T.C. Memo. 2002-65
UNITED STATES TAX COURT
HUNT & SONS, INC., Petitioner v. COMMISSIONER OF
INTERNAL REVENUE, Respondent
Docket No. 5127-00. Filed March 8, 2002.
Michael P. Casterton, for petitioner.
Christian A. Speck, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
BEGHE, Judge: On March 10, 2000, respondent issued a notice
of deficiency determining the following deficiencies and
penalties with respect to petitioner’s Federal income taxes:
- 2 -
Accuracy-Related
Penalty
TYE Dec. 31 Deficiency Sec. 6662(a)
1996 $278,640 $16,173.60
1997 357,963 17,087.00
After concessions by the parties, the only issues remaining
for determination are: (1) Whether petitioner overstated certain
rental expense deductions on six properties, and (2) whether
petitioner is liable for accuracy-related penalties under section
6662(a)1 for overstating rental expense deductions on these
properties.
We hold that petitioner deducted rent in excess of the fair
market rental value for two of the six properties of $30,300 for
1996 and $35,900 for 1997, and we therefore disallow $66,200 in
deductions. We further hold that petitioner is not liable for
accuracy-related penalties under section 6662(a).
FINDINGS OF FACT
Most of the facts have been stipulated and are so found.
The stipulation of facts and the related exhibits are
incorporated by this reference.
When petitioner filed its petition in this case, its
principal place of business was in Sacramento, California.
Petitioner is a supplier of petroleum products and equipment and
1
Unless otherwise indicated, section references are to the
Internal Revenue Code applicable to the tax years in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
- 3 -
an operator of commercial cardlocks. A commercial cardlock is an
unstaffed self-service gas station for commercial vehicles. To
accommodate large trucks, cardlocks are usually built on larger
parcels (on the order of 1-1/2 acres) than retail gas stations.
Cardlocks are usually built in industrial areas that are easily
accessible to trucks, rather than the more expensive sites used
for retail gas stations. Cardlocks are open 24 hours a day, 365
days a year.
When using a cardlock, the customer must supply (and the
supplier electronically captures) customer and billing
information, including the date, time of day, vehicle odometer
reading, and other miscellaneous information, as well as product
type and gallons pumped. The supplier bills the customer for the
gasoline and provides on the bill the detailed information
captured at the pump. Most cardlocks have video surveillance for
added security.
Petitioner operated the following five cardlocks in 1996 and
1997: 5750 South Watt Ave., Sacramento (Watt Avenue); 2891
Mosquito Road, Placerville (Mosquito Road); 4200 Roseville Road,
North Highlands (Roseville Road); 11341 White Rock Road, Rancho
Cordova (White Rock Road); and 4200 Mother Lode Drive, Shingle
Springs (Mother Lode Drive). On September 1, 1997, petitioner
leased the land for a sixth cardlock located at 1201 Fee Drive,
Sacramento (Fee Drive).
- 4 -
Petitioner is a closely held corporation. Warren Hunt, Jr.,
and his wife, Anita Hunt, own 48 percent of the stock of
petitioner; Randall Dean Hunt and his wife, Cynthia Hunt, own 26
percent of the stock of petitioner; Warren Hunt III and his wife,
Rosemarie Hunt, own 26 percent of the stock of petitioner.
Randall Dean Hunt and Warren Hunt III are the sons of Warren
Hunt, Jr., and Anita Hunt.
Petitioner paid Federal corporate income taxes of $256,863
for 1996 and $350,456 for 1997. For each of 1996 and 1997,
petitioner paid total dividends of $24,000.
Petitioner’s shareholders, through revocable living trusts,
own the raw land underlying all the cardlocks operated by
petitioner.2 Petitioner leases the raw land from its
shareholders’ revocable living trusts through ground leases.
Petitioner owns the improvements and operates the cardlock
businesses.
The operation of a cardlock business, which requires the use
of underground storage tanks and pipes, entails a high degree of
financial risk because of the potential for leaks, which can
cause soil and groundwater contamination that can be very
2
The Watt Avenue, Mother Lode Drive, and Fee Drive land is
owned by the Warren N. Hunt III and Rosemarie A. Hunt Revocable
Living Trust and the Randall Dean Hunt and Cynthia Lynne Hunt
Revocable Living Trust. The Mosquito Road, Roseville Road, and
White Rock Road land is owned by the Warren N. Hunt, Jr., and
Anita M. Hunt Revocable Living Trust.
