T.C. Memo. 1995-556
UNITED STATES TAX COURT
WINDSOR PRODUCTION CORPORATION, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 27654-91. Filed November 21, 1995.
Kenneth W. Gideon, Gregory P. Joseph, Sheldon S. Cohen,
Ellen K. Harrison, Mark S. Bader, B. John Williams, Jr., John F.
Coverdale, and Ruth E. Kent, for petitioner.
Lindsey D. Stellwagen and Chalmers W. Poston, Jr., for
respondent.
MEMORANDUM OPINION
COLVIN, Judge: This matter is before the Court on
petitioner's motion for litigation costs under section 74301 and
1
Section references are to the Internal Revenue Code in
(continued...)
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Rule 231. Respondent concedes that petitioner meets all of the
requirements for an award of litigation costs under section 7430
except whether respondent's position in the underlying proceeding
was substantially justified. For reasons discussed below, we
hold that respondent's position was not substantially justified.
The parties submitted memoranda and affidavits supporting
their positions. We decide the motion based on the memoranda and
affidavits provided by the parties. Neither party requested a
hearing, and respondent stated that no hearing is required.
There are no significant factual disputes. We conclude that a
hearing is not necessary to properly decide this motion. Rule
232(a)(3). Background
1. Petitioner and the Underlying Tax Case
Petitioner was a closely held corporation the principal
place of business of which was in New York when it filed its
petition. Petitioner was in the oil, gas, film and television
business during the years in issue.
Petitioner's underlying case was decided at Saltzman v.
Commissioner, T.C. Memo. 1994-641. Several consolidated cases
were decided by that opinion. The primary issue involving
petitioner was whether it was liable for accumulated earnings
tax under section 531.
1
(...continued)
effect for the years in issue. Rule references are to the Tax
Court Rules of Practice and Procedure.
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Petitioner's shareholders and board of directors met on
December 1, 1987. The minutes of that meeting show that
petitioner would probably need to plug 38 wells at a cost of
between $10,000 and $40,000 per well. The minutes also show
that petitioner had begun negotiations to buy oil or gas projects
which required initial investments as follows: $130,000 for
Kelso; $450,000 for Quail Creek; $375,000 for Boren; and $760,000
for Turkey Creek. The board allocated $1 million to plug wells
and acquire new projects.
2. Revenue Agent's Contacts with Petitioner's Representatives
Richard Saul (Saul), respondent's revenue agent assigned to
this case, worked closely with Leonard Hochheiser (Hochheiser),
petitioner's representative. On October 5, 1989, Saul asked
Hochheiser for a copy of petitioner's tax returns for 1986 and
1987. Hochheiser gave those returns to Saul on November 10,
1989. On January 3, 1991, Saul asked Hochheiser to agree to
extend the time to assess tax for petitioner's 1987 year. Saul
received a letter on February 4, 1991, in which Hochheiser
declined. On February 6, 1991, Saul met with Hochheiser and
discussed petitioner's business generally and the audit. Saul
briefly mentioned section 531 as an issue to be considered. He
did not ask petitioner's owners or Hochheiser whether petitioner
needed to accumulate earnings or had plans to expand. Hochheiser
did not say whether petitioner had plans to expand.
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On June 13, 1991, respondent notified petitioner in writing
that petitioner was under audit for fiscal years 1987, 1988, and
1989. On June 14, 1991, Saul sent petitioner an Information
Document Request (IDR). In it, Saul noted that the only issue
Saul was considering was the amortization of film rights for 1987
to 1990. The IDR led petitioner to believe that respondent would
not pursue the section 531 issue. Saul did not consider
asserting section 531 against petitioner then because he did not
believe the section 531 issue was strong for respondent. Saul
told Hochheiser that he leaned against pursuing the section 531
issue. However, after meeting with a reviewer in early August
1991, Saul concluded that respondent should assert the section
531 issue against petitioner on the assumption that Windsor
had substantial liquidity and no plans to expand and because
Hochheiser did not mention expansion plans after Saul briefly
mentioned section 531. Saul did not ask petitioner's owners
or Hochheiser about whether petitioner needed to accumulate
earnings. Saul did not ask to see petitioner's board minutes.
