry here focuses on whether
petitioner's disposition of Sunshine Liquor was a sale, as argued
by respondent, or an exchange, as argued by petitioner.
In Bezdjian v. Commissioner, 845 F.2d 217 (9th Cir. 1988),
affg. T.C. Memo 1987-140, the taxpayers received an oil company's
offer to sell a gas station that the taxpayers operated under a
lease. The oil company refused to accept a rental property owned
by the taxpayers in exchange and, instead, insisted on a cash
transaction. The taxpayers consented and bought the gas station
with the proceeds of a loan that was secured by a deed of trust
on their residence and the rental property. About 3 weeks after
the gas station was conveyed to the taxpayers, they sold the
rental property to a third party who assumed a mortgage and paid
the remainder of the price in cash. The taxpayers treated these
transactions as a like-kind exchange governed by section 1031 on
their 1978 tax return.
The U.S. Court of Appeals for the Ninth Circuit explained
that there was no "exchange" under the meaning of section 1031.
The court found that the taxpayers failed to understand that the
parties involved must make an exchange of property or an interest
in property for other property of a like kind in order for the
transaction to qualify for nonrecognition. The court also found
- 10 -
no proof that either party evidenced an intention to make an
exchange. "The fact that the * * * [taxpayers] intended the
* * * [new] parcel to replace the * * * [old] property in their
holdings does not render their transactions an exchange." Id. at
218.
Petitioners' factual circumstances are indistinguishable
from Bezdjian v. Commissioner, supra. In both cases, there was a
desire to purchase property and a need to dispose of like-kind
property to finance the acquisition. In both cases, there was an
inability to find a buyer for the original property and a
purchase of the new property before the original property could
be sold. In both instances, there was a borrowing against the
original property to finance the purchase of the new property,
and neither set of taxpayers received cash in hand from the sale
of the original property.
The facts here support respondent's position that
petitioners possessed indicia of ownership of both Bayshore
Liquor and Sunshine Liquor. If petitioners had been unable to
sell Sunshine Liquor, they would still have been liable to
Hanshaw on the note they gave him to finance their purchase of
Bayshore. Likewise, petitioners were legally entitled to keep
Sunshine Liquor in any event. Petitioners were liable to Hanshaw
for the outstanding debt, but they were not otherwise bound to
sell Sunshine Liquor. Furthermore, petitioners simultaneously
operated Sunshine Liquor and Bayshore Liquor from October 5,
- 11 -
1988, until March 31, 1989, when they finally sold Sunshine
Liquor. They kept the profits and losses from both businesses.
These circumstances do not reflect or otherwise show the
existence of a tax-free exchange under section 1031.
The purchase of Bayshore Liquor and the subsequent sale of
Sunshine Liquor were not structured as a section 1031 exchange.
The escrow documents do not refer to a section 1031 exchange.
There is no indication that this transaction was intended to be a
section 1031 exchange. Additionally, it does not appear that the
ultimate purchasers of Sunshine Liquor were aware that a section
1031 exchange was intended. There is no evidence that
petitioners relied on section 1031 until they filed their 1989
Federal income tax return.
Petitioners apparently argue that Hanshaw was the de facto
owner of Sunshine Liquor at the time of the sale because part of
the proceeds from petitioners' sale of Sunshine Liquor were
utilized to pay off the debt incurred and owed to Hanshaw. In
other words, petitioners appear to contend that they had
previously accomplished a section 1031 exchange with Hanshaw and
were merely his "agents" in the sale of Sunshine Liquor. This
gloss on Hanshaw's role is not confirmed by the record. Hanshaw
refused to purchase Sunshine Liquor from petitioners when the
Sathavorans reneged on the agreement to purchase the store.
Hanshaw did not have any rights other than those granted to him
by petitioners' note. Hanshaw was only a creditor of
- 12 -
petitioners. Petitioners retained title and equity in Sunshine
Liquor until they sold it.
