T.C. Memo. 1996-325
UNITED STATES TAX COURT
R. EDWIN BROWN AND WINSOME S. BROWN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 7462-94. Filed July 17, 1996.
Rex L. Sturm, for petitioners.
Lindsey D. Stellwagen, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
PARR, Judge: Respondent determined a deficiency in
petitioners’ Federal income tax for the taxable year 1990 in the
amount of $179,597 and an accuracy-related penalty under section
6662(a)1 in the amount of $35,919.
1
All section references are to the Internal Revenue Code in
effect for the taxable year in issue, and all Rule references are
(continued...)
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The issues for decision are: (1) Whether the amount of debt
outstanding on certain computer equipment contributed to the
Barnesville School is includable in the amount realized by
petitioners from the transaction. We hold the debt is includable
in the amount realized. (2) Whether petitioners are entitled to
a charitable contribution deduction for computer equipment and
lease rights contributed to the Barnesville School. We hold they
are not. (3) Whether petitioners are liable for an accuracy-
related penalty under section 6662(a) due to substantial
understatement of income tax. We hold they are liable.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulation of facts and the attached exhibits are
incorporated herein by this reference. At the time the petition
was filed, petitioners resided in Dickerson, Maryland.
Petitioners are married and filed a joint Federal income tax
return for the year in issue. Since petitioner husband entered
into the transaction at issue, the term “petitioner” refers to R.
Edwin Brown.
On July 2, 1985, Federal Data Corp. (hereinafter FDC)
entered into a Non-Recourse Loan and Security Agreement with and
executed a promissory note to the Old Stone Bank (hereinafter
(...continued)
to the Tax Court Rules of Practice and Procedure, unless
otherwise indicated.
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OSB) for the purpose of purchasing computer equipment. FDC
leased the equipment to American Telephone and Telegraph Co.
(hereinafter AT&T). FDC assigned its rights, title, and interest
in the lease to OSB.
On December 31, 1985, FDC and petitioner entered into a
sale/leaseback transaction with respect to the computer equipment
(hereinafter sometimes referred to as the equipment leasing
transaction). Pursuant to the equipment leasing transaction, the
parties executed a Master Purchase Agreement, a Bill of Sale, and
a promissory note entitled “Recourse Note and Security
Agreement”2 (FDC note) in the amount of $2,358,994. On January
2, 1990, petitioner and the Barnesville School (hereinafter the
School) executed an Assignment--Master Purchase Agreement and
Master Lease Agreement (hereinafter the agreement) and Bill of
Sale. The Bill of Sale provides for the sale of the computer
equipment and all rights in the lease with FDC to the School for
$1 consideration. The agreement provides, in relevant part, as
follows:
all right, title, and interest in the equipment and
rights described in the Master Purchase Agreement and the
Master Lease Agreement dated the 31st day of December, 1985,
entered into by and between Federal Data Corporation * * *
and R. Edwin Brown is by these presents hereby transferred,
assigned, and set over to The Barnesville School. * * * The
Barnesville School shall be substituted for the Buyer and
that all applicable terms and conditions of the aforesaid
2
Although the note was entitled Recourse Note, the parties have
acknowledged that the note, due to a stop loss clause, see sec.
465(b)(4), was treated as a nonrecourse note.
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Master Purchase Agreement and Master Lease Agreement shall
remain in full force and effect.
The Barnesville School agrees to use the proceeds from
the aforesaid Master Lease Agreement to first satisfy the
obligations under the Recourse Note and Security Agreement
dated December 31, 1985, between R. Edwin Brown, Payor, and
Federal Data Corporation, Payee, as provided in the Agency
Agreement between said parties.
On January 2, 1990, petitioner’s outstanding obligation under the
FDC note was $1,540,280.
On their Federal income tax returns for years 1985-89,
petitioners claimed deductions for depreciation and interest
relating to the equipment-leasing transaction. Three separate
statutory notices of deficiency were issued, in which respondent
disallowed petitioners’ claimed deductions pursuant to section
465. Petitioners petitioned the Tax Court in each instance.
Losses in the amount of $549,122 were disallowed for those years
and were treated as a carryforward of suspended losses. On July
21, 1993, respondent sent petitioners a statutory notice of
deficiency for the 1990 tax year, determining a gain on the
disposition of the computer equipment to the School and allowing
the gain to be reduced by suspended losses for years 1985-89.
