T.C. Memo. 1996-216
UNITED STATES TAX COURT
CARL J.D. BAUMAN AND MARGARET A. BAUMAN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 37669-85, 38099-85. Filed May 2, 1996.
Robert L. Manley, for petitioners.
Linda J. Wise, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
WRIGHT, Judge: Respondent determined deficiencies in and
additions to petitioners’ Federal income taxes as follows:1
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years at issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
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Docket No. 37669-85
Additions to Tax
Year1 Deficiency Sec. 6653(a)(1) Sec. 6653(a)(2) Sec. 6651
2
1979 $12,476 $624 -- --
2
1980 19,023 951 -- --
3
1981 13,573 679 $4,072
Docket No. 38099-85
Additions to Tax
Year1 Deficiency Sec. 6653(a)(1) Sec. 6653(a)(2) Sec. 6651
3
1982 $28,019 $1,705 $3,167
1
Increased interest under sec. 6621(c) was imposed.
2
The additions to tax for 1979 and 1980 were determined
pursuant to sec. 6653(a).
3
50 percent of the interest due on $13,573 and $28,019 for
taxable years 1981 and 1982, respectively.
After concessions, the issues for decision are:2
(1) Whether a lease transaction entered into by Energy
Resources, Ltd. (ERL), a limited partnership of which petitioner
husband was a limited partner, was devoid of economic substance.
We hold that it was.
2
The petition also presents an issue of whether respondent
is barred from assessing the taxes at issue pursuant to sec.
6501. Petitioners, however, did not address this issue at trial,
nor did they discuss it in their posttrial briefs. Accordingly,
the issue is deemed to have been conceded and is not discussed
herein.
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(2) Whether notes ERL issued with respect to advance
royalty payments due under a lease agreement represented bona
fide indebtedness. We hold that they did not.
(3) Whether annual payments ERL agreed to pay under a lease
agreement were properly accrued and deducted as advance royalties
due under a minimum royalty provision described under section
1.612-3(b), Income Tax Regs. We hold that they were not.
(4) Whether ERL was engaged in an activity for profit. We
hold that it was not.
(5) Whether petitioners have established their entitlement
to various other deductions stemming from ERL’s mining operations
pursuant to section 183(b). We hold that they have not.
(6) Whether petitioners are liable for the addition to tax
under section 6653(a) for taxable year 1980 and under section
6653(a)(1) and (2), for taxable years 1981 and 1982. We hold
that they are.
(7) Whether the increased interest rate attributable to
tax-motivated transactions under section 6621(c) applies. We
hold that it does to the extent stated herein.
(8) Whether petitioners are liable for the addition to tax
under section 6651(a)(1) for failure to file their 1982 tax
return by the prescribed date. We hold that they are.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulation of facts and the exhibits attached thereto are
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incorporated herein. At the time the petition was filed in this
case, petitioners resided in Anchorage, Alaska.
This case is part of a group of cases identified by
respondent as McIntyre-CN. McIntyre-CN is a national litigation
project involving coal mining partnerships promoted by Richard
McIntyre (McIntyre).
Petitioner husband (Bauman) has been employed as an attorney
with the same law firm (law firm) in Anchorage, Alaska, since
1973. He has been a partner in that law firm since 1975.
Petitioners timely filed their Federal income tax return for
1979. Petitioners’ Federal income tax return for 1980 was not
received by the Internal Revenue Service (IRS) until May 8, 1981.
Attached to petitioners’ return for taxable year 1980 is a brief
handwritten note in which Bauman explains the reason for the
untimely filing. This note essentially states that confusion
brought about by petitioner wife’s (Mrs. Bauman) second pregnancy
caused the couple to overlook the filing deadline. The note
concludes with the statement “it won’t happen again”.
Petitioners’ Federal income tax return for 1982 was not received
by the IRS until June 10, 1983. Attached to petitioners’ return
for taxable year 1982 is a brief typewritten note in which Bauman
explains the reason for the couple’s delinquent filing. In this
note, Bauman principally asserts that the couple was unable to
satisfy their obligation to file their return by the prescribed
date because Bauman’s father was ill and that such illness
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required Bauman’s periodic attention. Petitioners’ Federal
income tax return for 1981 was not received by the IRS until June
30, 1983. The record does not contain an explanation for the
tardiness of petitioners’ return for taxable year 1981.
Background
During the taxable years at issue,3 Bauman was a limited
partner in ERL. In 1980, ERL, as lessee, entered into a lease
agreement with JAD Coal Co., Inc. (JAD), as lessor, to mine and
market coal underlying certain land in Harlan County, Kentucky.
This lease transaction was the subject of this Court’s opinion in
Bauman v. Commissioner, T.C. Memo. 1988-122 (occasionally Bauman
I).4 In Bauman I, this Court held that ERL’s royalty obligations
under its lease agreement with JAD were not “substantially
uniform” and were not “paid at least annually”. As such, we
further held that the royalty obligations were not deductible as
advance royalties paid or accrued “as a result of a minimum
royalty provision” under section 1.612-3(b), Income Tax Regs.
The Court granted respondent’s motion for partial summary
judgment with respect to this minimum royalty issue. Bauman I,
however, was limited to the question of whether the royalty
obligations qualified under a minimum royalty provision as
3
The parties have reached settlement with respect to taxable
year 1979. The issues before the Court pertain to taxable years
1980, 1981, and 1982.