On August 19, 1991, Saul told Hochheiser that he would
assert the section 531 issue because he believed petitioner had
no reasonable needs to accumulate earnings and the 3-year
period to assess tax was about to expire. On August 29, 1991,
respondent issued notices to petitioner under section 534(b)
proposing to assert accumulated earnings tax for each year in
issue. On August 30, 1991, respondent issued a notice of
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deficiency to petitioner. The accumulated earnings tax issue
was the primary adjustment determined by respondent. Respondent
determined that petitioner had accumulated excess taxable income
of $116,291 in 1987, $76,275 in 1988, and $143,917 in 1989 that
was taxable under section 531.
On October 23, 1991, petitioner submitted a statement under
section 534(c) detailing its plans to expand its oil, gas, film,
and television businesses. Petitioner attached copies of
corporate minutes to verify the amounts of accumulated earnings
needed for each of petitioner's expansion programs. Petitioner
also stated that it needed a reserve for contingent liabilities
from an NFC Oil Co. lawsuit settled in 1988, environmental
liabilities including plugging oil wells, and breach of contract
and copyright violations. Petitioner attached copies of
corporate minutes to verify the amounts it needed for these
reserves.
On November 27, 1991, petitioner filed the petition in this
case. In it, petitioner denied that it was subject to the
accumulated earnings tax and referred to the section 534(c)
statement it filed in which it stated its needs to accumulate
earnings.
Respondent filed the answer on January 27, 1992, and an
amended answer on February 24, 1992. Respondent alleged that
petitioner's section 534(c) statement was not sufficient.
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Respondent conceded the accumulated earnings tax issue after
trial and after petitioner filed its opening brief.
Discussion
1. Motion for Litigation Costs: Introduction
Generally, a taxpayer who has substantially prevailed in a
Tax Court proceeding may be awarded reasonable litigation costs.
Sec. 7430(a)(2). To be entitled to an award, the taxpayer must:
(a) Exhaust administrative remedies. Sec. 7430(b)(1).
Respondent concedes that petitioner meets this requirement.
(b) Substantially prevail with respect to the amount in
controversy. Sec. 7430(c)(4)(A)(ii)(I). Respondent concedes
that petitioner meets this requirement.
(c) Show that the position of the United States in the
action was not substantially justified. Sec. 7430(c)(4)(A)(i)
(1988). Respondent contends that petitioner does not meet this
requirement. Petitioner contends and we hold that petitioner
meets this requirement.
(d) Be an individual whose net worth did not exceed
$2,000,000, or an owner of an unincorporated business, or any
partnership, corporation, etc., the net worth of which did
not exceed $7,000,000, when the petition was filed. Sec.
7430(c)(4)(A)(iii); 28 U.S.C. sec. 2412(d)(2)(B). Respondent
concedes that petitioner meets this requirement.
(e) Establish that the amount of costs and attorney's
fees claimed by petitioner is reasonable. Sec. 7430(a), (c)(1).
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Respondent concedes that petitioner meets this requirement.
A taxpayer has the burden of proving that it meets each
requirement before the Court may order an award of litigation and
administration costs under section 7430. Rule 232(e); Estate of
Johnson v. Commissioner, 985 F.2d 1315, 1318 (5th Cir. 1993),
Gantner v. Commissioner, 92 T.C. 192, 197 (1989), affd. 905 F.2d
241 (8th Cir. 1990); Minahan v. Commissioner, 88 T.C. 492, 497
(1987).
A taxpayer must establish that the position of the United
States in the litigation was not substantially justified to be
entitled to an award for administrative or litigation costs.
Sec. 7430(c)(4)(A)(i). The position of the United States is the
position taken by respondent: (a) In the court proceeding, and
(b) in the administrative proceeding as of the earlier of, (i)
the date the taxpayer receives the notice of the decision of the
Internal Revenue Service Office of Appeals, or (ii) the date of
the notice of deficiency. Sec. 7430(c)(7). Here, petitioner
did not receive a notice of decision from respondent's Appeals
office. Respondent's position in the notice of deficiency,
the answer, throughout trial, and until petitioner filed its
posttrial brief, was that petitioner accumulated earnings beyond
its reasonable business needs. Thus, respondent's position in
both the administrative and the judicial proceeding was that
taken in the notice of deficiency for purposes of section 7430.
