T.C. Memo. 2000-167
UNITED STATES TAX COURT
DARTMOUTH CLUBS, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 13251-98. Filed May 22, 2000.
William F. Patten, for petitioner.
Ronald F. Hood and David N. Brodsky, for respondent.
MEMORANDUM OPINION
PARR, Judge: This case is before the Court on petitioner's
motion for reasonable litigation and administrative costs
pursuant to section 74301 and Rules 230 through 232, filed
1
References to sec. 7430 in this opinion are to that section
of the Internal Revenue Code as amended by the Taxpayer Bill of
Rights 2 (TBOR 2), Pub. L. 104-168, secs. 701-704, 110 Stat.
1452, 1463-1464 (1996), which is effective with respect to
(continued...)
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February 2, 2000.
The issues for decision are: (1) Whether petitioner is the
prevailing party in the underlying tax case, within the meaning
of section 7430(c)(4). We hold it is not. (2) Whether the
litigation and administrative costs claimed by petitioner are
reasonable, within the meaning of section 7430(c)(1) and (2).
Because of our holding that petitioner is not the prevailing
party, we need not consider whether the costs claimed by
petitioner are reasonable.
Neither party has requested an evidentiary hearing on
petitioner's motion, and the Court concludes that such a hearing
is not necessary for the proper disposition of petitioner's
motion. See Rule 232(a)(2). Accordingly, we decide petitioner's
motion for an award of administrative and litigation costs on the
record of the case, including respondent's objection,
petitioner's response to respondent's objection, and the parties'
1
(...continued)
proceedings commenced after July 30, 1996. See TBOR 2 secs.
701(d), 702(b), 703(b), and 704 (b), 110 Stat. 1463-1464. Sec.
7430, as amended by TBOR 2, requires the United States to
establish that the position of the United States was
substantially justified. See sec. 7430(c)(4)(B)(i).
A judicial proceeding is commenced in this Court with the
filing of a petition. See Rule 20(a); Maggie Management Co. v.
Commissioner, 108 T.C. 430, 438 (1997). Petitioner filed its
petition on July 29, 1998; thus, sec. 7430 as amended by TBOR 2
is applicable. Other section references are to the Internal
Revenue Code in effect for the taxable years in issue.
All Rule references are to the Tax Court Rules of Practice
and Procedure, unless otherwise indicated.
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affidavits and exhibits, which are incorporated herein by this
reference.
Petitioner is an exotic dance club, whose address was
Westport, Massachusetts, at the time the petition in this case
was filed.
Background
Petitioner filed its Federal income tax returns using a
fiscal year ending on March 31. In April 1995, respondent began
an examination of petitioner's 1994 and 1995 corporate tax
returns. The examining revenue agent found that during these
years, petitioner had deducted cash payments made to many
individuals, including Henry Lauzon, Jr. (Lauzon, Jr.),
petitioner's president and sole shareholder, for which no Forms
W-2, Wage and Tax Statement, or Forms 1099-MISC, Miscellaneous
Income, had been issued. These cash payments totaled $644,743 in
1994 and $733,448 in 1995.
On July 16, 1995, January 30, 1996, July 12, 1996, and
September 18, 1997, the revenue agent sent petitioner information
document requests for documents that would substantiate that the
cash payments were corporate expenses. During the course of the
examination, the revenue agent and petitioner had several
meetings regarding the requested documentation.
Eventually, the revenue agent wrote a report on the disputed
items and proposed adjustments. In May 1997, petitioner
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protested the proposed adjustments at an administrative review in
the Internal Revenue Service Office of Appeals (Appeals).
Appeals returned the case to the revenue agent with instructions
to consider whether additional evidence that petitioner had
presented at the administrative review provided the required
substantiation.
The parties were not able to reach an agreement on the
disputed items, and petitioner refused to agree to a statutory
extension of the time to assess tax. Accordingly, on April 30,
1998, respondent mailed a notice of deficiency to petitioner.
