T.C. Memo. 1997-68
UNITED STATES TAX COURT
RELIABLE CREDIT ASSOCIATION, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 4283-95. Filed February 10, 1997.
Neale E. Creamer, for petitioner.
Shirley M. Francis, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
DAWSON, Judge: This case was assigned to Special Trial
Judge Carleton D. Powell pursuant to the provisions of section
7443A(b)(4) and Rules 180, 181, and 183.1 The Court agrees with
1
Unless otherwise indicated, section references are to the
Internal Revenue Code in effect for the years in issue, and all
Rule references are to the Tax Court Rules of Practice and
Procedure.
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and adopts the opinion of the Special Trial Judge that is set
forth below.
OPINION OF THE SPECIAL TRIAL JUDGE
POWELL, Special Trial Judge: This case is before the Court
on petitioner's motion, as supplemented, for an award of
reasonable litigation costs,2 pursuant to section 7430. The only
issues presented are: (1) Whether respondent's position was
substantially justified, and (2) whether, if not, the claimed
litigation costs are reasonable in amount.3
FINDINGS OF FACT
Reliable Credit Association, Inc. (Reliable or petitioner)
is a corporation engaged in the business of purchasing existing
notes and other contract receivables at a discount, thereby
realizing income over the life of the notes or receivables in the
form of interest and upon maturity or collection equal to the
discount. At the time the petition was filed, Reliable's
principal office was located in Portland, Oregon.
Respondent audited petitioner's 1991 and 1992 tax returns
and issued a notice of deficiency to petitioner. In the notice
of deficiency respondent determined that, for the taxable years
2
Petitioner does not request an award of reasonable
administrative costs. See sec. 7430(a)(1).
3
Respondent does not dispute that petitioner satisfies the
remaining elements of a claim for reasonable litigation costs.
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1991 and 1992, petitioner was liable for deficiencies in the
respective amounts of $1,432,427 and $1,057,707, and accuracy-
related penalties under section 6662(a) in the respective amounts
of $286,485 and $211,541. Essentially, respondent's
determinations were based on two contentions: (1) Petitioner's
method of accounting did not clearly reflect income, and, as a
result, various items of interest and discount income were
understated, and (2) petitioner failed to substantiate deductions
for bad debts, rental expenses, and depreciation. With regard to
the first contention, respondent determined that petitioner's
books and records were inadequate to establish the amount of
petitioner's gross income.
Petitioner timely filed a petition with this Court.
Subsequently, petitioner hired Milton D. Mittelstedt
(Mittelstedt), a certified public accountant with Deloitte &
Touche LLP, to assist in the litigation. Mittelstedt apparently
did not attempt to reconcile petitioner's income from its
accounting records. Rather he prepared net worth analyses. A
net worth analysis is a reconstruction of a taxpayer's taxable
income based on changes of net worth from the beginning to the
end of a taxable period. These analyses became the basis of a
settlement that was reached between petitioner and respondent's
appeals officer. For services rendered between June 1995 and
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February 1996, totaling 114 hours, Mittelstedt charged petitioner
$34,200.
This case was calendared for trial on May 20, 1996, and was
reported settled at the calendar call. The parties entered into
a closing agreement, signed by petitioner on June 6, 1996. This
agreement provided that the dispute would be resolved by using an
indirect method of determining taxable income because
petitioner's records were "inadequate to determine [the amount
of] unearned discount income from various deferred income
accounts and the [amount of] bad debts from the various bad debt
accounts", and that in subsequent years petitioner would maintain
records sufficient to allow its tax return to be audited on a
"line-by-line" basis "as the appropriate rules and regulations
may require."
On June 19, 1996, the parties filed a stipulation with this
Court providing that petitioner was liable for deficiencies in
income taxes for the taxable years 1991 and 1992 in the amounts
of $383,874 and $124,325, respectively. The stipulation further
provided that petitioner was not liable for the section 6662(a)
penalties for either year. The motion for litigation costs was
subsequently filed.
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OPINION
General Principles--Substantially justified
Section 7430(a)(2), subject to certain limitations not
relevant here, generally allows a taxpayer that files a petition
in this Court to recover reasonable litigation costs incurred
with respect to the determination of any tax or penalty, provided
the taxpayer is the "prevailing party". To be considered a
"prevailing party" a taxpayer must establish, inter alia, that
the position of the United States was "not substantially
justified".4 Sec. 7430(c)(4)(A)(i).
The fact that the Commissioner ultimately concedes all or
part of a case is not sufficient to establish that the
Commissioner's position was unreasonable in an administrative or
civil tax proceeding. Sokol v. Commissioner, 92 T.C. 760, 765-
767 (1989); Sher v. Commissioner, 89 T.C. 79, 87 (1987), affd.