Accordingly, we must decide whether respondent's position was
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substantially justified when respondent issued the notice of
deficiency and when respondent filed the answer in this case.
2. Whether Respondent's Position That Petitioner
Accumulated Earnings Beyond Its Reasonable Business Needs
Was Substantially Justified
a. Background
The Equal Access to Justice Act's substantially justified
standard requires that the Government's position be justified
to a degree that would satisfy a reasonable person. Pierce v.
Underwood, 487 U.S. 552, 565 (1988). That standard applies to
motions for litigation costs under section 7430. Nicholson v.
Commissioner, 60 F.3d 1020, 1026 (3d Cir. 1995), revg. T.C. Memo.
1994-280; Comer Family Equity Pure Trust v. Commissioner, 958
F.2d 136, 139-140 (6th Cir. 1992), affg. T.C. Memo. 1990-316;
Powers v. Commissioner, 100 T.C. 457, 470 (1993), affd. on this
issue and revd. in part and remanded on other issues 43 F.3d
172 (5th Cir. 1995). To be substantially justified, the
Commissioner's position must have a reasonable basis in both law
and fact.2 Pierce v. Underwood, supra; Hanover Bldg. Matls.,
Inc. v. Guiffrida, 748 F.2d 1011, 1015 (5th Cir. 1984); Powers v.
Commissioner, supra at 473. For a position to be substantially
justified, there must be "substantial evidence" to support it.
2
Respondent recognizes that this is the controlling
standard at issue in this case. On brief respondent states:
"To determine whether respondent acted reasonably, the Court
must consider whether respondent's position had a reasonable
basis both in law and fact. Pierce v. Underwood, 487 U.S. 552,
564 (1988); Powers v. Commissioner, 100 T.C. 457, 470 (1993)."
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Pierce v. Underwood, supra at 564-565; Powers v. Commissioner,
supra at 473.
The fact that the Commissioner eventually loses or concedes
the case does not in itself establish that a position is
unreasonable. Wilfong v. United States, 991 F.2d 359, 364 (7th
Cir. 1993); Hanson v. Commissioner, 975 F.2d 1150, 1153 (5th Cir.
1992), revg. an unpublished Order of this Court. However, it is
a factor to be considered. Heasley v. Commissioner, 967 F.2d
116, 120 (5th Cir. 1992), affg. in part and revg. in part T.C.
Memo. 1991-189; Estate of Perry v. Commissioner, 931 F.2d 1044,
1046 (5th Cir. 1991); Powers v. Commissioner, supra at 471.
The taxpayer need not show bad faith to establish that the
Commissioner's position was not substantially justified for
purposes of a motion for litigation costs under section 7430.
Estate of Perry v. Commissioner, supra; Powers v. Commissioner,
supra.
b. Respondent's Claimed Basis in Fact
A taxpayer is liable for accumulated earnings tax if it is
formed or availed of to avoid income tax for its shareholders by
permitting earnings and profits to accumulate instead of being
divided or distributed. Sec. 532(a), Hughes, Inc. v.
Commissioner, 90 T.C. 1, 15 (1988). The most important factor
in deciding if the accumulated earnings tax applies is whether
a corporation accumulated earnings and profits beyond the
reasonable needs of the business. United States v. Donruss Co.,
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393 U.S. 297, 307 (1969); Technalysis Corp. v. Commissioner,
101 T.C. 397, 403 (1993).
Respondent contends that there was a reasonable basis in
fact for the position in the notice of deficiency and the answer
because respondent knew the following facts before issuing the
notice of deficiency: (i) Petitioner had passive assets such
as certificates of deposit; (ii) petitioner had investments
unrelated to its oil and gas operations; (iii) petitioner had a
steady cash-flow from film rights; (iv) petitioner paid Arnold
Saltzman a $30,000 dividend in 1989; and (v) petitioner paid
management fees to Arnold Saltzman. We do not believe that these
facts provide a reasonable basis in fact for respondent's
position. Respondent does not state the amounts of petitioner's
liquid assets. Respondent alleged in the answer that petitioner
had accumulated liquid assets worth more than $500,000 in each
year in issue. Respondent might have been referring to amounts
in petitioner's Federal corporate tax returns for the years in
issue. Petitioner reported "other investments" of $748,771 on
its tax returns for 1987, $779,913 for 1988, and $729,419 for
1989. However, the only way to know if these amounts are
excessive is to compare them to petitioner's business plans.
