T.C. Summary Opinion 2001-34
UNITED STATES TAX COURT
STEPHEN J. ROLING AND PEGGY A. ROLING, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 15224-99S. Filed March 20, 2001.
Stephen J. Roling and Peggy A. Roling, pro sese.
George W. Bezold, for respondent.
DEAN, Special Trial Judge: This case is before the Court on
petitioners' Motion for Litigation and Administrative Costs filed
pursuant to section 7430 and Rule 231. This case was filed
pursuant to the provisions of section 7463 of the Internal
Revenue Code as in effect at the time the petition was filed.
Unless otherwise indicated, all other section references are to
the Internal Revenue Code in effect for the year at issue, and
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all Rule references are to the Tax Court Rules of Practice and
Procedure. The decision to be entered is not reviewable by any
other court, and this opinion should not be cited as authority.
Background
Respondent filed a response to petitioners’ motion in which
he agrees that petitioners: (a) Have substantially prevailed
with respect to the amount in controversy; and (b) meet the net
worth requirements as provided by law.
Respondent does not agree that petitioners: (1) Have
substantially prevailed on the most significant issue in the
case; (2) have exhausted their administrative remedies; (3) have
not unreasonably protracted the administrative or Court
proceedings; or (4) have claimed a reasonable amount of costs.
More importantly, respondent argues that his positions in
the administrative and Court proceedings were substantially
justified.
The parties have not requested a hearing in this case and
the Court concludes that a hearing is not necessary to decide
this motion. See Rule 232(a)(2). Accordingly, the Court decides
the motion after consideration of the petition, the stipulation
of settlement, petitioners' motion for litigation and
administrative costs, respondent's response to the motion, and
petitioners' response to respondent's response to the motion.
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Petitioners resided in Bellevue, Iowa, at the time they
filed their petition.
The Examination
Timber Expenditures
Stephen Roling (petitioner) operates a logging business as a
sole proprietor. As part of his business petitioner enters into
"right to cut" contracts with landowners. The contracts allow
petitioner to enter onto the land to cut specifically identified
trees within a certain time frame, usually from 12 to 15 months.
Petitioner does not actually cut the timber until he has a buyer
for it. The buyer, a lumber mill, picks up the cut trees from
the landowner's property.
Typically, petitioner makes a payment of 20 percent of the
contract price (downpayment) at the time the contract is signed,
and the balance is paid at the time the timber is cut. The
landowner retains ownership of the trees until the contract is
paid in full. Petitioner, a cash basis taxpayer, deducted the
downpayments on the contracts to cut in the year the payments
were made.
Upon examination of petitioners' Federal income tax return
for 1994, the Internal Revenue Service (IRS) determined that
petitioners' contract downpayments were not currently deductible.
It was respondent's position at the examination that the contract
payments must be capitalized into "inventory" to match
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expenditures with income in the same taxable period. The
adjustment proposed was to disallow the deduction in 1994 of
downpayments on five contracts identified by petitioner as signed
in 1994 where it appeared the trees were not cut and sold by him
until 1995.
Unreported Income
During the examination of petitioners' return for 1994,
petitioner advised the examining agent that he had some income
that was not reported on the return. The examining agent
performed a source and application of funds analysis that
indicated petitioners had spent $5,061 more than reported funds
available. Petitioner explained that he had sold a tractor that
cost $550 for $1,050, and he recalled getting a $5,000 loan from
his brother.
Consideration by Appeals Division
Petitioners' argument that their lack of ownership in the
trees precluded them from having an "inventory" and their
explanation for the unreported income were not accepted by the
examiner. Petitioners took their case to the Appeals Division of
the IRS (Appeals).
In Appeals, petitioners were represented by an enrolled
agent (EA) through whom they argued that as owners of an economic
interest in timber they were entitled as lessees to deduct the
payments at issue in the year paid. By a letter dated April 20,
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1999, petitioners' EA sent to Appeals a copy of a handwritten
note as evidence of a loan of $10,000 from petitioner's father to
them in July of 1994.
On June 22, 1999, Appeals issued the notice of deficiency in
this case containing the $15,672 adjustment denying the timber
contract downpayment deduction, the unreported income adjustment
of $5,061, and the adjustment determining an accuracy-related
penalty under section 6662.
Post-Appeals
The petition was filed with the Court on September 20, 1999,
and by notice dated March 29, 2000, was set for trial at the
Court's Des Moines trial session beginning on June 19, 2000.
Petitioners retained counsel to represent them in this
matter. Counsel for the parties discussed the timber cutting
contracts and the unreported income issues for a period of weeks.