4
In 1986, Congress amended sec. 7430 by replacing the term
"unreasonable" with the phrase "not substantially justified".
Tax Reform Act of 1986, Pub. L. 99-514, sec. 1551, 100 Stat.
2752. This change was effected to conform sec. 7430 more closely
with the Equal Access to Justice Act (EAJA), 28 U.S.C. sec. 2412
(1988). H. Conf. Rept. 99-841, at 799, 801 (1986), 1986-3 C.B.
(Vol. 4) 1, 799, 801. In the context of the EAJA, the Supreme
Court has interpreted the phrase "not substantially justified" to
mean "justified to a degree that could satisfy a reasonable
person." Pierce v. Underwood, 487 U.S. 552, 565 (1988). This
Court has consistently held that the "substantially justified"
standard is not a departure from the "reasonableness" standard.
See, e.g., Sher v. Commissioner, 89 T.C. 79, 84 (1987), affd. 861
F.2d 131 (5th Cir. 1988).
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861 F.2d 131 (5th Cir. 1988). Furthermore, it is generally
considered "reasonable" for the Commissioner to require a
taxpayer to substantiate income and deductions, and the
Commissioner typically will not be held liable for costs under
section 7430 for taking a position that requires a taxpayer to
show that such requirements have been met. See Amann v.
Commissioner, T.C. Memo. 1993-542, affd. without published
opinion 40 F.3d 1235 (1st Cir. 1994); Chiaffarano v.
Commissioner, T.C. Memo. 1992-614.
The Parties' Contentions
Petitioner sets forth various arguments in support of the
contention that respondent's position was not substantially
justified. The gravamens of petitioner's contention are: (1)
Respondent conceded the majority of the deficiencies; (2)
respondent failed to employ certain "standard auditing
procedures" that would have enabled respondent to easily
ascertain the correct amount of the taxable income; and (3)
petitioner offered to settle the case prior to the issuance of
the notice of deficiency for roughly the same amount as
ultimately stipulated.
Respondent's primary contention is that petitioner's books
and records were inadequate, and, as a result, respondent's
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determination was substantially justified. Specifically,
respondent contends that the records petitioner maintained were
insufficient to establish the amount of petitioner's gross
income. Petitioner does not dispute this point. In reply,
however, petitioner contends that this contention "evidences
[the] Commissioner's continued obsession that each line item of
gross income must be known with certainty rather than
concentrating [her] attention on taxable income (the quantity on
which the tax is actually calculated)."
We note initially that section 63(a) defines "taxable
income" as gross income minus allowable deductions. Thus, gross
income is the starting point for the computation of taxable
income. In addition, our tax system is based on self-assessment.
Flora v. United States, 362 U.S. 145, 176 (1960). As a result,
the Code and the regulations contain various record keeping
requirements. Section 6001 requires that
Every person liable for any tax imposed by this title
* * * shall keep such records, render such statements, make
such returns, and comply with such rules and regulations as
the Secretary may from time to time prescribe. * * *
Section 1.6001-1(a), Income Tax Regs., provides that
any person subject to tax under subtitle A of the Code * * *
shall keep such permanent books of account or records * * *
as are sufficient to establish the amount of gross income,
deductions, credits, or other matters required to be shown
by such person in any return of such tax * * *
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While the requirements of sec. 1.6001-1, Income Tax Regs., are
connected with the term "or", in this context, we interpret "or"
in the conjunctive rather than disjunctive. Cf. DeSylva v.
Ballentine, 351 U.S. 570, 573 (1956) (interpreting "or" in the
conjunctive); United States v. One 1973 Rolls Royce, V.I.N. SRH-
16266, 43 F.3d 794, 815 (3d Cir. 1994) (holding that context is
determinative of whether the term "or" is used in the conjunctive
or disjunctive). It is not open to question that taxpayers must
keep records sufficient to establish the amount of income
received, deductions claimed, as well as the amount of any
credit, rather than records that establish just one of the three.
See, e.g., Lias v. Commissioner, 24 T.C. 280, 308 (1955), affd.
235 F.2d 879 (4th Cir. 1956); Rao v. Commissioner, T.C. Memo.
1996-500; Wynn v. Commissioner, T.C. Memo. 1996-415; Baker v.
Commissioner, T.C. Memo. 1994-283; Mitchell v. Commissioner,
T.C. Memo. 1968-137, affd. 416 F.2d 101 (7th Cir. 1969).
In the absence of adequate books and records, the
Commissioner may determine the existence and amount of a
taxpayer's income by any method that clearly reflects income.
