T.C. Memo. 2000-96
UNITED STATES TAX COURT
TED AND TAMMY ESTES, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 10493-98. Filed March 21, 2000.
Bruce A. Moates, for petitioners.
Bruce K. Meneely, for respondent.
MEMORANDUM OPINION
DAWSON, Judge: This case was assigned to Special Trial
Judge Daniel J. Dinan pursuant to Rules 180, 181, and 183.
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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The Court agrees with and adopts the opinion of the Special
Trial Judge, which is set forth below.
OPINION OF THE SPECIAL TRIAL JUDGE
DINAN, Special Trial Judge: This case is before the Court
on petitioners’ motion, and supplemental motion, for award of
litigation and administrative costs pursuant to the provisions of
Rule 231 and of section 7430 of the Internal Revenue Code in
effect at the time the petition in this case was filed.
Although respondent requested a hearing on this motion, we
find that a hearing is not necessary. See Rule 232(a).
Accordingly, we rule on petitioners’ motion on the basis of the
parties’ submissions and the existing record. Petitioners
resided in Oklahoma City, Oklahoma, at the time the petition was
filed in this case.
Background
The overriding issue in this case was the substantiation of
expenses and costs of goods sold claimed by petitioners to have
been incurred in connection with petitioner husband’s
(petitioner) business. While the question of whether petitioners
initially maintained adequate business records remains disputed
by the parties, the poor condition of the records at the time of
respondent’s examination is not disputed. Petitioner contends
that a fire partially destroyed his records, making them
unavailable to respondent. The parties agree that for one reason
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or another complete records did not exist at the time of the
audit and that reconstructions of petitioners’ income and
expenses had to be made. The reconstructions to a large extent
were based upon petitioners’ checks and deposit tickets from the
years in issue. The examining agent also relied upon bank
records and summary documents prepared by petitioners’
accountant.
The primary issues discussed by the parties prior to the
issuance of the notice of deficiency were cost of goods sold,
gross receipts, and the sale of oil royalties. The third issue,
sale of oil royalties, was resolved in petitioners’ favor prior
to the issuance of the notice of deficiency. Because petitioners
believed they would owe no taxes if the first issue, cost of
goods sold, were decided in their favor, petitioners in
settlement negotiations agreed to concede all other issues if
respondent made a favorable determination regarding the cost of
goods sold amounts.
Respondent issued a statutory notice of deficiency to
petitioners dated May 19, 1998. The notice set forth the
following adjustments:
1992 1993 1994
Advertising expense ($14,725) -0- -0-
Aircraft expense -0- -0- ($14,186)
Commission expense -0- $31,000 -0-
Cost of goods sold 219,038 (2,204) 289,491
Depreciation expense (471) (902) (832)
Gross receipts (16,808) 5,113 (200,250)
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1992 1993 1994
Insurance expense -0- $7,820 $8,763
Interest income $228 524 -0-
Misc/other expense 2,624 2,704 3,444
Net operating loss deduction 25,800 18,775 28,789
Reclassification items (4,553) (17,062) (9,588)
Sale of oil royalties -0- 3,048 -0-
Taxes/licenses expense 2,228 (1,299) 3,463
Travel expense 3,875 9,764 3,625
Truck expense 6,960 -0- -0-
Utilities/phone expense 4,778 4,587 5,012
Self-employment tax deduction (4,641) (223) (4,865)
Capital gains and losses -0- 2,460 (3,000)
Taxable Social Security -0- 826 4,730
Deduction for exemptions 2,208 -0- -0-
Total adjustments 226,541 64,931 114,596
Taxable income on return1 (18,756) (39,689) (44,427)
Taxable income as adjusted 207,785 25,242 70,169
1
The taxable income amounts are those which the notice of
deficiency indicates were on the original returns filed by
petitioners.
These adjustments resulted in the determination that petitioners
were liable for the following deficiencies, section 6662(a)
accuracy-related penalties, and section 6651(a)(1) additions to
tax in the total amount of $114,514:
1992 1993 1994
Deficiencies $66,446 $4,231 $24,438
Penalties 13,289 -0- 4,888
Additions to tax -0- -0- 1,222
Total 79,735 4,231 30,548
Petitioners filed a petition with the Court on June 10,
1998, seeking a redetermination of the deficiencies stated in the
notice. Respondent filed an answer on July 9, 1998. In the
answer, respondent took the same position as reflected in the
notice of deficiency. Petitioners’ counsel first met with a
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representative and counsel for respondent on January 11, 1999.
At this meeting, several issues were discussed. Among them were
various details relating to the proper cost of goods sold
amounts, including the contested issue of the amount of beginning
inventory for 1992. In addition, petitioners presented documents
regarding insurance premiums which respondent accepted as
substantiation of properly deductible expenses.