However, on February 10, 1994, in response to petitioners’
continued litigation in the Tax Court with respect to the 1988
and 1989 losses, respondent sent petitioners a second statutory
notice of deficiency for the 1990 tax year allowing the gain to
be reduced by suspended losses for years 1985-87 only.
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Subsequently, on April 19, 1994, this Court entered a decision
reflecting the settlement of petitioners’ 1988 and 1989 tax
years. As a consequence, respondent concedes that to the extent
petitioner realized a gain on the disposal of the computer
leasing equipment, the gain is reduced by suspended losses from
1985-89. Petitioners did not claim a charitable contribution
deduction on their 1990 Federal income tax return relating to the
property transferred to the School.
At the end of the trial, respondent orally moved for leave
to conform the pleadings to the evidence. Petitioners objected.
We took the motion under advisement. We subsequently issued an
order indicating that to the extent we allow respondent to amend
the pleadings to conform to the proof we would grant petitioners
the same privilege. To this end, we directed the parties to
brief the consequences of the sale of the computer equipment and
rights to the lease for purposes of claiming a charitable
contribution deduction.
OPINION
As a preliminary matter, we must resolve two issues:
Whether the second statutory notice of deficiency is valid and
whether respondent’s motion to conform the pleadings to the
evidence should be granted.
Validity of Respondent’s Second Statutory Notice of Deficiency
In their petition, petitioners allege that respondent
improperly issued a second statutory notice of deficiency.
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Respondent argues she was not precluded from issuing a second
notice of deficiency because petitioners had not filed a Tax
Court petition with respect to the first notice of deficiency.
If the Commissioner mails a notice of deficiency in income
tax and the taxpayer files a timely petition with the Tax Court,
the Commissioner is in general precluded from mailing to the
taxpayer a second notice of deficiency determining an additional
deficiency in income tax for the same year. Sec. 6212(c); McCue
v. Commissioner, 1 T.C. 986, 987-988 (1943). See generally
Breman v. Commissioner, 66 T.C. 61, 65-70 (1976). Accordingly,
the Commissioner is restricted from issuing a second notice of
deficiency with respect to the same taxable year only if the
taxpayer has filed a Tax Court petition with respect to the first
notice of deficiency. Goff v. Commissioner, 18 B.T.A. 283, 288-
289 (1929); Gmelin v. Commissioner, T.C. Memo. 1988-338, affd.
without published opinion 891 F.2d 280 (3d Cir. 1989).
On July 21, 1993, respondent sent a statutory notice of
deficiency to petitioners determining a deficiency for taxable
year 1990. Petitioners did not file a petition with respect to
the July 21, 1993, notice of deficiency. Respondent issued a
second statutory notice of deficiency on February 10, 1994, in an
attempt to preserve respondent's position with respect to prior
year deductions being contested by petitioners in another
proceeding before the Court.
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Since petitioners had not filed a petition with the Court,
section 6212(c) did not preclude respondent from issuing a second
statutory notice of deficiency for tax year 1990. Accordingly,
we hold that the second statutory notice of deficiency is valid.
Motion To Conform Pleadings to the Evidence
Respondent’s motion is for leave to file an amended answer
for an increased deficiency and penalty. The increase from
$1,017,248 to $1,540,280 arises due to correction of the amount
realized from the transfer of the computer lease obligation.
Petitioners allege harm and prejudice should we allow respondent
to amend her answer.
At the close of trial, respondent moved pursuant to Rule
41(b) to increase the deficiency. This Court has held on
numerous occasions that it will not consider issues which have
not been properly pleaded or otherwise preserved. Markwardt v.
Commissioner, 64 T.C. 989, 997-998 (1975). Nevertheless, Rule
41(b) provides a procedure whereby in appropriate circumstances
the pleadings may be amended to conform to the evidence presented
at trial.3
3
Rule 41(b) provides as follows:
(1) Issues Tried by Consent: When issues not raised by
the pleadings are tried by express or implied consent of the
parties, they shall be treated in all respects as if they
had been raised in the pleadings. The Court, upon motion of
any party at any time, may allow such amendment of the
pleadings as may be necessary to cause them to conform to
the evidence and to raise these issues, but failure to amend
(continued...)