Sec. 446(b); Harbin v. Commissioner, 40 T.C. 373, 377 (1963).
The Commissioner may use any reasonable method. DiLando v.
Commissioner, T.C. Memo. 1975-243. No particular method is
required since circumstances will vary in individual cases.
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Harbin v. Commissioner, supra at 377. Further, the Commissioner
is not required to make estimations or ferret out every possible
itemized deduction. Conforte v. Commissioner 74 T.C. 1160,
1177-1178 (1980), affd. in part and revd. and remanded in part on
other grounds 692 F.2d 587 (9th Cir. 1982).
Petitioner does not directly attack the method of accounting
that respondent used in determining its income and deductions,
and we have not been informed as to that methodology. Rather,
petitioner asserts that a taxpayer is not required to
substantiate its gross income provided taxable income can be
determined with reasonable accuracy. Given the definition of
taxable income and the recordkeeping requirements, we disagree,
and conclude that petitioner was required to keep records
sufficient to establish the amount of its gross income. DiLeo v.
Commissioner, 96 T.C. 858, 867 (1991), affd. 959 F.2d 16 (2d Cir.
1992). Accordingly, we find petitioner's argument that
respondent's position was not substantially justified is fatally
flawed. See Amann v. Commissioner, T.C. Memo. 1993-542, affd.
without published opinion 40 F.3d 1235 (1st Cir. 1994);
Chiaffarano v. Commissioner, T.C. Memo. 1992-614.
Petitioner makes other arguments, most of which rely to some
extent on the premise that petitioner was not required to keep
records sufficient to establish the amount of its gross income,
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and for that reason they lack merit. A few of these arguments,
however, deserve some further discussion.
Petitioner asserts that respondent's settlement of the case
largely in petitioner's favor, and for an amount roughly equal to
an offer made by petitioner during audit, establishes that
respondent's position was not substantially justified. We
disagree. As stated previously, the settlement of a case in
petitioner's favor is not determinative of whether respondent's
position is substantially justified. We find this particularly
true in cases where the issue is substantiation of gross income
and deductions. In reaching this conclusion, we note that this
case does not involve a situation where the Commissioner
continued to litigate the issue long after the taxpayer had
provided the net worth analyses. Here, despite petitioner's
apparent failure to keep adequate records, respondent settled the
case accepting an indirect method of verifying taxable income
proposed by petitioner on condition that petitioner would change
its method of accounting. In such circumstances, we believe that
respondent's refusal of petitioner's settlement offers little
weight in determining whether respondent's position was
substantially justified. In this regard, while petitioner may
have substantially prevailed, the agreed deficiency is hardly de
minimis.
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Petitioner also argues that respondent should be estopped
from challenging the adequacy of petitioner's records because
respondent failed to raise the issue in a prior audit. This
argument is not well taken. It is well established that the
Commissioner's failure to challenge a taxpayer's treatment of an
item in an earlier year does not preclude an examination of the
correctness of the treatment of that item in a later year.
Automobile Club of Michigan v. Commissioner, 353 U.S. 180, 183
(1957); Alfred I. duPont Testamentary Trust v. Commissioner, 66
T.C. 761, 765 (1976), affd. 574 F.2d 1332 (5th Cir. 1978).
Lastly, petitioner claims respondent failed to employ
certain "standard auditing procedures" that would have enabled
respondent to easily ascertain the correct amount of the
deficiencies. While, as mentioned above, petitioner does not
directly attack respondent's method for determining gross income
and deductions, petitioner contends that respondent was required
to make net worth analyses similar to that prepared by
Mittelstedt. Leaving aside the fact that this supposedly simple
endeavor cost petitioner almost $35,000 in accounting fees,
petitioner has not cited, and we are not aware of, any authority
that requires the Commissioner to employ particular auditing
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procedures in particular situations.5 In sum, "when the taxpayer
has defaulted in * * * [its] task of supplying adequate records,
* * * [the taxpayer] is not in a position to be hypercritical of
the Commissioner's labor." Webb v. Commissioner, 394 F.2d 366,
372 (5th Cir. 1968), affg. T.C. Memo. 1966-81.
Since we have found that respondent's position was
substantially justified, and, therefore, petitioner is not
entitled to recover litigation costs, there is no reason to
determine whether the costs claimed are reasonable. To reflect
the above and the stipulation of the parties,
An appropriate order and
decision will be entered.
5
Petitioner has cited provisions of the Internal Revenue
Manual; however, such provisions are not mandatory and do not
confer any rights upon taxpayers. United States v. Will, 671
F.2d 963, 967 (6th Cir. 1982).