In the notice, respondent determined deficiencies of
$219,885 and $249,372, and accuracy-related penalties of $43,977
and $49,874, for petitioner's fiscal years 1994 and 1995,
respectively. The deficiencies were based on the disallowance of
deductions that petitioner claimed for casual labor, security
expenses, talent scouting expenses, music expenses, and
management consulting fees.
The notice of deficiency stated that the deductions for the
casual labor, security expenses, music expenses, and management
consulting fees were disallowed because petitioner did not
provide substantiation, including invoices, matching canceled
checks, and Forms 1099, to support its claimed deductions.
Respondent disallowed the deduction for the talent scouting
expenses, because he determined that $104,000 of the amount
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claimed in each of the years at issue for this expense was a
dividend paid to Lauzon, Jr.
On July 29, 1998, petitioner filed a petition with this
Court. On September 28, 1998, respondent's answer was filed.
On September 25, 1998, respondent sent the case to Appeals
for consideration. On June 10, 1999, an Appeals officer
contacted petitioner's attorney, William F. Patten (Mr. Patten),
and the parties scheduled a conference for July 2. The Appeals
officer requested that Mr. Patten bring copies of any Forms 1099
that petitioner had issued, a worksheet reconciling the Forms
1099 to the corporate records, and a list of all persons that
received less than $600 from petitioner. Mr. Patten brought the
Forms 1099 to the conference, and he stated that the worksheet
and other information would be provided on July 7. Preparation
of the worksheets took longer than expected, and petitioner was
not able to provide them by the promised date.
On August 16, 1999, the Appeals officer received the
worksheet and other requested information for both years in
issue, except for any information about the $104,000 payments to
Lauzon, Jr. After reviewing the worksheets and other
information, the Appeals officer concluded that all the claimed
deductions were allowable as ordinary and necessary business
expenses, except for the $104,000 payments to Lauzon, Jr.
Petitioner claimed, and respondent allowed, deductions of
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$309,923 and $326,767 in 1994 and 1995, respectively, for
management consulting fees paid to Lauzon, Jr. The $104,000
payments were also recorded on petitioners books as management
consultant fees paid to Lauzon, Jr.; however, petitioner later
reclassified these payments as expenses incurred in scouting new
talent. Considering the amount of the management consultant fees
paid to Lauzon, Jr., the Appeals officer believed that the
$104,000 payments may have been excessive compensation.
Accordingly, on September 10, 1999, the Appeals officer
initiated a discussion with petitioner's accountant to resolve
this last item. On September 16, the Appeals officer and
petitioner agreed to split the $104,000--one-half of the amount
claimed was allowed as a deduction in each year, and one-half was
disallowed.
On September 24, 1999, the Appeals officer received the
audit department's computation and prepared the stipulated
decision document. The decision document showed income tax
deficiencies of $8,354 and $8,000 for 1994 and 1995,
respectively. On October 30, 1999, Mr. Patten signed the
stipulated decision document and respondent signed it two days
later. The Court entered the stipulated decision on November 5,
1999.
Petitioner thereafter filed a motion to vacate the decision
and a motion for administrative and litigation costs. Petitioner
claims that it incurred $61,632 in administrative and litigation
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costs from December 1996 to December 1999. The Court issued an
order granting petitioner's motion to vacate the decision, and we
now consider petitioner's motion for administrative and
litigation costs.
Discussion
Section 7430(a) provides that the prevailing party may be
awarded: (1) Reasonable administrative costs incurred in
connection with an administrative proceeding within the Internal
Revenue Service and (2) reasonable litigation costs incurred in
connection with a court proceeding. For this Court to award
reasonable administrative and litigation costs under section
7430, several conjunctive requirements must be met. The record
must show that: (1) The moving party exhausted any
administrative remedies available to him or her within the
Internal Revenue Service. See sec. 7430(b)(1). Respondent
concedes that petitioner has met this requirement. (2) The
moving party did not unreasonably protract the administrative
proceeding or the proceeding in this Court. See sec. 7430(b)(3).
Respondent concedes that petitioner has met this requirement.
(3) The moving party is the prevailing party. See sec. 7430(a).