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Section 6214(a) requires a claim for increased deficiency to
be asserted at or before the hearing or a rehearing. It is well
established that the word “hearing” as used in section 6214(a)
encompasses the entire “proceeding” up until the decision of the
Tax Court has been entered. Henningsen v. Commissioner, 243 F.2d
954 (4th Cir. 1957), affg. 26 T.C. 528 (1956); Law v.
Commissioner, 84 T.C. 985, 989 (1985).
As part of the parties’ joint stipulations, Exhibit 8-H was
admitted into evidence. That exhibit is the recourse note
entered into between petitioner and FDC. In addition, page 8 of
Exhibit 8-H is the debt service schedule. The schedule begins
with the principal balance of $2,358,994 and chronicles the
payments made on the note. As of January 2, 1990, the date of
the transfer to the School, the debt service schedule shows a
balance of $1,540,280.
3
(...continued)
does not affect the result of the trial of these issues.
(2) Other Evidence: If evidence is objected to at the
trial on the ground that it is not within the issues raised
by pleadings, then the Court may receive the evidence and at
any time allow the pleadings to be amended to conform to the
proof, and shall do so freely when justice so requires and
the objecting party fails to satisfy the Court that the
admission of such evidence would prejudice such party in
maintaining such party’s position on the merits.
(3) Filing: The amendment or amended pleadings
permitted under this paragraph (b) shall be filed with the
Court at the trial or shall be filed with the Clerk at
Washington, D.C., within such time as the Court may fix.
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The basic issue in the instant case--whether the nonrecourse
debt should be included in the amount realized upon transfer of
the computer to the School--was not altered by the increase in
the deficiency asserted by respondent. Petitioners had full
opportunity to meet the claim for an increased deficiency because
it was apparent from the outset of this suit that respondent
included the "nonrecourse debt" in the amount realized by
petitioners from the transfer of the equipment, and they
themselves stipulated the document which showed that the debt was
$1,540,280 rather than $1,017,248, thus giving rise to the
corresponding assertion of an increased deficiency. We find that
justice requires that we allow respondent’s answer to be amended.
Rule 41(a).
Accordingly, respondent’s motion to amend her answer to
conform to the evidence so as to assert an increased deficiency
will be granted. Respondent has the burden of proving, however,
that petitioners are liable for the increased deficiency. Rule
142(a).
Issue 1. Income From the Disposition of the Equipment Leasing
Interest
Respondent asserts that petitioners’ amount realized from
the transfer to the School must include the obligation under the
FDC note as a consequence of the School’s assumption of the note.
Petitioners argue that the note was not assumed by the School
and, furthermore, that the note was illusory.
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Generally, gain or loss from the disposition of property is
measured by the amount realized less the adjusted basis of the
property. Sec. 1001(a). The amount realized from the sale or
other disposition of property is defined as money received plus
the fair market value of any property received. Sec. 1001(b).
Furthermore, the amount realized generally includes the amount of
liabilities from which the transferor is discharged as a result
of the sale or disposition. Sec. 1.1001-2(a), Income Tax Regs.
An exception to this rule applies if the liability was incurred
by reason of the acquisition of the property but such liability
was not taken into account in determining the transferor’s basis
for the property. Sec. 1.1001-2(a)(3), Income Tax Regs.; see
also Brown-Forman Corp. v. Commissioner, 94 T.C. 919, 940 (1990),
affd. 955 F.2d 1037 (6th Cir. 1992); cf. Mendham Corp. v.
Commissioner, 9 T.C. 320 (1947); Lutz & Schramm Co. v.
Commissioner, 1 T.C. 682 (1943).
When a nonrecourse liability is at issue, a discharge of
the liability occurs when there is a sale or other disposition of
the property that secures the nonrecourse liability. Sec.
1.1001-2(a)(4)(i), Income Tax Regs. A charitable contribution of
property can be treated as a sale or exchange. Guest v.
Commissioner, 77 T.C. 9, 25 (1981); sec. 1.1011-2(a)(3), Income
Tax Regs.
Both parties cite Commissioner v. Tufts, 461 U.S. 300
(1983), in their arguments.