Counsel for the parties agreed that inventorying was not
appropriate treatment for petitioners' timber payments. During
their discussions, counsel for petitioners provided respondent's
counsel with documentation showing that with respect to two of
the five contracts, trees were cut and sold in 1994. Since the
income for the sale of the trees was reported in the same year as
the deduction of the downpayment, the adjustment for the two
contracts totaling $8,950 was conceded by respondent's counsel.
As part of the overall settlement, petitioners agreed that the
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$6,772 of payments for the other three contracts are not
deductible and must be capitalized.
Counsel for petitioners submitted to respondent's counsel
unsworn, and on June 15, 2000, sworn statements from petitioner
and his father as evidence of the June 1994 loan to petitioners.
Petitioners also submitted petitioner's father's Federal income
tax return for 1994. Bank records of petitioner's father from
1994 were unavailable.
As part of the overall settlement, respondent conceded the
unreported income adjustment and the accuracy-related penalty in
June of 2000. On July 21, 2000, the Court filed the parties'
stipulation of settlement in which it is agreed that there is a
deficiency in income tax due from petitioners for 1994 in the
amount of $2,055. Since respondent conceded the unreported
income item, the deficiency necessarily relates to a portion of
the timber contract downpayment adjustment.
Discussion
We apply section 7430 as most recently amended by Congress
in the IRS Restructuring and Reform Act of 1998 (RRA 1998), Pub.
L. 105-206, sec. 3101, 112 Stat. 685, 727. However, the
amendments made by RRA 1998 to section 7430 apply only to costs
incurred or services performed after January 18, 1999. Id. at
729. To the extent the claimed costs were incurred on or before
January 18, 1999, we shall apply section 7430 as amended by the
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Taxpayer Relief Act of 1997 (TRA), Pub. L. 105-34, secs. 1285,
1453, 111 Stat. 1038, 1055.
Requirements Under Section 7430
Under section 7430(a), a judgment for litigation costs
incurred in connection with a court proceeding may be awarded
only if a taxpayer: (1) Is the "prevailing party"; (2) has
exhausted his or her administrative remedies within the IRS;
and (3) did not unreasonably protract the court proceeding.
Sec. 7430(a) and (b)(1), (3). Similarly, a judgment for
administrative costs incurred in connection with an
administrative proceeding may be awarded under section 7430(a)
only if a taxpayer: (1) Is the "prevailing party"; and (2) did
not unreasonably protract the administrative proceeding. Sec.
7430(a) and (b)(3).
A taxpayer must satisfy each of the respective requirements
in order to be entitled to an award of litigation or
administrative costs under section 7430. See Rule 232(e). Upon
satisfaction of these requirements, a taxpayer may be entitled to
reasonable costs incurred in connection with the administrative
or court proceeding. See sec. 7430(a)(1) and (2), (c)(1) and (2).
To be a prevailing party, the taxpayer must substantially
prevail with respect to either the amount in controversy or the
most significant issue or set of issues presented and satisfy the
applicable net worth requirement. See sec. 7430(c)(4)(A).
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Respondent concedes that petitioner has satisfied the
requirements of section 7430(c)(4)(A). Petitioner will
nevertheless fail to qualify as the prevailing party if
respondent can establish that respondent's position in the
administrative and court proceedings was substantially justified.
See sec. 7430(c)(4)(B).
Substantial Justification
The Commissioner's position is substantially justified if,
based on all of the facts and circumstances and the legal
precedents relating to the case, the Commissioner acted
reasonably. See Pierce v. Underwood, 487 U.S. 552 (1988); Sher
v. Commissioner, 89 T.C. 79, 84 (1987), affd. 861 F.2d 131 (5th
Cir. 1988). In other words, to be substantially justified, the
Commissioner's position must have a reasonable basis in both law
and fact. See Pierce v. Underwood, supra; Rickel v.
Commissioner, 900 F.2d 655, 665 (3d Cir. 1990), affg. in part and
revg. in part on other grounds 92 T.C. 510 (1989). A position is
substantially justified if the position is "justified to a degree
that could satisfy a reasonable person". Pierce v. Underwood,
supra at 565 (construing similar language in the Equal Access to
Justice Act). Thus, the Commissioner's position may be incorrect
but nevertheless be substantially justified "'if a reasonable
person could think it correct'". Maggie Management Co. v.
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Commissioner, 108 T.C. 430, 443 (1997) (quoting Pierce v.
Underwood, supra at 566 n.2).
The relevant inquiry is "whether the Commissioner knew or
should have known that * * * [his] position was invalid at the
onset". Nalle v. Commissioner, 55 F.3d 189, 191 (5th Cir. 1995),
affg. T.C. Memo. 1994-182. We look to whether the Commissioner's
position was reasonable given the available facts and
circumstances at the time that the Commissioner took his
position. See Maggie Management Co. v. Commissioner, supra at
443; DeVenney v. Commissioner, 85 T.C. 927, 930 (1985).