4
The parties in Bauman v. Commissioner, T.C. Memo. 1988-122,
are identical to the parties in the instant case.
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envisioned by section 1.612-3(b), Income Tax Regs. Bauman I
involved taxable years 1979, 1980, and 1981. Bauman v.
Commissioner, supra.
Subsequent to this Court’s decision in Bauman v.
Commissioner, supra, we decided Coggin v. Commissioner, T.C.
Memo. 1993-209, affd. 71 F.3d 855 (11th Cir. 1996) (occasionally
the Coggin case). The Coggin case was among a number of cases
included in respondent’s national litigation project entitled
McIntyre-CN. Like Bauman in the instant case, the taxpayer in
the Coggin case was a limited partner in ERL. As a majority of
the facts in the Coggin case are identical to the facts in the
instant case, the parties have stipulated pertinent parts of the
record in the Coggin case.
As a result of Bauman’s investment in ERL, petitioners
claimed certain losses and credits on their Federal income tax
returns for 1980, 1981, and 1982. Respondent determined that ERL
was a sham, engaged in solely for the resulting tax benefits, and
disallowed the losses and credits claimed by petitioners for each
year at issue.
Energy Resources, Ltd.
ERL was a Tennessee limited partnership. It operated under
the accrual method of accounting. Investors were solicited
through a private placement memorandum (the offering memorandum
or offering materials) dated October 1, 1980. The offering
materials explained that ERL was organized to lease (the lease)
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3,520 acres of land in Harlan County, Kentucky (occasionally the
coal property), and that ERL would earn future income for its
partners by exploiting its rights under the lease. The offering
materials consisted of 94 pages of information concerning the
offering and contained a discussion of a variety of matters,
including the partnership’s objectives, the terms of the
agreement, potential risk factors, and related Federal tax
issues. Sixteen pages of the 94-page offering memorandum
consisted of a discussion regarding the Federal income tax
consequences relating to the offering. Attachments to the
offering memorandum included a tax opinion, a Coal Reserve
Report, and accounting and productivity projections. Although
many of these attachments were lacking in detail and specificity,
the tax opinion was an exception. The tax opinion, which was
authored by the taxpayer in the Coggin case, exceeded 100 pages
in length and was extensive and thorough. The offering
memorandum also contained 12 exhibits. Included among the
exhibits were a copy of the limited partnership agreement, a copy
of the lease agreement, and copies of various partnership
promissory notes.
McIntyre was ERL’s managing general partner and the sponsor
of the offering materials. ERL’s associate general partner was
McIntyre’s brother, Charles McIntyre. The offering materials
advised potential investors that McIntyre was the president of
Economic Research Analysts, Inc. (ERA). ERA was an entity with
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various specialties, including tax incentive investments.
Potential investors were further advised that McIntyre’s
experience in the coal mining business was limited and that
McIntyre’s involvement as a general partner in other mining
partnerships might compete with ERL for McIntyre’s time.
Pursuant to the offering materials, 200 limited partnership
units were available to prospective investors. The minimum
investment was one unit per investor; however, McIntyre possessed
authority to issue fractional units to a maximum of 35 investors.
According to the terms set forth in the offering materials, the
capital contribution for each unit was $190,000. This amount
consisted of $45,000 in cash and a promissory note in the amount
of $145,000 executed by each investor and payable to ERL. The
cash portion of each investor’s capital contribution was payable
in three annual installments. The offering materials explained
that each investor’s capital contribution represented his or her
proportionate personal liability for three recourse notes, which
were to be executed by ERL and payable to JAD, for advance
minimum royalties due during the first 3 years of the lease.
Accordingly, the total capital contribution by limited partners
was designed to equal $38 million.
The offering materials contained a copy of the ERL limited
partnership agreement (agreement). Pursuant to the terms of the
agreement, 99 percent of ERL’s profits and losses were to be
allocated to the limited partners. The two general partners were
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to receive the remaining 1 percent of ERL’s profits and losses.
The agreement explained that McIntyre, as managing general
partner, had the responsibility of managing the partnership’s
affairs. The offering materials further explained that McIntyre
would receive an acquisition fee equal to 22 percent of the total
cash contributions made by the limited partners to ERL in 1980,
1981, and 1982. As managing general partner, McIntyre was also
entitled to a management fee in the amount of $1 per ton of coal
mined by or for the partnership. Payment of this fee, however,
was conditioned on ERL’s realization of a minimum per-ton profit
of $4. Additionally, the management fee was structured to
terminate once the limited partners received cash distributions
equal to their total cash contributions.
The principal term of ERL’s lease with JAD was 30 years;
however, ERL could terminate the lease in the event the retrieval
of coal became economically prohibitive. Additionally, if and to
the extent that ERL determined it to be economically feasible,
ERL had the option of extending the primary term of the lease on
a yearly basis.