- 5 -
expensive to clean up. In the mid-1980s, government regulators
in California imposed strict new regulations on operators of
underground storage tanks, requiring the use of double-wall
tanks, double-wall piping, tank-monitoring devices, and leakage
alarms. Government regulators also require annual testing of the
systems to prevent or minimize soil, groundwater, and air
pollution. Petitioner spent $60,000 to clean up a leak at its
Roseville Road site and has incurred expenses of more than
$500,000 to clean up contamination at its Placerville plant.
Petitioner paid and deducted the following amounts as rent
during 1996 and 1997 with respect to its cardlock locations:
Property 1996 1997
Watt Avenue $120,000 $120,000
Mosquito Road 55,200 53,400
Roseville Road 48,000 54,000
White Rock Road 54,000 55,500
Mother Lode Drive 27,600 28,800
1
Fee Drive -- 16,000
Total 304,800 327,700
1
The Fee Drive property was leased for only
4 months in 1997, at a rent of $4,000 per
month.
The annual fair market rental value for both 1996 and 1997
of Watt Avenue was $89,700 and of Mother Lode Drive was $29,900.
The fair market rental value of Fee Drive for the 4 months of
1997 (during which the property was leased to petitioner) was
$10,400. Respondent offered no evidence to contradict
petitioner’s and petitioner’s experts’ testimony that petitioner
- 6 -
paid fair market rental value for the other properties (Mosquito
Road, Roseville Road, and White Rock Road).
ULTIMATE FINDINGS OF FACT
1. Petitioner paid the following amounts to its
shareholders in excess of the fair rental value of the
properties:
Property 1996 1997 Total
Watt Avenue $30,300 $30,300 $60,600
Fee Drive -- 5,600 5,600
Total 30,300 35,900 66,200
Petitioner paid fair market rental value for the other cardlock
properties.
2. Petitioner’s payments in excess of the fair market
rental value of the properties are not deductible in computing
taxable income.
3. Petitioner was not negligent in deducting rent in excess
of the fair market rental value of the Watt Avenue and Fee Drive
properties.
OPINION
The parties agree that potential for abuse is inherent in
rental transactions between a corporation and its shareholders.
As we stated in Wy’East Color v. Commissioner, T.C. Memo.
1996-136:
A taxpayer generally may deduct reasonable rents
paid for property used in a trade or business. A
taxpayer who rents property from a related person may
not deduct more than he or she would have paid if the
- 7 -
parties had dealt at arm’s length. A taxpayer may
deduct only the fair rental value of premises it rents
from related persons. We closely scrutinize whether
rents exceed fair rental value if the lessor and lessee
are related. Fair rental value is a question of fact.
* * * [Citations omitted.]
See also, e.g., Limericks, Inc. v. Commissioner, 165 F.2d 483,
484 (5th Cir. 1948), affg. 7 T.C. 1129 (1946); Associated
Dentists v. Commissioner, T.C. Memo. 1998-287. We must therefore
determine whether (and if so, to what extent) the rents paid by
petitioner to its shareholders, and deducted by petitioner, were
in excess of the fair market rental values of the properties.
I. Burden of Proof
Before enactment of section 7491 by the Internal Revenue
Service Restructuring and Reform Act of 1998 (RRA), Pub. L.
105-206, sec. 3001(a), 112 Stat. 726, it would have been clear
that respondent’s determinations in the notice of deficiency of
the fair market rental values of the properties were entitled to
a presumption of correctness, and petitioner would bear the
burden of proving that respondent’s determinations were
incorrect. Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115
(1933); Wy’East Color v. Commissioner, supra.
The Court of Appeals for the Ninth Circuit has held that the
presumption of correctness does not apply where the Commissioner
takes a position in Court that abandons the determination in the
notice of deficiency. Morrissey v. Commissioner, 243 F.3d 1145
- 8 -
(9th Cir. 2001), revg. and remanding Estate of Kaufman v.
Commissioner, T.C. Memo. 1999-119.
In the case at hand, the notice of deficiency does not
segregate the portion of the excess rental expense disallowance
attributable to each property for each year. We are therefore
unable to determine, on a property-by-property basis, whether the
appraisals of respondent’s expert, Mr. Harris, are consistent
with the determinations contained in the notice of deficiency.