The fact that the Commissioner eventually concedes, or even
loses, a case does not establish that his position was
unreasonable. See Estate of Perry v. Commissioner, 931 F.2d
1044, 1046 (5th Cir. 1991); Sokol v. Commissioner, 92 T.C. 760,
767 (1989). However, the Commissioner's concession remains a
factor to be considered. See Powers v. Commissioner, 100 T.C.
457, 471 (1993), affd. in part, revd. in part and remanded on
another issue 43 F.3d 172 (5th Cir. 1995).
As relevant herein, the position of the United States that
must be examined against the substantial justification standard
with respect to the recovery of administrative costs is the
position taken by the Commissioner as of the date of the notice
of deficiency. See sec. 7430(c)(7)(B). The position of the
United States that must be examined in light of the substantial
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justification standard with respect to the recovery of litigation
costs is the position taken by the Commissioner in the answer to
the petition. See Bertolino v. Commissioner, 930 F.2d 759, 761
(9th Cir. 1991), affg. an unpublished decision of this Court;
Sher v. Commissioner, 861 F.2d 131, 134-135 (5th Cir. 1988).
Ordinarily, we consider the reasonableness of each of these
positions separately. See Huffman v. Commissioner, 978 F.2d
1139, 1144-1147 (9th Cir. 1992), affg. in part, revg. in part and
remanding on other issues T.C. Memo. 1991-144. There was no
answer filed in this case. See Rule 175(b). There is, however,
no indication that respondent's position changed between the
issuance of the notice of deficiency and the partial concession
by respondent's counsel.
The issue of whether respondent's positions in the
underlying proceedings were substantially justified shall be
addressed first. In order to decide whether a position of
respondent was substantially justified, we must review the
substantive merits of the case.
Reasonable Basis In Fact
Petitioners do not suggest that respondent applied the wrong
legal standard in taking a position on their documentation of the
loan in 1994 as an explanation of apparent unreported income.
Petitioners argue that respondent's position on the adjustment
was not reasonable in fact based on the evidence they presented.
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As to that argument, respondent asserts that it was
incumbent upon petitioners to substantiate the fact and amount of
the loan. It is reasonable, according to respondent, not to
concede an adjustment until he has received and verified adequate
substantiation for the item in question. He therefore concludes
that as to the unreported income adjustment, his position was
reasonable when taken and appropriately conceded when
substantiation was provided to Appeals.
Petitioners argue that they provided to Appeals a copy of a
"loan document" that verifies a $10,000 loan received by them
from petitioner's father. Mere presentation of a note or "loan
document" may not be sufficient evidence of the existence of such
a loan. See Sullivan v. Commissioner, T.C. Memo. 1985-217.
Further documentation and testimony might be required. See Kim
v. Commissioner, T.C. Memo. 2000-83; Coutsoubelis v.
Commissioner, T.C. Memo. 1993-457; Facuseh v. Commissioner, T.C.
Memo. 1988-10; Mahigel v. Commissioner, T.C. Memo. 1983-529;
Adams v. Commissioner, T.C. Memo. 1980-398.
It is reasonable for respondent to make an adjustment for an
item and refuse to concede the adjustment until he has received
and verified petitioners' substantiation for the amount adjusted.
See Beecroft v. Commissioner, T.C. Memo. 1997-23; Simpson
Financial Servs., Inc. v. Commissioner, T.C. Memo. 1996-317;
McDaniel v. Commissioner, T.C. Memo. 1993-148.
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We are persuaded that respondent's position on the
unreported income issue was reasonable. Respondent's position
was based on petitioners' failure to fully account for the item.
Further, the issue was settled within a reasonable period after
petitioners gave sufficient information to respondent. See
Harrison v. Commissioner, 854 F.2d 263, 265 (7th Cir. 1988),
affg. T.C. Memo. 1987-52; Wickert v. Commissioner, 842 F.2d 1005
(8th Cir. 1988), affg. T.C. Memo. 1986-277; Ashburn v. United
States, 740 F.2d 843 (11th Cir. 1984); McDaniel v. Commissioner,
supra.
Reasonable Basis in Law
According to petitioners, respondent unreasonably determined
that they were not entitled to current deductions for
downpayments on "right to cut" timber contracts. Petitioners
argue that the payments on the timber contracts were either
amounts subject to regular depletion deductions or depletable
advanced royalty payments deductible for 1994.
In the case of timber, taxpayers are allowed as a deduction
in computing taxable income, a reasonable allowance for depletion
under regulations prescribed by the Secretary. See sec. 611. In
the case of standing timber, the depletion must be computed
solely upon the adjusted basis of the property. See sec. 1.611-
1(a), Income Tax Regs. The depletable basis applicable to timber
is contained in section 1.611-3(a), Income Tax Regs. which
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describes the cost basis provided by section 612, which, in turn,
describes an "adjusted basis" provided by section 1011. The
adjusted cost basis under section 1011 for determining gain or
loss from the sale of property is the cost basis or other basis
determined under section 1012 adjusted as provided by section
1016.