The terms of the lease obligated ERL to pay JAD an advance
production royalty of 8 percent of ERL’s gross coal sales. The
lease also obligated ERL to pay JAD a minimum annual advance
royalty of $10 million. ERL was required to pay the minimum
advance royalties annually and each such payment was due without
regard to actual production levels; however, such payments were
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subject to credits from actual production. The first two minimum
annual royalty payments were to consist of a cash payment and a
promissory note. All remaining payments were to consist of
individual promissory notes. The first 3 notes were to be
denoted as “recourse” notes, while the remaining 17 notes were to
be considered “nonrecourse” notes. The first note was to be
executed on the date the lease was created, and each subsequent
note was to be delivered to JAD on the same date of each
successive year. This payment pattern was to continue for the
shorter of 20 years or the life of the lease. The following
table depicts the manner in which the offering materials
presented the discharge of the annual royalty payments:
Source 1980 1981 1982 1983-99
Cash $750,000 $250,000 -- --
Recourse 9,250,200 9,750,000 $10,000,000
note
Nonrecourse
notes --- --- --- $10,000,000
(each)
Total 10,000,000 10,000,000 10,000,000 170,000,000
The partnership agreement was structured such that the $29
million in notes issued by the limited partners to purchase the
partnership units represented the limited partners’ personal
liability for the first three annual notes of the partnership for
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royalty payments. ERL’s total liability for the advance
royalties, however, totaled $200 million in cash and notes.
Each note, recourse and nonrecourse, became due 20 years
after execution; however, at the election of either JAD or ERL,
each note could be extended for an additional 10 years. Although
each note bore annual interest at a rate of 6 percent, no partner
was personally liable for the payment of such interest. The
maturity date of each recourse note would not change if the lease
were terminated prior to its primary term. The offering
materials explained that the coal reserves underlying the leased
property would serve as security for each note.
The coal property was acquired by JAD in 1977 for
$3,750,000. Information pertaining to this acquisition was
presented in the offering materials. The offering materials
explained that the coal property contained three principal coal
seams; namely the Mason, Harlan, and Wallins Creek seams. The
offering materials further explained that the objective of the
partnership was to develop these three seams and then to develop
other seams if such development were practicable. The Coal
Reserve Report, which accompanied the offering memorandum,
however, did not lend solid support for this objective. Although
it maintained that the Mason seam was “of good quality”, the Coal
Reserve Report noted that the Mason seam was not without serious
limitations. The report further indicated that coal recovered
from the Harlan seam would be burdened by a high ash content and
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would require additional premarketing procedures. Moreover,
because the Wallins Creek seam had already been extensively
mined, the Coal Reserve Report concluded that no recoverable coal
reserves existed in the Wallins Creek seam. The Coal Reserve
Report continued and further discussed several shortcomings with
other potential seams.
The record does not support a finding that the Coal Reserve
Report was prepared by a qualified expert. The author of the
Coal Reserve Report subsequently became an employee of ERL and
performed other work for the coal partnerships organized and
operated by McIntyre. Nevertheless, the report estimates that
the property contained approximately 52.6 million tons of total
potential coal reserves. This figure consists of 23.6 million
tons in calculated recoverable reserves and 29 million tons in
possible additional reserves. The Coal Reserve Report explained,
however, that the above figure regarding possible additional
reserves was uncertain and that additional exploration was needed
to verify its accuracy. The Coal Reserve Report did not conclude
whether it would be profitable to mine the underlying property,
but it did indicate that a prudent production estimate was
approximately 1 million tons of coal per year. The Coal Reserve
Report did, however, warn potential investors that an in-depth
study was necessary before an assessment of the property’s
profitability could be made. No such study was ever performed.
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The tax opinion contained in the offering materials was
exhaustive. It discussed essentially all relevant Code sections,
Treasury regulations, and revenue rulings pertaining to the
structure of ERL and its transactions. Much case law was also
presented, explaining how the courts had interpreted the various
Code sections, regulations, and rulings discussed therein.
The accounting projections accompanying the offering
materials included an estimate of ERL’s taxable income for 1980,
1981, and 1982. Also included in the accounting projections was
an analysis of ERL’s estimated mining operations for the 29-year
period ending with 2009. The accounting projections estimated
that ERL would realize a net loss of $10,105,000 in 1980.
Similarly, for 1981 and 1982, net losses were estimated to be
$9,200,000 and $7,712,500, respectively. As previously stated,
all but 1 percent of these losses were allocable to the limited
partners pursuant to the partnership agreement. The accounting
projections further explained that, in light of this loss
forecast, and based on the limited partners’ cash capital
contributions, the ratios of the tax deductions to the cash
capital contributions would be 333 percent, 304 percent, and 255
percent, respectively, for 1980, 1981, and 1982.
The accounting projections also contained a tabular analysis
of projected mining operations. It was projected that ERL would
sell 200,000 tons of coal in 1981. The projections increased
annually, and during the period from 1989 through 2009 it was
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projected that ERL would sell in excess of 2 million tons of coal
per year. This tabular analysis, however, bore the qualification
that all projections were hypothetical and were in no way
warranted or guaranteed.
The offering materials advised potential investors that
there were no assurances as to the accuracy of the recoverable
coal estimates upon which the substance of the offering materials
depended. Potential investors were also advised by the offering
materials that ERL did not have any existing long-term contracts
for the sale of coal and that future demand for coal was
unpredictable. The offering materials further advised potential
investors that McIntyre had limited experience in the mining
business and that extensive competition should be expected from
entities with substantially superior financial, technical, and
intellectual resources. The offering materials also discussed
the probable likelihood of labor disputes common to the
geographic area in which the land covered by the lease was
situated.
ERL executed the lease agreement for the coal property on
December 1, 1980. The terms of the lease were consistent with
the representations presented in the offering materials.
In 1980 and 1981, ERL received eight mining permits. Two of
the mines were never operated; the remaining six mines produced
an approximate total of 167,000 tons of coal. All ERL mining
operations ceased by the end of 1981, and no other coal was
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produced from the coal property subsequent to that time. The
mines were not reclaimed or restored to their premining
condition, and ERL forfeited the reclamation bonds it had posted
in order to obtain the mining permits.