As discussed below, we find that petitioner is not the prevailing
party.
To be a "prevailing party", a taxpayer must establish that
the taxpayer substantially prevailed with respect to the amount
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in controversy or with respect to the most significant issue or
set of issues presented, sec. 7430(c)(4)(A)(i), and that the
taxpayer is either an individual whose net worth does not exceed
$2 million, or an owner of any unincorporated business, or any
partnership, corporation, etc., the net worth of which does not
exceed $7 million, at the time the petition is filed, see sec.
7430(c)(4)(A)(ii); 28 U.S.C. sec. 2412(d)(2)(B) (1988).
Respondent concedes that petitioner substantially prevailed with
respect to either the amount in controversy or the most
significant issues and that petitioner meets the net worth
requirements.
A party, however, will not be treated as the prevailing
party if the United States establishes that the position of the
United States in the proceeding was substantially justified. See
sec. 7430(c)(4)(B)(i). Respondent contends that petitioner is
not the prevailing party because the position that respondent
took regarding the disallowed expense deductions was
substantially justified. We agree with respondent.
The United States' position is substantially justified if it
is "justified to a degree that could satisfy a reasonable person"
and has a "reasonable basis in both law and fact." Pierce v.
Underwood, 487 U.S. 552, 565 (1988) (interpreting similar
language in the Equal Access to Justice Act, 28 U.S.C. sec 2412
(1988)); see also Maggie Management Co. v. Commissioner, 108 T.C.
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430, 443 (1997). A position has a reasonable basis in fact if
there is such relevant evidence as a reasonable mind might accept
as adequate to support a conclusion. See Pierce v. Underwood,
supra at 564-565. The reasonableness of respondent's position
and conduct necessarily requires considering what respondent knew
at the time. Cf. Rutana v. Commissioner, 88 T.C. 1329, 1334
(1987); DeVenney v. Commissioner, 85 T.C. 927, 930 (1985). Thus,
in determining whether respondent acted reasonably, this Court
must "consider the basis for respondent's legal position and the
manner in which the position was maintained." Wasie v.
Commissioner, 86 T.C. 962, 969 (1986).
The fact that the Commissioner eventually loses or concedes
the case is not determinative as to whether the taxpayer is
entitled to an award of administrative or litigation costs. See
Sokol v. Commissioner, 92 T.C. 760, 767 (1989); Wasie v.
Commissioner, supra at 968-969. It remains, however, a relevant
factor to consider in determining the degree of the
Commissioner's justification. See Estate of Perry v.
Commissioner, 931 F.2d 1044, 1046 (5th Cir. 1991); Powers v.
Commissioner, 100 T.C. 457, 470, 472 (1993), affd. in part and
revd. in part 43 F.3d 172 (5th Cir. 1995).
In some cases courts have adopted an issue-by-issue approach
to section 7430, apportioning the requested awards between those
issues for which the respondent was, and those issues for which
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respondent was not, substantially justified. See Powers v.
Commissioner, 51 F.3d 34, 35 (5th Cir. 1995); Swanson v.
Commissioner, 106 T.C. 76, 102 (1996). In the instant case, both
parties make their respective arguments for all the adjustments
in the notice of deficiency collectively. Thus, we do not
determine whether to apportion the awards, if any, between those
adjustments for which respondent was, or was not, substantially
justified.
In deciding this issue, we must identify the point in time
at which the United States is first considered to have taken its
position, and then decide whether the position from that point
forward was substantially justified. The "substantially
justified" standard is applied as of the separate dates that
respondent took a position in the administrative proceedings as
distinguished from the proceedings in this Court. See sec.
7430(c)(7)(A) and (B).
The administrative position of respondent means the position
taken in the administrative proceedings as of the earlier of the
date of receipt of the appeals decision by the taxpayer or the
date of the notice of deficiency. See sec. 7430(c)(7)(B). In
this case, respondent took a position in the administrative
proceeding as of April 30, 1998, the date the notice of
deficiency was issued. See sec. 7430(c)(7)(B)(ii).