Section 7491 shifts the burden of proof to the Commissioner
if certain requirements are met. However, section 7491 applies
only to court proceedings arising in connection with examinations
commenced after July 22, 1998. RRA sec. 3001(c), 112 Stat. 727.
Neither party offered evidence to show whether the audit in the
case at hand was commenced before July 23, 1998. However,
respondent claimed in his pretrial memorandum that the audit was
commenced before July 23, 1998, and petitioner in its opening
brief appears to accept respondent’s allegation by asserting that
it has met its burden of proof.
Both parties introduced evidence as to the fair market
rental values of the Watt Avenue, Mother Lode Drive, and Fee
Drive properties. The case at hand is not one of those rare
cases in which the weight of the evidence adduced by the parties
is in equipoise. We will therefore determine the fair market
rental values of these properties on the basis of the
- 9 -
preponderance of the evidence rather than on an allocation of the
burden of proof.
With respect to the White Rock Road, Roseville Road, and
Mosquito Road properties, only petitioner introduced direct
evidence regarding fair market rental value. In lieu of offering
evidence, respondent asks us to infer that the rents on these
properties were overstated in the same overall proportion as the
rents on the other three properties. We decline to do so. As
discussed infra, petitioner has established by a preponderance of
the evidence that the rents paid on these properties did not
exceed their fair market rental values.
II. Fair Market Rental Value of the Properties
In his notice of deficiency, respondent disallowed
petitioner’s rental deductions, in the gross amounts shown on the
following table, with respect to the six properties under review:
1996 1997 Total
Rent claimed $304,800 $327,700 $632,500
Rent disallowed
by respondent (203,600) (211,620) (415,220)
Rent allowed by
respondent 101,200 116,080 217,280
Respondent determined that the excess rents petitioner paid
constituted disguised dividends. Respondent claims that
petitioner’s purpose in disguising the dividends as rental
- 10 -
expenses was to avoid the corporate income tax by converting
nondeductible dividends into deductible rental expenses.
Section 162(a)(3) allows as a deduction all ordinary and
necessary expenses paid or incurred during the taxable year in
carrying on any trade or business, including “rentals or other
payments required to be made as a condition to the continued use
or possession, for purposes of the trade or business, of
property”. In determining whether the payments here in issue
were rental payments deductible under this section, the “basic
question is * * * whether they were in fact rent instead of
something else paid under the guise of rent.” Place v.
Commissioner, 17 T.C. 199, 203 (1951), affd. per curiam 199 F.2d
373 (6th Cir. 1952). In connection with a lease between related
parties, the inquiry “requires a careful examination of the
circumstances surrounding the rental of the property to determine
the intentions of the parties in agreeing upon * * * [the] lease
and in fixing the terms thereof.” Davis v. Commissioner, 26 T.C.
49, 56 (1956). The question whether payments are rental payments
within the meaning of the statute is a question of fact to be
resolved on the basis of all the facts and circumstances. Thomas
v. Commissioner, 31 T.C. 1009, 1012 (1959); S. Ford Tractor Corp.
v. Commissioner, 29 T.C. 833, 842 (1958).
- 11 -
A. The Fair Market Rental Value of Watt Avenue, Mother
Lode Drive, and Fee Drive
Both parties submitted substantial evidence concerning the
fair market rental value of three of the properties petitioner
leased: Watt Avenue, Mother Lode Drive, and Fee Drive.
Respondent submitted separate appraisal reports on each of
the three properties prepared by Kenneth R. Harris, MAI, of
Hopkins Appraisal Services, Inc., a national appraisal firm
specializing in the appraisal of petroleum properties. Mr.
Harris used the same basic methodology for all three properties.
First, Mr. Harris determined the fair market value of the land
using only the cost approach to value, because he found both the
market and income approaches to be irrelevant to the appraisal of
raw land. Under the cost approach, Mr. Harris determined the
sale prices of four or five comparable properties and computed a
sale price per square foot for each of the comparable properties.
He then used his judgment to adjust the sale price per square
foot of each of the comparable properties for perceived
differences between the comparable properties and the subject.