Mr. and Mrs. Bauman
Neither Bauman nor Mrs. Bauman had any formal education,
training, or experience in coal mining. Bauman purchased two-
thirds of a partnership unit in ERL. This purchase was motivated
at least in part by Bauman’s prior participation in a coal mining
project promoted and managed by McIntyre. Many of the partners
in Bauman’s law firm were also involved in McIntyre-related coal
projects. Several of these partners were also limited partners
in ERL. The members of the law firm routinely discussed with one
another the potential opportunities presented by an ERL
investment. Bauman’s preinvestment research of ERL was
principally limited to these intrafirm discussions and a review
of the information contained in the offering materials.
OPINION
Petitioners maintain that respondent has erroneously
determined that they are liable for the deficiencies, additions
to tax, and increased interest set forth at the beginning of this
opinion. The essence of petitioners’ argument is twofold.
First, petitioners maintain that ERL was a legitimate entity
organized and managed with a true and objective profit motive.
Petitioners also contend that they invested in ERL only after
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consulting various professionals and that such investment was
undertaken with the intent of making a profit. Accordingly,
petitioners conclude, such consultation and reliance preclude a
finding that they were negligent.
Respondent rejects petitioners’ arguments as self-serving
and contends that the sole purpose underlying ERL’s formation was
to enable the limited partners to claim tax benefits based on the
pass-through of enormous losses. As a result, respondent
maintains, ERL’s lease transaction was devoid of economic
substance and, as such, must be disregarded for Federal income
tax purposes. Respondent further maintains that ERL was not
engaged in an activity for profit and that petitioners have
failed to substantiate various ERL deductions. Respondent also
maintains that certain additions to tax are appropriate for each
year at issue.
Issues 1 & 2. Economic Substance & Bona Fide Indebtedness
Numerous cases hold that transactions which are devoid of
economic substance are to be disregarded for Federal tax
purposes. See Larsen v. United States, 89 T.C. 1229, 1252
(1987), affd. in part and revd. in part sub nom.; Casebeer v.
Commissioner, 909 F.2d 1360 (9th Cir. 1990); Rose v.
Commissioner, 88 T.C. 386, 410 (1987), affd. 868 F.2d 851 (6th
Cir. 1989). In James v. Commissioner, 87 T.C. 905, 918 (1986),
affd. 899 F.2d 905 (10th Cir. 1990), we summarized the holdings
of such cases and explained that a transaction will not be
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recognized for Federal income tax purposes if it is a sham or is
otherwise devoid of economic substance. See Frank Lyon Co. v.
United States, 435 U.S. 561, 573 (1978); Knetsch v. United
States, 364 U.S. 361, 366 (1960); Bail Bonds by Marvin Nelson,
Inc. v. Commissioner, 820 F.2d 1543 (9th Cir. 1987), affg. T.C.
Memo. 1986-23; Falsetti v. Commissioner, 85 T.C. 332 (1985). The
substance of the transaction, not its form, determines its tax
consequences. Gregory v. Helvering, 293 U.S. 465 (1935). A
transaction must have economic substance which is compelled or
encouraged by business or regulatory realities, is imbued with
tax-independent considerations, and is not shaped solely by tax
avoidance features that have meaningless labels attached. Frank
Lyon Co. v. United States, supra; Hilton v. Commissioner, 74 T.C.
305 (1980), affd. per curiam 671 F.2d 316 (9th Cir. 1982).
There are several key indicators which are helpful in
determining whether a transaction possesses or lacks economic
substance. Among these are (1) the presence or absence of arm’s-
length price negotiations, (2) the relationship between the sales
price and fair market value, (3) the structure of the
transaction’s financing, (4) the degree of adherence to
contractual terms, and (5) whether there was a shifting of the
benefits and burdens of ownership. See, e.g., Helba v.
Commissioner, 87 T.C. 983 (1986), supplemented by T.C. Memo.
1987-529, affd. without published opinion 860 F.2d 1075 (3d Cir.
1988); Zirker v. Commissioner, 87 T.C. 970 (1986); James v.
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Commissioner, supra; Grodt & McKay Realty, Inc. v. Commissioner,
77 T.C. 1221 (1981); Karme v. Commissioner, 73 T.C. 1163 (1980),
affd. 673 F.2d 1062 (9th Cir. 1982)
In evaluating whether a transaction is a sham, the Court of
Appeals for the Ninth Circuit, to which this case is appealable,
applies a two-factor test. The analysis requires an examination
of both the objective and subjective aspects of the transaction.
The objective factor focuses on whether the transaction would
have been likely to produce economic benefits aside from tax
benefits. The subjective analysis focuses on whether the
taxpayer entered into the transaction with a bona fide business
purpose other than tax avoidance. Bail Bonds by Marvin Nelson,
Inc. v. Commissioner, supra. The Court of Appeals, however, does
not apply these two factors in a rigid fashion. Sochin v.
Commissioner, 843 F.2d 351 (9th Cir. 1988), affg. Brown v.
Commissioner, 85 T.C. 968 (1985). Instead, both factors are
viewed in a manner intended to aid the court’s traditional
analysis with respect to alleged sham transactions. The
underlying objective is to determine whether the transaction had
any practical economic effects other than the creation of tax
losses. Id.