Respondent lacked a basis in fact for applying the accumulated
earnings tax because respondent had no facts about petitioner's
business plans.
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The fact that petitioner had a steady cash-flow from its
film rights, without more, does not provide a basis for
respondent's position that petitioner unreasonably accumulated
income. The fact that petitioner paid dividends and management
fees to Arnold Saltzman, without more, does not provide a basis
for respondent's position. Respondent does not state how much
petitioner paid to Arnold Saltzman, nor does respondent say how
an expense by a business shows that the business accumulated too
much. We conclude that the facts known to respondent do not
provide a reasonable basis in fact for respondent's position in
the notice of deficiency. After respondent issued the notice of
deficiency, petitioner filed its statement under section 534(c)
explaining its reasons to accumulate earnings. Respondent does
not claim to rely on different facts for the answer than those
upon which respondent relied in the notice of deficiency. We
conclude that the facts known to respondent do not provide a
reasonable basis for respondent's position.
c. Effect of Burden of Proof
Respondent claims to be substantially justified in
determining that petitioner is liable for the accumulated
earnings tax because petitioner has the burden of proof. We
disagree. The fact that petitioner bears the burden of proof
does not give respondent a basis in fact or establish that
respondent's position is substantially justified. Powers v.
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Commissioner, supra at 472-474; Williford v. Commissioner, T.C.
Memo. 1994-135.
d. Respondent's Lack of Diligence
Respondent erroneously assumed that petitioner had no
reasonable business needs to accumulate earnings or plans to
expand which would justify accumulations. Respondent did not ask
to see petitioner's records or otherwise investigate petitioner's
needs to accumulate funds before issuing the notice of
deficiency. On July 1, 1981, Saul believed that the accumulated
earnings issue was not strong for respondent. He told Hochheiser
that respondent would not pursue the accumulated earnings issue.
The Commissioner did not have a reasonable basis in fact and law
without diligently investigating the case. Nicholson v.
Commissioner, 60 F.3d at 1029; Lennox v. Commissioner, 998 F.2d
244, 248 (5th Cir. 1993), revg. and remanding T.C. Memo. 1992-
382; United States v. Estridge, 797 F.2d 1454, 1458 (8th Cir.
1986); Powers v. Commissioner, 100 T.C. at 473.
The fact that respondent issued the accumulated earnings tax
notice under section 534(b) 1 day before respondent issued the
notice of deficiency suggests that respondent was not seriously
interested in investigating the accumulated earnings tax issue.3
3
Sec. 534(b) provides:
Before mailing the notice of deficiency referred to in
subsection (a), the Secretary may send by certified
mail or registered mail a notification informing the
(continued...)
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Section 534(c) is designed to enable a taxpayer to respond to
the Commissioner's section 534(b) notification before the
Commissioner determines a deficiency. Manson W. Corp. v.
Commissioner, 76 T.C. 1161, 1164 (1981). In that case we said:
[The Commissioner] admits that part of section 534's
function is to "encourag[e] the Internal Revenue Service
to be more deliberate than it had been in the past."
Such deliberation can result only if respondent reads
and considers a taxpayer's section 534(c) response
before issuing a notice of deficiency, and we are
confident that Congress intended for respondent to do
just that. [Id.; fn. ref. omitted.]
Respondent failed to request information about petitioner's
needs to accumulate earnings even though Hochheiser gave copies
of petitioner's tax returns to Saul in November of 1989 and Saul
knew in February 1991 that petitioner would not agree to extend
the time to assess tax. We conclude that respondent did not
diligently investigate this case before issuing the notice of
deficiency or filing the answer.
3
(...continued)
taxpayer that the proposed notice of deficiency
includes an amount with respect to the accumulated
earnings tax imposed by section 531.