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In Tufts, the Supreme Court held that where a taxpayer
disposes of property encumbered by nonrecourse indebtedness in an
amount that exceeds the fair market value of the property, the
outstanding amount of the nonrecourse obligation is includable in
the amount realized by him. Moreover, the Supreme Court
concluded:
Unless the outstanding amount of the mortgage is deemed
to be realized [at the time of sale], the mortgagor
effectively will have received untaxed income at the
time the loan was extended and will have received an
unwarranted increase in the basis of his property.
* * * [Id. at 310; fn. ref. omitted.]
“In so holding, the Supreme Court reaffirmed the Crane ‘balancing
entry’ theory which is that the amount of the nonrecourse
liability is to be included in calculating both the basis and the
amount realized upon disposition.” Rice’s Toyota World, Inc. v.
Commissioner, 81 T.C. 184, 196 n.9 (1983), affd. in part, revd.
in part and remanded 752 F.2d 89 (4th Cir. 1985). This theory is
based upon the assumption that the mortgage was properly
includable in basis from the beginning and that it will be repaid
in full. Id. Accordingly, we have concluded that Tufts involved
the symmetrical treatment to be accorded where nonrecourse
liability has been properly included in basis initially and must
thereafter also be included in the amount realized on disposition
of the encumbered property. Dean v. Commissioner, 83 T.C. 56, 78
n.10 (1984).
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Respondent argues that Tufts is controlling, while
petitioners argue that the transaction at issue was subject to
section 465(b)(4) and therefore Tufts has no application.4
We essentially rejected petitioners' argument when we previously
held that the at-risk rules of section 465 do not supersede the
judicial doctrines for testing the inclusion of purported
nonrecourse debt in basis. Waddell v. Commissioner, 86 T.C. 848,
899 (1986) (citing S. Rept. 94-938 (1976), 1976-3 C.B. (Vol. 3)
49, 86, and noting that the at-risk rules do not replace the
rules for basis determination), affd. 841 F.2d 264 (9th Cir.
1988). Since the debt is included in basis notwithstanding any
limitations imposed by section 465, the exception in section
1.1001-2(a)(3), Income Tax Regs., would not apply. Moreover,
under the symmetrical analysis, it follows that where nonrecourse
liability has been properly included in basis initially, it must
thereafter also be included in the amount realized on disposition
of the encumbered property.
Furthermore, we note that the losses limited by section 465
are recognized upon disposition of the property. Allen v.
Commissioner, T.C. Memo. 1988-166; see also sec. 465(a)(2).
4
Petitioners refer to a footnote in Tufts in support of their
position: “this congressional action [enactment of sec. 465] may
foreshadow a day when nonrecourse and recourse debts will be
treated differently”. However, respondent points out that the
Supreme Court went on to say that “neither Congress nor the
Commissioner has sought to alter Crane’s rule of including
nonrecourse liability in both basis and the amount realized.”
Commissioner v. Tufts, 461 U.S. 300, 309 n.7 (1983).
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Respondent has conceded this effect. Therefore, we disagree with
petitioners that section 465 and the inclusion of the debt in
amount realized are mutually exclusive.
Moreover, we find no support in the record that respondent
and petitioners treated the debt as illusory. In contrast,
petitioners included the amount of the debt in their basis and
attempted to claim deductions relating thereto. Similarly,
respondent disallowed those deductions, not because the debt was
illusory, but rather because the section 465 at-risk rules
applied. Accordingly, we hold that petitioners must include in
their amount realized the amount of the FDC liability.
Since we have granted respondent’s motion to increase the
deficiency, she has the burden of proving the increased amount.
In light of the debt service schedule reflecting a balance of
$1,540,280 as the principal balance of the FDC note on January 2,
1990, and since petitioners have not offered any evidence to the
contrary, we hold that respondent has met her burden of proof
with respect to the increased deficiency.
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Issue 2. Charitable Contribution Deduction
Respondent argues that petitioners are not entitled to a
charitable contribution deduction because the amount of the
encumbrance exceeded the fair market value of the property at the
time of the transfer. Petitioners argue that they should be
allowed a charitable contribution deduction for the projected
income stream associated with the lease.
A taxpayer may make a charitable contribution by selling or
disposing of property to a charity for less than its fair market
value. Estate of Bullard v. Commissioner, 87 T.C. 261, 265
(1986). The amount of the charitable contribution resulting from
such a “bargain sale” generally is the excess of the fair market
value of the property over its sale price. Id.; Stark v.