In the instant case, respondent determined that ERL’s lease
transaction lacked economic substance. Accordingly, petitioners
have the burden of proving that respondent’s determination is
erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111 (1933).
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The issue involving the economic substance of ERL’s lease
transaction has twice before been decided in respondent’s favor.
In both Coggin v. Commissioner, T.C. Memo. 1993-209, and Suivski
v. Commissioner, T.C. Memo. 1993-291, this Court held that ERL’s
lease transaction lacked economic substance and, pursuant to the
line of cases identified above, was to be disregarded for Federal
income tax purposes. Petitioners have failed to persuade us that
a different outcome is now appropriate.
On brief, petitioners have expended much effort in an
attempt to convince us that ERL was a legitimate entity that
should not be disregarded as a sham. Despite this effort,
however, we find petitioners’ argument cursory and unconvincing.
We agree with respondent that the majority of the offering
materials consisted of information pertaining to the tax benefits
associated with the venture. We also agree that such material
was extensive and thorough as compared to most of the remaining
contents of the offering materials. The offering materials
provide minimal insight as to the actual profit-making potential
of the coal mining venture. See Rose v. Commissioner, supra at
412.
Petitioners contend that the offering materials focus
principally on the risks rather than the benefits of the
underlying investment. We disagree. Having carefully examined
the offering materials, we are convinced that such materials,
when collectively considered, heavily emphasize relevant tax
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issues properly characterized as benefits ensuing from the
investment.
Respondent argues that ERL entered into the lease agreement
with JAD without regard to whether the royalty obligations were
commensurate with the fair market value of the coal that could
reasonably be extracted from the leased property. Petitioners
contend that respondent fails to understand the complexities of
the financial transaction as structured by McIntyre. In light of
the evidence contained in the record, however, we agree with
respondent and conclude that the royalty obligations at issue
substantially exceed the fair market value of ERL’s rights under
its lease with JAD. See Coggin v. Commissioner, supra.
Petitioners have failed to establish that ERL’s purported royalty
obligations of $200 million were reasonably commensurate with the
fair market value of the coal underlying the leased property.
Perhaps the most compelling fact rendering support to this
conclusion is that JAD acquired the land covered by the lease for
$3,750,000 on July 30, 1977, approximately 3 years prior to ERL’s
execution of the lease with JAD for the same property. Id.
Petitioners attempt to address this disparity in two ways.
First, they advance a misguided argument based on the concept of
present valuation analysis. Petitioners also argue that
subsequent to JAD’s acquisition of the subject property, the
infrastructure of the property underwent extensive development.
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We find neither argument persuasive. Petitioners have
failed to offer sufficient evidence to establish that the coal
property’s fair market value had so greatly appreciated to an
amount which would justify ERL’s agreement to pay $200 million in
minimum royalties during the initial 20-year period of its lease.
Rose v. Commissioner, supra at 412-419. A grossly inflated price
is a hallmark of a sham transaction. Sacks v. Commissioner, 69
F.3d 982 (9th Cir. 1995), revg. T.C. Memo. 1992-596.
Additionally, the record establishes that McIntyre acted without
adequate information regarding the coal property when he executed
ERL’s lease with JAD. Although McIntyre commissioned a firm to
prepare the Coal Reserve Report contained in the offering
materials, the report is inherently flawed as the leased property
constitutes only a portion of the property covered by the report.
Furthermore, McIntyre’s actions and representations conflict with
the substance of the Coal Reserve Report. That is, despite the
Coal Reserve Report’s conclusion that the property subject to its
scope could realistically be expected to produce 1 million tons
of raw coal annually, McIntyre represented in the offering
materials that the coal property would yield annually 2 million
tons of marketable coal. Moreover, the author of the report
cautioned McIntyre that the report was based upon insufficient
data and an additional in-depth study was necessary in order to
render a determination of probable profitability. No additional
study was engaged. See Rose v. Commissioner, 88 T.C. at 415.
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Petitioners also contest respondent’s argument that McIntyre
disregarded evidence of comparable minimum royalty obligations in
use at the time ERL entered into the lease with JAD. Petitioners
restrict their attack on this argument to a challenge of
respondent’s expert’s ability to appreciate the nature and
quality of the transaction. Respondent’s argument, however, is
convincing. JAD leased a portion of the same property in October
1979 to an independent company. The terms of that agreement
required the lessee to pay an annual minimum royalty of just
under $25,000. Furthermore, ERL’s manager of mining operations,
a person possessing a thorough knowledge of the coal mining
industry, testified that the largest minimum royalty with which
he was familiar, excluding those in which McIntyre was a party,
involved a lease which required an annual minimum royalty of
$200,000 on an 80,000-acre tract of land. This witness did,
however, attempt to justify the disparity by noting that while
ERL’s minimum royalty obligations were considerably higher than
the minimum royalty obligations with which he was familiar, they
were justified because ERL could defer each payment for up to 30
years. We reject this attempted justification and, based upon
the record, conclude that ERL’s minimum royalty obligations were
not reasonably comparable to those provided under similar leases
in the geographic region.
Respondent next argues that petitioners have failed to
establish that ERL had an actual and bona fide objective to
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satisfy its royalty obligations and generate a profit. We agree.
Neither the testimony at trial nor the unreliable Coal Reserve
Report persuades us that ERL intended to generate sufficient
revenue to meet its royalty obligations and earn profits.