Very significant adjustments were made, leading us to question
whether these properties were true “comparables”. Adjustments on
the Fee Drive property ranged from 20 to 60 percent and on the
Mother Lode Drive property ranged from 15 to 40 percent. One of
the four “comparables” on the Watt Avenue property was adjusted
by 65 percent. It would be very easy to justify much higher or
- 12 -
lower values by making smaller or larger adjustments to the sale
prices per square foot used in adjusting the comparable
properties. Because the “comparables” used by Mr. Harris were so
different from the subject properties, and thus required such
significant discretionary adjustments in order to provide a basis
for comparison, we are left with some doubt about the reliability
of Mr. Harris’s conclusions. Presumably, these were the most
“comparable” properties that Mr. Harris was able to find.
Next, Mr. Harris used the adjusted per-square-foot values
for the “comparable” properties to determine the value of the
subject properties. For two of the properties (Watt Avenue and
Fee Drive), Mr. Harris computed an average adjusted price per
square foot for the “comparable” properties, which was rounded up
to the nearest whole dollar amount per square foot. For the
remaining property (Mother Lode Drive), Mr. Harris eliminated the
high and low comparable values and used a whole dollar amount in
the range of the remaining three values.
Mr. Harris then computed a fair market value for the subject
properties by multiplying the per-square-foot values he
determined from his average or median adjusted “comparable”
properties by the number of square feet of each of the subject
properties.
After deriving a current fair market value for the subject
properties, Mr. Harris computed the annual fair market rental
- 13 -
value of the properties by applying a flat 10-percent
“capitalization” rate to the fair market value.3 Mr. Harris
based his “capitalization” rate on conversations with several
people who had experience with ground leases with major oil
companies, all of whom indicated that annual ground lease rates
were a flat 10 percent of the current fair market value of the
land.4 Mr. Harris made no adjustment in the rental
3
The parties’ experts referred to the rate applied to the
fair market value to compute the first year’s annual rent as a
“capitalization rate”. A true capitalization rate is a rate used
to convert a perpetual stream of income into a discounted present
value. Narver v. Commissioner, 75 T.C. 53, 91 n.17 (1980), affd.
670 F.2d 855 (9th Cir. 1982); Lanier v. Commissioner, T.C. Memo.
1998-7. We nevertheless recognize that it is common practice to
refer to both the capitalization rate and its inverse as the “cap
rate”.
4
Mr. Harris’s appraisal (and the appraisals of the other
experts) did not take into account that these properties were
subject to existing ground leases, some of which were made in
earlier years. For example, the Watt Avenue lease was entered
into in 1990 and provided for annual escalations based on
increases in the consumer price index, none of which were
apparently made. Instead of determining the rent for the years
in issue on the basis of market conditions existing at the time
the leases were entered into, Mr. Harris determined the current
fair market lease rate for a new lease. The parties should have
taken into consideration any change in market conditions. “[A]
transaction must not be disregarded simply because it was not at
arm’s length.” Sun Props., Inc. v. United States, 220 F.2d 171,
174 (5th Cir. 1955). Our role is merely to limit deductions to
the amount that would have been paid if the parties had entered
into the transactions at arms length. “In the absence of arm’s
length negotiations ‘an inquiry into what constitutes reasonable
rental is necessary to determine whether the sum paid is in
excess of what the lessee would have been required to pay had he
dealt at arm's length with a stranger.’” Sparks Nugget, Inc. v.
Commissioner, 458 F.2d 631, 635 (9th Cir. 1972) (quoting Place v.
Commissioner, 17 T.C. 199, 203 (1951), affd. 199 F.2d 373 (6th
(continued...)
- 14 -
“capitalization” rate for the greater risks involved in leasing
property for use as a cardlock operation to a small independent
operator, such as petitioner, rather than to a major oil
company.5
Using this methodology, Mr. Harris determined the fair
market value and fair market rental value for the three
properties to be as follows:
Fair Market Capitalization Fair Market
Property Value Rate Rental Value
Watt Avenue $690,000 10% $69,000
Fee Drive 240,000 10 24,000
Mother Lode 230,000 10 23,000
Drive
Petitioner’s experts criticized Mr. Harris for failing to
account for the significant risks a landlord undertakes when
leasing property to an independent cardlock operator. According
to their uncontradicted testimony, underground petroleum storage
tanks have a history of leaking, causing soil and groundwater
contamination that must be remediated at significant cost. While
4
(...continued)
Cir. 1952)), affg. T.C. Memo. 1970-74. The validity and amount
of allowed deductions should not depend on changes in market
conditions occurring after the parties’ contractual arrangements
were set. Because neither party offered evidence of changes in
market conditions, we will assume that market conditions did not
change between the lease date and the years in issue.