Annual depletion deductions are allowed only to the owner of
an "economic interest" in standing timber. See Palmer v. Bender,
287 U.S. 551, 557 (1933); Georgia-Pacific Corp. v. United States,
648 F.2d 653, 657-659 (9th Cir. 1981); sec. 1.611-1(b)(1), Income
Tax Regs.
For purposes of this discussion it is assumed that
petitioners' right to cut contracts made them owners of economic
interests in timber in the year at issue. See International
Paper Co. v. United States, 33 Fed. Cl. 384, 407-409 (1995). As
owners of economic interests in timber, petitioners would, as
they contend, be entitled to depletion deductions. That would
not, however, change the result in this case because "The
depletion of timber takes place at the time timber is cut", not
at the time of payment. Sec. 1.611-3(b)(1), Income Tax Regs. To
the extent that depletion is allowable in a year with respect to
timber the products of which are not sold during the taxable
year, the depletion allowable is included "as an item of cost in
the closing inventory of such products for such year." Id.
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Since, with respect to three of the contracts at issue,
petitioners did not cut the timber in the year that the
downpayment was made, they were not entitled to a current
depletion deduction for the payment.
Under regulations provided by the Secretary, "advanced
royalties" in the case of mineral deposits and standing timber
may be the subject of depletion deductions. Sec. 1.612-3(b),
Income Tax Regs. An advanced royalty is a required payment of
royalties on a specified number of units of timber annually
whether or not cut within the year that may be applied against
the royalties on the timber thereafter cut. See sec. 1.612-
3(b)(1), Income Tax Regs. The facts in the record of this case
are not sufficient to support the treatment of petitioners'
downpayments as advanced royalties. The timber contracts are not
part of the record. There is no evidence that petitioners'
downpayments were based on a specified "number of units of
timber", or that the downpayments were capable of being applied
to any future royalties, and there were no "annual" payments.
From the facts available in the record, we are unable to find
that petitioners were entitled to treat their downpayments on
timber contracts as advanced royalties.
Even if petitioners' payments did constitute advanced
royalties, we find no authority for their current deductibility
by petitioners. Section 1.612-3(b)(1), Income Tax Regs., allows,
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in certain circumstances, the payee receiving the advanced
royalty payments on standing timber to take a depletion deduction
from his gross income in the year the payments are made. And
section 1.612-3(b)(3), Income Tax Regs., allows the payer of
amounts under a "minimum royalty provision" to deduct them when
paid, but only in connection with mineral property.
Petitioners' payments are not described in section 1.612-
3(b)(1), or (3), Income Tax Regs., and their downpayments must be
capitalized. Section 1.631-2(e)(1), Income Tax Regs., requires
that amounts paid for timber cutting rights be treated as the
cost of timber and "constitute part of the lessee's depletable
basis of the timber, irrespective of the treatment accorded such
payment in the hands of the lessor."1
Once petitioners' counsel presented to respondent's counsel
sufficient evidence that two of the contracts represented
situations where the timber was cut in the same year the payments
were made, respondent conceded the issue within a reasonable
time. See Harrison v. Commissioner, supra at 265; Ashburn v.
United States, supra; Wickert v. Commissioner, 842 F.2d 1005 (8th
1
Generally, sec. 162 requires that an item be paid or
incurred and the benefit exhausted during the taxable year to be
a business deduction. Where the value of the item extends beyond
the taxable year, that is evidence that the expenditure is a cost
of acquisition, a capital item. See Wells Fargo & Co. v.
Commissioner, 224 F.3d 874 (8th Cir. 2000), affg. in part and
revg. in part sub nom. Norwest Corp. v. Commissioner, 112 T.C. 89
(1999); Central Tex. Sav. & Loan Association v. United States,
731 F.2d 1181, 1183 (5th Cir. 1984); see also sec. 1.461-1,
Income Tax Regs.
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Cir. 1988); McDaniel v. Commissioner, T.C. Memo. 1993-148.
We find that respondent's positions on the disputed issues
were reasonable positions sufficiently supported by the facts and
circumstances in petitioner's case and the existing legal
precedent. See Pierce v. Underwood, 487 U.S. 552 (1988).
Because we find respondent's positions to have been
reasonable, we cannot find petitioners to be "prevailing"
parties, and their motion will therefore be denied. Because we
find that petitioners are not prevailing parties, we do not
address the other issues raised by respondent.
To reflect the foregoing,
An appropriate Order
and Decision will be entered.