Petitioners' argument implies that an intent on their part
to undertake an exchange should be sufficient to bring the
transactions within the ambit of section 1031. We cannot agree.
Although intent can be relevant in determining what events
transpired, it is not sufficient to cause these transactions to
fall within section 1031. Garcia v. Commissioner, 80 T.C. 491,
498 (1983); Biggs v. Commissioner, 69 T.C. 905, 915 (1978).
Rather these transactions constitute a purchase and subsequent
sale.
We hold that the transactions here are properly
characterized as a purchase followed by a sale. Accordingly,
there was no exchange within the meaning of section 1031.
Section 6654 provides an addition to tax for the failure to
pay estimated income tax. This addition to tax is mandatory
unless petitioners demonstrate that they come within one of the
computational exceptions of section 6654(e). The addition to tax
is imposed regardless of reasonable cause or extenuating
circumstances. Dodge v. Commissioner, 96 T.C. 172, 183 (1991),
affd. in part and revd. in part 981 F.2d 350 (8th Cir. 1992);
Grosshandler v. Commissioner, 75 T.C. 1, 20-21 (1980).
Furthermore, they have not demonstrated that they come within any
exception or that they had reasonable cause or extenuating
circumstances. Petitioners failed to make any estimated tax
- 13 -
payments in 1989. Therefore, respondent's determination is
sustained.
We next consider whether petitioners are liable for the
addition to tax for substantially understating their income tax.
Sec. 6662(b)(2). A substantial understatement is one that
exceeds the greater of 10 percent of the tax required to be shown
or $5,000. Sec. 6662(d)(1). Any understatement is reduced by an
item that is adequately disclosed or for which there was
substantial authority for its tax treatment.
Petitioners' failure to report the gain from the sale of
Sunshine Liquor resulted in a $34,079 understatement of income
tax. This amount is in excess of $5,000, and exceeds 10 percent
of the amount of tax required to be shown on the return.
Next, we must decide if petitioners adequately disclosed
their position or had substantal authority. Section
6662(d)(2)(B)(ii) defines a disclosed item as one regarding
which "the relevant facts affecting the item's tax treatment are
adequately disclosed in the return or in a statement attached to
the return". The statute does not set forth what constitutes
adequate disclosure of relevant facts. Schirmer v. Commissioner,
89 T.C. 277, 285 (1987). Under generally applicable regulatory
authority, however, respondent may prescribe the form of such
disclosure. H. Conf. Rept. 97-760 (1982), 1982-2 C.B. 600, 650;
Schirmer v. Commissioner, supra at 285.
- 14 -
Even where a taxpayer fails to comply with the methods set
forth by the regulations, this Court has indicated that a
taxpayer may also satisfy the requirements of adequate disclosure
for purposes of section 6662 if he provides sufficient facts on
the face of his return that enable respondent to identify the
potential controversy involved. Schirmer v. Commissioner, supra
at 286. We hold that petitioners have satisfied the adequate
disclosure requirement.
Petitioners properly completed their 1989 Federal income tax
return identifying the property in question, the amount of gain
involved, and the facts affecting the tax treatment.
Furthermore, on the face of petitioners' return there are only
two items reported: (1) Business income generated by a liquor
store as reported on Schedule C, and, (2) a transaction involving
the same liquor store which produced zero capital gain as
reported on Schedule D. It appears likely that the items
reported generated respondent's audit. The information reported
was sufficient to apprise respondent of and enable respondent to
identify the potential controversy involved here, that is,
whether petitioners actually engaged in a tax-free exchange. We
hold that petitioners have adequately disclosed the relevant
facts relating to the questioned transaction.
We hold that petitioners are not liable for the addition to
tax under section 6662(a).
To reflect the foregoing,
- 15 -
Decision will be entered for
respondent as to the deficiency
and addition to tax under sec.
6654, and for petitioners as to the
addition to tax under sec. 6662(a).