The position taken by the United States, for purposes of
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litigation costs, refers to the position of the United States in
a judicial proceeding. See sec. 7430(c)(7)(A). Respondent's
position in the proceeding before this Court was established on
September 28, 1998, the date respondent filed his answer. See
Huffman v. Commissioner, 978 F.2d 1139, 1148 (9th Cir. 1992),
affg. in part and revg. in part T.C. Memo. 1991-144.
Although ordinarily the reasonableness of each of those
positions is considered separately to allow respondent to change
his position, Huffman v. Commissioner, supra at 1144-1147, it
appears in this case that respondent took the same position in
both the notice of deficiency and the answer. More specifically,
respondent's position was that petitioner failed to substantiate
the deductions for cash payments that it claimed on its returns.
Petitioner contends that it provided the required
substantiation at the administrative review in May 1997, that the
case should have concluded at that point, and that the "Notice of
Deficiency constituted nothing but harassment".
The record does not support petitioner's contention. At
respondent's request in June 1999, petitioner promised to provide
worksheets reconciling the Forms 1099 to the corporate records;
however, petitioner required 2 months to prepare the worksheets.
Therefore, it is apparent that the worksheets did not exist at
the time of the May 1997 conference, and that petitioner did not
provide respondent information sufficient to substantiate its
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claimed deductions before August 1999.
On this record, we conclude that respondent's position was
substantially justified. In the notice of deficiency, respondent
premised the adjustments primarily on petitioner's failure to
substantiate items on its returns. Taxpayers do not have an
inherent right to take tax deductions. Deductions are a matter
of legislative grace, and a taxpayer bears the burden of proving
entitlement to any deduction claimed. See Deputy v. du Pont, 308
U.S. 488, 493 (1940); New Colonial Ice Co. v. Helvering, 292 U.S.
435, 440 (1934). This includes the burden of substantiating the
amount and purpose of the item claimed. See sec. 6001; Hradesky
v. Commissioner, 65 T.C. 87, 89-90 (1975), affd. per curiam 540
F.2d 821 (5th Cir. 1976); sec. 1.6001-1(a), Income Tax Regs. We
find that "It was reasonable for respondent not to concede the
adjustments until * * * [he] had received and verified adequate
substantiation for the items in question." Simpson Fin. Servs.,
Inc. v. Commissioner, T.C. Memo. 1996-317 (citing Harrison v.
Commissioner, 854 F.2d 263, 265 (7th Cir. 1988), affg. T.C. Memo.
1987-52; Sokol v. Commissioner, supra at 765).
Petitioner argues that the Commissioner mishandled this
case, and that if it had been administered properly, petitioner
would have incurred much less expense. Petitioner states that
the Appeals officer raised issues that were not in the revenue
agent's examination report, and that it was denied the
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opportunity to respond to these issues before respondent issued
the notice of deficiency.
Petitioner also stated that when it was informed by
respondent that a notice of deficiency would be issued if
petitioner did not agree to an extension of the statutory period
for assessment, that it welcomed the notice as an opportunity to
resolve the issues. This statement is contrary to petitioner's
statement that the notice of deficiency was issued to harass
petitioner.
We are not persuaded by petitioner's arguments. We find
nothing in our review of the record to support petitioner's
claims of overreaching or abusive tactics by respondent's agents.
Rather, we find that respondent promptly conceded that
petitioner's deductions were allowable once petitioner provided
the information necessary to substantiate the disputed items.
Although petitioner attempts in its motion to articulate the
overreaching of respondent's agents, such statements are not
proof. See Rule 143(b); see also Niedringhaus v. Commissioner,
99 T.C. 202, 214 n.7 (1992); Viehweg v. Commissioner, 90 T.C.
1248, 1255 (1988).
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We hold that respondent's positions had a reasonable basis
in law and fact. Accordingly, petitioner is not entitled to
administrative and litigation costs under section 7430.
To reflect the foregoing,
An appropriate order will be
issued denying petitioner's
motion for an award of
administrative and litigation
costs, and a decision will be
entered.