At a meeting on January 26, 1999, petitioners presented
additional material regarding the beginning inventory issue. At
another meeting held on February 17, 1999, several topics were
again discussed, including travel and entertainment expenses, for
which respondent allowed a partial deduction. At this meeting,
respondent made a settlement offer which proposed to make some
concessions favorable to petitioners in exchange for reciprocal
concessions. Respondent contends that petitioners provided new
information with regard to the costs of goods sold issue at this
meeting, but petitioners dispute this contention. After the
meeting, respondent made final calculations regarding the
settlement offer, and forwarded the offer to petitioners on
February 23, 1999. The offer consisted of the following
liabilities in the total amount of $24,540:
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1992 1993 1994
Deficiencies $18,647 $2,164 -0-
Penalties 3,729 -0- -0-
Additions to tax -0- -0- -0-
Total 22,376 2,164 -0-
Petitioners rejected this settlement offer.
Counsel for both parties, along with respondent’s Appeals
officer, met on March 23, 1999. Counsel again met on April 2,
1999, this time with petitioner present. Respondent and
petitioners dispute whether and to what extent new evidence was
given in these later stages of negotiation to substantiate the
amounts claimed as cost of goods sold. The parties also dispute
whether petitioners’ personal conversations with respondent’s
counsel yielded information previously not available to
respondent. After this meeting, however, respondent made the
decision to concede the case in whole to petitioners.
A stipulated decision was entered on May 11, 1999. The
decision document stated that petitioners were not liable for any
deficiencies, penalties, or additions to tax.1 The Statement of
Income Tax Changes–-prepared by respondent and filed with the
1
The Statement of Income Tax Changes lists an
overassessment for taxable year 1992 in the amount of $1,376.
The decision document, however, states that there were no
overpayments in the years at issue.
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Court by petitioners with their motion for costs–-lists the
following basis for settlement of the case:2
1992 1993 1994
Advertising expense $14,725 -0- -0-
Aircraft expense -0- -0- ($14,186)
Commission expense -0- ($31,000) -0-
Cost of goods sold -0- (2,204) -0-
Depreciation expense (471) (902) (832)
Gross receipts (16,808) 5,113 (200,250)
Insurance expense -0- (2,497) (1,868)
Interest income 228 524 -0-
Misc/other expense (2,624) (2,704) (3,444)
Net operating loss deduction -0- 18,775 28,789
Reclassification items (4,553) (17,062) (9,588)
Sale of oil royalties -0- 3,048 -0-
Taxes/licenses expense (2,228) (1,299) (3,463)
Travel expense (1,938) (4,882) (1,813)
Truck expense (6,960) -0- -0-
Utilities/phone expense (4,778) (4,587) (5,012)
Self-employment tax deduction 688 -0- -0-
Capital gains and losses -0- 2,460 (3,000)
Taxable Social Security -0- -0- -0-
Deduction for exemptions -0- -0- -0-
Total adjustments (24,719) (37,217) (214,667)
Taxable income on return (18,756) (39,689) (44,427)
Taxable income as adjusted (43,475) (76,906) (259,094)
A motion by petitioners to vacate the decision was filed on June
14, 1999, and was subsequently granted. A motion by petitioners
for litigation and administrative costs was filed on June 17,
1999.
2
The settlement adjustments seemingly do not accurately
reflect the adjustments agreed to by the parties, as reflected
elsewhere in the record. The reasons for these discrepancies are
unclear. The sole issue before the Court, however, is the
appropriate ruling on petitioners’ motion for litigation and
administrative costs.
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Discussion
Section 7430 provides for the award of reasonable
administrative and litigation costs to a taxpayer in an
administrative or court proceeding brought against the United
States involving the determination of any tax, interest, or
penalty pursuant to the Internal Revenue Code. An award of
administrative or litigation costs may be made where the
taxpayer: (1) Is the “prevailing party”; (2) exhausted available
administrative remedies;3 and (3) did not unreasonably protract
the administrative or judicial proceeding. See sec. 7430(a),
(b)(1), (3). The costs claimed must also be reasonable in
amount. See sec. 7430(c). These requirements are conjunctive,
and failure to satisfy any one will preclude an award of costs to
petitioners. See Minahan v. Commissioner, 88 T.C. 492, 497
(1987).
To be a “prevailing party”, the taxpayer must show that (1)
the taxpayer substantially prevailed with respect to the amount
in controversy or with respect to the most significant issue(s)
presented, and (2) the taxpayer satisfied the net worth
requirement. See sec. 7430(c)(4)(A). If respondent establishes
that the position of the United States in the proceeding was
3
This requirement does not apply to an award for
reasonable administrative costs. See sec. 7430(b)(1).