Sec. 534(c) provides:
Within such time (but not less than 30 days) after the
mailing of the notification described in subsection (b)
as the Secretary may prescribe by regulations, the
taxpayer may submit a statement of the grounds
(together with facts sufficient to show the basis
thereof) on which the taxpayer relies to establish that
all or any part of the earnings and profits have not
been permitted to accumulate beyond the reasonable
needs of the business.
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e. Whether Respondent's Desire to Have a Trial Bars an
Award of Litigation Fees
Respondent contends that trial was needed so respondent
could assess the probative value, admissibility of testimony and
documents offered by petitioner to prove its business needs.
For example, respondent wanted to assess Arnold Saltzman's
credibility at trial. Respondent argues that until respondent
conceded the accumulated earnings tax issues, respondent's
litigating position was substantially justified because this case
could only be resolved by examining the facts and circumstances,
including assessing the credibility of the witnesses. We
disagree. The Government is not automatically excused from
having a reasonable basis in fact in cases where facts and
witnesses' credibility are in dispute.
Respondent cites Richman v. Commissioner, T.C. Memo. 1994-
140 for the proposition that respondent's position is
substantially justified where the issues are factual and depend
on a determination of credibility. This is not what we held
in Richman. In Richman, the Commissioner determined that the
taxpayer fraudulently omitted interest income. We held that
the Commissioner had a reasonable basis in fact because, when
respondent issued the notice of deficiency, respondent knew that
the taxpayer used an incorrect Social Security number on his
account statements, and the account statements contained a notice
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that the amount of interest would be reported to the Internal
Revenue Service. Id.
Respondent contends that respondent was substantially
justified in asserting the accumulated earnings issue because
petitioner did not provide documents relevant to that issue in
its protest letter dated May 15, 1991. We disagree. Respondent
first proposed to assert the accumulated earnings issue in August
1991. It is unreasonable to fault petitioner for not
anticipating that respondent would raise the accumulated earnings
issue later.
Respondent contends that petitioner acknowledged the need
for trial in its motion to shift the burden of proof to
respondent. We disagree; petitioner's motion to shift the burden
of proof did not state that trial was needed. Rather, petitioner
asserted that respondent should bear the burden of proof if the
matter went to trial.
Respondent contends that petitioner admitted that trial
was needed by proposing 65 findings of fact after trial. We
disagree. Petitioner properly proposed findings of fact in its
posttrial brief. This has no bearing on whether respondent's
position was substantially justified.
Respondent argues that respondent's position was
substantially justified because
In response to discovery, petitioners represented
that they had produced all documents establishing the
allegations in their petition; but in fact not all of
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the documents were produced and identified until after
respondent filed her response to Petitioner's Motion
For An Order To Show Cause Pursuant to Rule 91(f).
Respondent points out that respondent had objected to
petitioner's motion under Rule 91(f) to compel stipulation in
part because respondent had not seen many of the documents that
petitioner proposed to be stipulated. These facts could not
provide a basis in fact for respondent's position when the notice
of deficiency was issued or the answer was filed. We conclude
that the documents that petitioner sought to include in a
proposed stipulation do not show that trial was needed or
otherwise substantially justify respondent's position.
f. Whether Petitioner Must Show That Respondent Had
Neither a Basis In Fact Nor a Basis in Law
Respondent contends that to establish that the position of
the United States was not substantially justified, petitioner
must show that legal precedent does not substantially support
respondent's position given the facts reasonably available to
respondent. Respondent contends that petitioner has failed to
do this. We disagree. As discussed above, facts about
petitioner's need to accumulate earnings were reasonably
available to respondent if respondent had investigated the issue.
Respondent failed to make such an investigation. In the
circumstances, we conclude that respondent had insufficient
knowledge of the facts of the case to render respondent's
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position substantially justified. Pierce v. Underwood, 487 U.S.
552 (1988); Powers v. Commissioner, 100 T.C. 457, 472 (1993).
3. Conclusion
We conclude that respondent's position was not substantially
justified when respondent issued the notice of deficiency or
filed the answer.
To reflect the foregoing,
An order will be
issued granting petitioner's
motion for an award of
litigation costs.