5
Petitioner’s witnesses made a strong showing that leasing
property for use as a gas station carries with it significant
risks for the lessor, risks not taken into account in Mr.
Harris’s analysis.
- 15 -
current double-hull tanks provide much greater protection against
leaks, significant risks still exist. Both the owner of the land
and the tenant are liable under California law for the cost of
cleanup, even through the tenant whose tanks leak generally is
liable under the terms of the lease or under California’s
equitable indemnity laws to reimburse cleanup costs paid by the
landlord. See, e.g., Meghrig v. KFC Western, 516 U.S. 479 (1996)
(reciting that owner ordered by California regulatory authorities
to clean up prior owner’s petroleum contamination); First San
Diego Properties v. Exxon Co., 859 F. Supp. 1313 (S.D. Cal. 1994)
(innocent current owner seeking indemnity from prior owner and
operator who caused contamination is not liable to prior operator
for contribution); Zands v. Nelson, 797 F. Supp. 805 (S.D. Cal.
1992) (owner and operator jointly and severally liable to clean
up petroleum contamination); Mangini v. Aerojet-Gen. Corp., 227
Cal. App. 3d 1248, 1273-1274 (1991) (doctrine of equitable
indemnity under California law). Because of the substantial cost
of cleaning up soil and groundwater contamination, the landlord
assumes significant risk when the tenant does not have the
financial wherewithal to respond in damages for the cost of
cleaning up a petroleum leak.
In addition, property containing underground petroleum
storage tanks may become stigmatized because of concern of
potential buyers about soil and groundwater contamination.
- 16 -
Stigmatization can cause a reduction in the value of the property
even when the environmental hazards have been remediated or
mitigated. See In re Custom Distribution Servs., Inc., 216
Bankr. 136, 154-155 (Bankr. N.J. 1997) (reducing fair market
value of property by 20 percent to account for environmental
stigma); Inmar Associates Inc. v. Borough of Carlstadt, 549 A.2d
38, 45 (N.J. 1988) (“not reasonable to conclude that contaminated
property is unmarketable, but stigma of contamination and other
factors suggest that capitalization rate may have to be altered
to reflect condition” (citing Patchin, “Valuation of Contaminated
Properties”, The Appraisal Journal 7 (Jan. 1988))).
A landlord takes on much greater risk when leasing property
to an independent operator of cardlocks (such as petitioner) than
when leasing the same property to a major oil company, because of
the difference in the lessee’s financial strength. An
independent operator may not have the financial wherewithal to
respond to a significant environmental problem, which would leave
the landlord primarily liable for the cost of the cleanup. A
landlord would thus likely require a greater return (by requiring
the payment of more rent) when leasing property to a small
independent operator of underground storage tanks than when
leasing the same property to a major oil company.
The additional credit risk assumed by a landlord leasing
property to an independent cardlock operator rather than a major
- 17 -
oil company should be reflected in the “capitalization” rate, or
otherwise accounted for in determining the fair market value and
fair market rental value of the property. Cf. In re Custom
Distribution Servs., supra at 155 n.17 (“The New Jersey Supreme
Court appears to favor an approach that accounts for the stigma
of environmental contamination via an adjustment to the
capitalization rate”.); Inmar Associates, Inc. v. Borough of
Carlstadt, supra at 45 (suggesting that environmental stigma
should be reflected in higher capitalization rate).
Mr. Harris improperly used a flat 10-percent
“capitalization” rate, relying on information concerning the
“capitalization” rates used in leases between landowners and
major oil companies. We disagree with Mr. Harris’s use of a flat
10-percent “capitalization” rate in light of the special risks
borne by the lessor when leasing property to an independent
cardlock operator. We also have greater uncertainty about Mr.
Harris’s conclusions than we would if the “comparable” properties
were more similar to the subject properties. Despite these
misgivings, we give substantial weight to Mr. Harris’s
conclusions of value because his report is professionally
prepared, he is well qualified to make adjustments to equate the
comparable properties, and he fully disclosed his methodology and
analysis.