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substantially justified, however, a taxpayer is not a “prevailing
party” for purposes of section 7430. See sec. 7430(c)(4)(B).4
After concessions by respondent, the remaining issues are:
(1) Whether the position of the United States in the proceeding
was substantially justified, and (2) whether the amounts of
administrative and litigation costs claimed by petitioners are
reasonable. Because we hold that respondent’s position was
substantially justified, we need not consider respondent’s
alternative argument that the administrative and litigation costs
requested by petitioners are not reasonable.
The substantially justified standard under section 7430 is
applied as of the separate dates respondent took positions in the
administrative and judicial proceedings. See sec. 7430(c)(7).
For purposes of administrative costs, the position of the United
States is that taken in an administrative proceeding as of the
earlier of the date of the receipt by the taxpayer of the notice
of decision by the Internal Revenue Service Office of Appeals or
the date of the notice of deficiency. See sec. 7430(c)(7)(B).
The position of the United States for purposes of litigation
costs refers to the position of the United States in a judicial
4
Because the petition in this case was filed after July
30, 1996, under sec. 7430 the burden is on respondent to show
that the Government’s position was substantially justified. See
Taxpayer Bill of Rights 2, Pub. L. 104-168, sec. 701(d), 110
Stat. 1452, 1464 (1996); Maggie Management Co. v. Commissioner,
108 T.C. 430, 438 (1997).
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proceeding. See sec. 7430(c)(7)(A). A judicial proceeding in
this Court is commenced with the filing of a petition. See Rule
20(a). Generally, respondent initially takes a position in the
litigation on the date he files the answer in response to the
petition. See, e.g., Han v. Commissioner, T.C. Memo. 1993-386.
The Commissioner’s position is substantially justified if
that position could satisfy a reasonable person and if it has a
reasonable basis in both fact and law. See Pierce v. Underwood,
487 U.S. 552, 565 (1988). Determining the reasonableness of the
Commissioner’s position and conduct requires considering what the
Commissioner knew at the time. See DeVenney v. Commissioner, 85
T.C. 927, 930 (1985). The Commissioner’s position can be
justified even if the Commissioner eventually concedes the case.
See Sokol v. Commissioner, 92 T.C. 760, 767 (1989).
Petitioners’ records were at best in a disordered state when
respondent sought to review them. Only incomplete information
was available to respondent, and respondent was forced to rely
upon reconstructed records to determine petitioners’ tax
liability. It is well established that taxpayers are required to
keep adequate books and records, and in the absence of such,
respondent may determine a taxpayer’s tax liability by any method
which respondent finds to clearly reflect income. See sec. 6001;
sec. 446(b); sec. 1.6001-1(a), Income Tax Regs.; sec. 1.446-
1(a)(4), (b)(1), Income Tax Regs. This is true even where the
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taxpayer’s records are destroyed by fire, and the taxpayer’s
reconstructions are inadequate. See, e.g., Jernigan v.
Commissioner, T.C. Memo. 1978-13. The record in this case
indicates that respondent adopted a reasonable, and therefore
substantially justified, position in light of the inadequacy of
petitioners’ books and records and the information accessible to
respondent throughout the administrative proceedings and in
respondent’s filing of the answer in this case on July 9, 1998.5
Petitioners argue that respondent was not substantially
justified in his position because respondent’s counsel ultimately
offered to concede the entire tax liability for all years in
issue based upon essentially the same information that was
available to respondent prior to the issuance of the notice of
deficiency. We find, however, that respondent’s position was
substantially justified in this case because of the lack of
adequate books and records available to respondent. The fact
that respondent’s counsel ultimately decided to concede the case
may reflect a consideration of a variety of factors–-including
litigation risks–-which earlier were not considered or which were
5
Petitioners contend that respondent’s position is that
taken in a notice of decision which was sent to petitioners on
Jan. 15, 1998, several months before the notice of deficiency.
It is unclear from the record whether this notice was in fact a
final decision by the Appeals Office. This is not determinative
in this case, however, because we find that respondent was
substantially justified at all times during the administrative
proceeding.
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not weighed as heavily by respondent. Furthermore, the record
shows that the parties were actively engaged in negotiations
throughout the administrative and litigation process, and that
respondent did not unreasonably delay acting upon any information
which he received from petitioners.
In view of the foregoing, we find that the position of the
United States was substantially justified. Accordingly, we hold
that petitioners are not entitled to administrative and
litigation costs under section 7430. Based on this holding, we
need not consider respondent’s alternative argument that the
administrative and litigation costs requested by petitioners are
not reasonable. Petitioners’ motion will therefore be denied.
An appropriate order and
decision will be entered.