Petitioners assert that the lease between ERL and JAD was
negotiated at arm’s length and that the notes representing ERL’s
minimum royalty obligations were of a type commonly used in
business. Essentially, petitioners attribute the structure of
the ERL’s lease agreement to the financial wizardry of McIntyre.
We are not persuaded by petitioners’ argument. The entire
transaction is covered by a blanket of suspicion. The terms of
the lease agreement, in effect, permit ERL to postpone payment on
each note for 30 years. Moreover, no partner, limited or
general, was personally liable for the interest payable on such
notes. Additionally, except for the first three notes, all
notes representing ERL’s obligations were to be nonrecourse.
Nonrecourse financing is a common indicator of a sham
transaction. Sacks v. Commissioner, supra; Ferrell v.
Commissioner, 90 T.C. 1154 (1988). Such notes are not the type
of obligations commonly used in commerce or by banks and other
financial institutions. See Rose v. Commissioner, supra at
419-421.
The Court is not convinced that the notes were bona fide
debt instruments. Although petitioners claim that a letter from
JAD to Bauman which notified Bauman of ERL’s default constitutes
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evidence of the bona fide nature of the notes, we find
petitioners’ argument to be unpersuasive. That a note is labeled
“recourse” is not itself dispositive; substance, not form, must
govern. Gregory v. Helvering, 293 U.S. 465 (1935); Zmuda v.
Commissioner, 731 F.2d 1417 (9th Cir. 1984), affg. 79 T.C. 714
(1982). A nonrecourse debt may be disregarded for tax purposes
where it appears likely from all the facts and circumstances that
the obligation will not be paid. Waddell v. Commissioner, 86
T.C. 848, 902 (1986), affd. per curiam on other issues 841 F.2d
264 (9th Cir. 1988). Even a recourse debt may not be recognized
if its payment is unlikely or too contingent. Id. The three
recourse notes at issue have a “strong nonrecourse flavor”, and,
because the record fails to establish that payment of any note,
recourse or nonrecourse, was reasonably likely, we are not
convinced that such notes represented bona fide indebtedness.
In sum, petitioners have not sustained their burden of
establishing that ERL’s activities were motivated by anything
other than a desire to obtain the related tax benefits. See Karr
v. Commissioner, 924 F.2d 1018, 1023 (11th Cir. 1991), affg.
Smith v. Commissioner, 91 T.C. 733 (1988). The nature of the
offering materials, the manner in which the partnership’s
activities were actually conducted, and the illusory nature of
the lease agreement’s financing convince us that ERL’s lease with
JAD was devoid of economic substance. Consequently, having
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considered the underlying subjective business motivation and the
objective economic substance of ERL’s activity, we sustain
respondent’s determination that ERL’s lease transaction was a
sham which is to be disregarded for Federal income tax purposes.
Issue 3. Minimum Royalty
ERL claimed substantial loss deductions on its 1980, 1981,
and 1982 returns. In material part, these deductions were
attributable to “accrued advance royalties”. In Bauman v.
Commissioner, T.C. Memo. 1988-122, a case involving the same
partnership and the same lease, the Court held that the royalty
obligations with respect to taxable years 1980 and 1981 were
neither “substantially uniform” nor “paid at least annually”.
Consistent with that holding, the Court further held that such
royalties were not deductible as advance royalties paid or
accrued “as a result of a minimum royalty provision” under
section 1.612-3(b), Income Tax Regs.
The facts before the Court in the instant case are
essentially identical to those before the Court in Bauman v.
Commissioner, supra, where the Court granted a motion by
respondent for partial summary judgment regarding the minimum
royalty issue. That case involved the years 1980 and 1981. An
additional year, 1982, is now before the Court. The facts with
respect to 1982, however, do not differ in any material aspect
from those pertaining to 1980 and 1981. Therefore, we reaffirm
our earlier decision, and, for the reasons stated therein, hold
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that, with respect to taxable year 1982 as well, ERL’s royalty
obligations are not deductible as advance royalties paid or
accrued “as a result of a minimum royalty provision” under
section 1.612-3(b), Income Tax Regs. Accordingly, we decline
petitioners’ invitation to reverse our earlier decision and
sustain respondent’s determination as to this issue.
Issues 4 & 5. Profit Motive & Substantiation
In the notice of deficiency, respondent also determined that
ERL’s activities were not engaged in for profit. We sustain that
determination, primarily for the reasons stated in Coggin v.
Commissioner, T.C. Memo. 1993-209. Petitioners have adduced no
persuasive evidence or argument to distinguish their case from
Coggin in this respect. The objective facts presented in this
case fail to establish that ERL entered into the lease with an
actual and honest objective of making an economic profit,
independent of tax savings. See generally Drobny v.
Commissioner, 86 T.C. 1326 (1986); Dreicer v. Commissioner, 78
T.C. 642 (1982), affd. without opinion 702 F.2d 1205 (D.C. Cir.
1983). Consequently, we resolve this issue in favor of
respondent.
Petitioners argue in the alternative that, if ERL was not
engaged in an activity for profit, they are entitled to deduct
their allocable share of ERL’s expenses, excluding the royalty
obligations, in accordance with section 183(b) for each year at
issue. Respondent contends that petitioners are in any event
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precluded from taking such deductions because they have failed to
substantiate their entitlement to them. We agree with
respondent.
Deductions are a matter of legislative grace, and
petitioners bear the burden of proving that they are entitled to
the deductions claimed. Rule 142(a); New Colonial Ice Co. v.