Commissioner, 86 T.C. 243, 255-256 (1986); Knott v. Commissioner,
67 T.C. 681 (1977); Waller v. Commissioner, 39 T.C. 665, 677
(1963). Furthermore, to the extent that the fair market value of
property contributed exceeds the debt on the property, taxpayers
are entitled to a charitable contribution deduction. Guest v.
Commissioner, supra at 25.
A taxpayer has the burden of proving the amount of a
charitable contribution that he or she may deduct. Rule 142(a);
Guest v. Commissioner, supra; Lamphere v. Commissioner, 70 T.C.
391 (1978). Section 1.170A-1(c)(1), Income Tax Regs., provides
that the amount of a charitable contribution of property other
than money is the fair market value of the property at the time
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of the contribution subject to certain reductions. Section
1.170A-1(c)(2), Income Tax Regs., defines fair market value as
“the price at which the property would change hands between a
willing buyer and a willing seller, neither being under any
compulsion to buy or sell and both having a reasonable knowledge
of relevant facts.”
Petitioners offered virtually no evidence regarding the fair
market value of the computer and lease. The School received
lease payments on the Master Lease, but there is no proof that
those amounts were contributed by petitioners. Petitioners did
not contribute any cash to the School. Nor did petitioners
report as income any of the lease payments received by the
School. Moreover, petitioners have not offered proof on the
projected income stream, if any, with respect to the lease of the
computer equipment.
Petitioners have not proven that the fair market value of
the contributed property was in excess of the debt assumed.
Accordingly, we hold that petitioners are not entitled to a
charitable contribution deduction.
Issue 3. Section 6662 Substantial Understatement Penalty
Respondent determined that petitioners are liable for the
section 6662(a) penalty for 1990. Petitioners argue that there
was substantial authority for the position taken on their return.
Furthermore, petitioners argue that the complexity of the matter
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and the prior inconsistent positions of respondent make any
penalty inappropriate.
Section 6662(a) imposes an accuracy-related penalty of 20
percent on any portion of an underpayment of tax that is
attributable to items set forth in section 6662(b). Section
6662(b)(2) specifies as one of those items “Any substantial
understatement of income tax.” An understatement is substantial
if it exceeds the greater of 10 percent of the amount of tax
required to be shown on the return or $5,000. Sec. 6662(d)(1)(A)
and (B). An understatement means the excess of the amount of the
tax required to be shown on a return over the amount of tax
imposed which is shown on the return, reduced by any rebate
(within the meaning of section 6211(b)(2)). Sec. 6662(d)(2)(A).
An understatement is reduced to the extent it is (1) based
on substantial authority or (2) adequately disclosed in the
return or in a statement attached to the return. Sec.
6662(d)(2)(B). To determine whether the treatment of any portion
of an understatement is supported by substantial authority, the
weight of authorities in support of the taxpayer’s position must
be substantial in relation to the weight of authorities
supporting contrary positions. Antonides v. Commissioner, 91
T.C. 686, 700-704 (1988), affd. 893 F.2d 656 (4th Cir. 1990);
sec. 1.6662-4(d)(3), Income Tax Regs.
Furthermore, the accuracy-related penalty under section
6662(b)(2) does not apply with respect to any portion of an
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underpayment if it is shown that there was reasonable cause for
such portion of the underpayment and that the taxpayers acted in
good faith with respect to such portion. Sec. 6664(c)(1). The
determination of whether the taxpayers acted with reasonable
cause and in good faith depends upon the pertinent facts and
circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs. The most
important factor is the extent of the taxpayers’ effort to assess
their proper tax liability for the taxable year. Id.
After carefully examining the record, we find no basis on
which we can find that petitioners had substantial authority,
that they adequately disclosed the relevant facts concerning the
items on their tax return, or that they acted with reasonable
cause and in good faith with respect to any portion of the
understatement determined by respondent. We have considered all
of petitioners’ arguments on this point and find them to be
without merit. On the instant record, we sustain respondent’s
determination that petitioners are liable for the accuracy-
related penalty with respect to their entire underpayment of tax
for 1990.
To reflect the foregoing, and to take into account
concessions made,
An appropriate order will be
issued and decision will be
entered under Rule 155.