Helvering, 292 U.S. 435, 440 (1934); Welch v. Helvering, 290 U.S.
at 115.
Petitioners argue that, because respondent had possession of
25 boxes of ERL’s records for a substantial period of time prior
to trial, it is incumbent upon respondent to come forward with
evidence establishing that the claimed deductions were not in
fact paid or incurred by ERL. We reject such a contention and
decline to shift the burden of proof to respondent. On brief,
petitioners claim entitlement to various expenses, but the
exhibits and self-serving testimony on which they rely fail to
substantiate that the alleged expenses were in fact paid or
incurred. Consequently, respondent is sustained on this ssue.
Issue 6. Section 6653(a) and Section 6653(a)(1) and (2)
Respondent determined that petitioners are liable for an
addition to tax under section 6653(a) for 1980 and additions to
tax under section 6653(a)(1) and (2) for 1981 and 1982.
Petitioners bear the burden of proof in establishing that they
are not liable for such additions to tax. Rule 142(a). Section
6653(a) for 1980 and section 6653(a)(1) for 1981 and 1982 provide
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for an addition to tax equal to 5 percent of the underpayment of
tax if any part of such underpayment is due to negligence or
intentional disregard of rules or regulations. Section
6653(a)(2), as in effect for 1981 and 1982, provides for an
addition to tax of 50 percent of the interest on that portion of
the underpayment attributable to negligence. Negligence under
section 6653(a) is the failure to do what a reasonable or
ordinarily prudent person would do under the circumstances.
Zmuda v. Commissioner, 731 F.2d at 1422; Neely v. Commissioner,
85 T.C. 934, 947 (1985).
Petitioners advance several arguments in an attempt to
convince the Court that no addition to tax under section 6653(a)
or section 6653(a)(1) and (2) is appropriate. Each argument,
however, is self-serving and without merit. Petitioners first
argue that section 6653's extensive history of amendments
suggests that the section is inherently flawed, and, as such,
should not be applied against them. We reject such an argument.
Petitioners next argue that respondent has treated various
taxpayers in the McIntyre-CN litigation project differently with
respect to the application of section 6653. This argument must
be rejected because it is the well-established position of this
Court that our responsibility is to apply the law to the facts of
the case before us and to determine the tax liability of the
taxpayer in that case. Davis v. Commissioner, 65 T.C. 1014, 1022
- 29 -
(1976). In reaching our decision, the Commissioner’s treatment
of other taxpayers is generally considered irrelevant. Id.
Petitioners next argue that Bauman invested in ERL only
after extensive discussions with other partners in his law firm.
They also contend that certain professional financial advisers
were consulted by various partners of Bauman’s law firm and that
such consultations contributed to Bauman’s decision to invest in
ERL. We reject this argument as self-serving; it is not
supported by the facts of the record.
Petitioners further argue that Bauman relied heavily on the
contents of the offering materials, which petitioners contend
were prepared by various experts. But those responsible for
preparing the contents of the offering materials were not
disinterested advisers, nor were they shown to be in fact
experts. Moreover, Bauman was not an unsophisticated investor.
We find his testimony regarding his alleged good faith reliance
questionable. At best, the information contained in the offering
materials was speculative conjecture. The offering materials
were “long on conclusions, but short on reasoning”, and we are
skeptical that an intelligent, educated person such as Bauman
could in good faith rely thereon in hope of earning a profit
independent of tax considerations. See Lieber v. Commissioner,
T.C. Memo. 1993-424.
Reliance on the advice of professionals may serve to defeat
a finding of negligence, but we are not convinced that
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petitioners have shown that the purported reliance in the instant
case was reasonable. See Freytag v. Commissioner, 89 T.C. 849,
889 (1987), affd. 904 F.2d 1011 (5th Cir. 1990), affd. 501 U.S.
868 (1991). "In the face of a transaction which clearly lacked
economic substance, and which was designed to produce tax
benefits out of proportion with total investment, * * *
[petitioners’ arguments] do not establish the exercise of due
care.” Hildebrand v. Commissioner, 967 F.2d 350, 353 (9th Cir.
1992), affg. Ames v. Commissioner, T.C. Memo. 1990-87. Had there
been a bona fide examination of the offering materials, no
ordinarily prudent person would have found ERL to be a legitimate
investment. “Warning bells tolled, but * * * [Bauman] ignored
them”. Freytag v. Commissioner, supra at 889; see also Kantor v.
Commissioner, 998 F.2d 1514, 1522-1523 (9th Cir. 1993), affg. in
part and revg. in part T.C. Memo. 1990-380. At the very least,
Bauman was negligent. Accordingly, respondent’s determination
that petitioners are liable for the addition to tax under section
6653(a) for 1980 and additions to tax under section 6653(a)(1)
and (2) for 1981 and 1982 is sustained.
Issue 7. Section 6621(c)
Section 6621(c) provides for an increased rate of interest
with respect to any substantial underpayment of tax attributable
to one or more tax motivated transactions. An underpayment is
substantial if it exceeds $1,000. Sec. 6621(c)(2). A tax-
motivated transaction includes any sham or fraudulent
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transaction. Sec. 6621(c)(3)(A)(v). Additionally, section
6621(c)(3)(B) authorizes the Secretary to specify by regulation
additional types of transactions which will be treated as
tax-motivated transactions. Section 301.6621-2T, Q&A-4,
Temporary Proced. & Admin. Regs., 49 Fed. Reg. 50392 (Dec. 28,
1984), provides that deductions disallowed for any period in the
case of an activity not engaged in for profit within the meaning
of section 183 are considered to be attributable to a
tax-motivated transaction.
Petitioners contend that section 6621(c) cannot be properly
applied to them because the “any sham or fraudulent transaction”
clause of section 6621(c)(3)(A)(v) was not added to the Internal
Revenue Code until 1984, which was after the years presently at
issue. This argument must fail. The statute, as so amended,
applies to interest accrued after December 31, 1984, even though
the transaction was entered into prior to that date. See
Solowiejczyk v. Commissioner, 85 T.C. 552 (1985), affd. per
curiam without published opinion 795 F.2d 1005 (2d Cir. 1986);
Kozlowski v. Commissioner, T.C. Memo. 1993-430, affd. without
published opinion 70 F.3d 1279 (9th Cir. 1995).
The section 6621(c) increased rate of interest does not
apply to deductions disallowed on separate and independent
grounds which do not fall within the specified categories of
tax-motivated transactions. McCrary v. Commissioner, 92 T.C.
827, 858-860 (1989). Here, we have sustained the disallowance of
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the deductions claimed as advance minimum royalty payments under
section 1.612-3(b), Income Tax Regs. The basis for disallowance
of the advance minimum royalty payments is independent of and
separable from the tax-motivated transactions upon which the
other deductions of ERL were disallowed. Therefore, to the
extent that petitioners’ underpayment of tax is attributable to
the disallowed advance minimum royalty payments, petitioners are
not liable for the increased interest under section 6621(c). All
other disallowed deductions, however, have been sustained on
grounds of economic sham and lack of profit objective.
Accordingly, petitioners will be liable for increased interest
under section 6621(c) for the underpayment in tax attributable to
these adjustments, if the underpayments for each year exceed
$1,000.
Issue 8. Late Filing Addition to Tax
Section 6651(a)(1) provides for an addition to tax for
failure to timely file a Federal income tax return. Section
6651(a)(1) also provides for an exception to this addition when
the taxpayer shows that the failure to file was due to reasonable
cause and not due to willful neglect. Willful neglect has been
defined as “a conscious, intentional failure or reckless
indifference”. United States v. Boyle, 469 U.S. 241, 245
(1985). Merely demonstrating an absence of willful neglect does
not meet the burden of proof required of the taxpayer; the
taxpayer must also make an affirmative showing that a reasonable
- 33 -
cause existed for the untimely filing. Paula Constr. Co. v.
Commissioner, 58 T.C. 1055, 1061 (1972), affd. without published
opinion 474 F.2d 1345 (5th Cir. 1973). In order to establish
reasonable cause, petitioners must show that they exercised
ordinary business care and prudence and were nevertheless unable
to file the return by the prescribed date. Crocker v.
Commissioner, 92 T.C. 899, 913 (1989); sec. 301.6651-1(c)(1),
Proced. & Admin. Regs.
Petitioners advance three arguments with respect to this
issue. First, petitioners argue that their failure to timely
file their 1982 return was due to Bauman’s preoccupation with his
father’s ailing health and that such preoccupation constitutes
sufficient cause to excuse their untimely filing. Petitioners
further argue that the late filing addition to tax should not be
applied to them because their 1982 return was in fact filed prior
to the expiration of the automatic 4-month extension period that
they would have received had they filed an application for an
extension of time to file. Finally, petitioners argue that the
late filing addition to tax should not be applied to them because
their explanation for the untimely filing was accepted by an
agent for respondent when their 1982 return was being audited in
1983.
Respondent, in contrast, contends that petitioners’ failure
to timely file their 1982 return was not due to reasonable cause,
but rather due to willful neglect. Respondent explains that
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despite the poor health of Bauman’s father, Bauman managed to
continue his practice of law. This ability to continue managing
his normal affairs, respondent contends, indicates that Bauman
was not so overwhelmed by his concern for his father that he
could not comply with his obligation to file the tax return.
Respondent also argues that Bauman’s concern for his father did
not preclude Mrs. Bauman from fulfilling their obligation to file
a timely return. We agree with respondent.
Petitioners have not established that their failure to file
their 1982 tax return by the prescribed date was due to
reasonable cause and not due to willful neglect. While we
appreciate the emotional difficulties Bauman may have experienced
while caring for his father, the record does not support his
contention that he was so overwhelmed by his father’s
deteriorating health as to preclude a timely filing. The fact
that Bauman continued to practice law throughout this period
indicates that his father’s condition did not prevent him from
filing the return on time. See Dickerson v. Commissioner, T.C.
Memo. 1990-577. Moreover, petitioners failed to explain why Mrs.
Bauman was unable to satisfy the couple’s obligation to file a
timely return.
We reject petitioners’ contention that the late filing
addition to tax should not be applied to them merely because
their return was in fact filed prior to the expiration of the 4-
month extension period that would have been granted automatically
- 35 -
had they filed an application for extension of time to file. The
fact remains that no such extension was applied for or granted.
We also reject petitioners’ argument that the late filing
addition to tax should not be applied to them in light of
discussions which they allegedly had with respondent’s agent
regarding the untimely filing. Bauman’s testimony as to the
nature of these discussions was self-serving, and the record
lacks evidence to corroborate his testimony. Accordingly,
respondent’s determination as to this issue is sustained.
To reflect the foregoing,
Decisions will be
entered under Rule 155.