- 18 -
We cannot say the same of the reports submitted by
petitioner’s experts. Petitioner submitted reports from two
experts: Patrick D. McIntosh, a licensed appraiser for McIntosh
& Associates, and Skip Vanderbundt, a real estate agent and
senior vice president of Cornish & Carey Commercial. Mr.
McIntosh supported his testimony with two reports: A “narrative
summary restricted report” (restricted report) in which Mr.
McIntosh had appraised, for estate-planning purposes, the land
both raw and improved, and a “summary consulting report”
(consulting report) in which Mr. McIntosh determined the fair
market rental value of the properties leased by petitioner. Both
reports reach conclusions of value without providing any support
or analysis for the conclusions. The restricted report describes
the real property and states a conclusion of value. Nothing is
expressed in the report to support Mr. McIntosh’s conclusion of
value. In the consulting report, Mr. McIntosh concludes that
petitioner’s leases are all within the range of fair market
rental values on the basis of one identified lease, known as the
Nella Oil lease, and Mr. McIntosh’s knowledge of other lease
transactions, the specific terms of which, Mr. McIntosh says in
the report, he cannot disclose.
In cross-examination and through the testimony of Mr.
Harris, respondent established that the Nella Oil property is
superior in every way to petitioner’s properties. It is a highly
- 19 -
visible property in a prime location and is used as a retail gas
station, convenience store, and cardlock operation. Mr. McIntosh
discloses no analysis to adjust for the superiority of the Nella
Oil lease. He simply attempts to justify petitioner’s lease
rates by pointing out that the rent per square foot paid by Nella
Oil is higher than the rent per square foot paid by petitioner.
Mr. McIntosh criticized Mr. Harris’s report, arguing that it
is not appropriate to apply a capitalization rate to the fair
market value of the property to derive the fair market rental
value of the property. Yet in a letter to petitioner dated
December 8, 1999, criticizing an Internal Revenue Service
engineer’s report in a prior dispute,6 Mr. McIntosh stated that
6
Petitioner provided a copy of Mr. McIntosh’s letter to the
Internal Revenue Service. Respondent used this letter at trial
for impeachment purposes. Mr. McIntosh testified at trial that
he reviewed Mr. Vanderbundt’s report and found it to be a sound
basis for determining the fair rental value of the subject
properties. Mr. Vanderbundt relied entirely on a single
“comparable” lease for property in Lodi, California, which is 23
miles south of Sacramento, California, near Stockton, California.
Mr. McIntosh was asked at trial whether the Modesto and Stockton
areas are comparable to Sacramento:
A: Some of the areas around Modesto and Stockton, and
I’m familiar with those areas, because I do
appraising in that area, would be familiar
[similar] with many of the areas around the
Sacramento metropolitan area.
* * * * * * *
Q: Mr. McIntosh, would you ever attempt to use a
comparable from areas like Modesto or Stockton for a
property in Sacramento?
(continued...)
- 20 -
6
(...continued)
A: It would depend on the kind of property. I think of
some times when they would be very comparable.
Yet in his December 8, 1999, letter criticizing respondent’s
engineer’s report, Mr. McIntosh stated:
The IRS appraiser appears to feel that the Modesto/
Stockton areas are equal to the Sacramento area. He is
either unaware or does not mention that the former
areas have been economically depressed for some time,
while the Sacramento area has been rebounding. I
regularly appraise stations and mini marts in all of
these cities. I do not consider them equivalent, nor
would I ever attempt to use comparables from areas like
Modesto or Stockton for a property in Sacramento.”
[Emphasis added.]
At trial, Mr. McIntosh also sought to justify the
conclusions reached by Mr. Vanderbundt in his report by stating
that he thought the Vanderbundt report was well prepared and
would meet the requirements for a professional appraisal if Mr.
Vanderbundt were licensed as an appraiser. As discussed in more
detail below, Mr. Vanderbundt used as a “comparable” a single
lease transaction between related parties, not an arm’s-length
transaction. Mr. McIntosh testified that it is appropriate for
an appraiser to use a related-party lease as a comparable if he
could “verify the information, and see that it’s factual, and
that it is pretty much parallel with the rest of the market data
that you’ve got.”
While it may be acceptable to mention a related-party
transaction as additional support for an appraisal, it is clearly
improper for an appraiser to rely solely on a related-party lease
in determining the fair market value of another property. The
purpose of an appraisal is to determine fair market value of the
subject property. Fair market value is the price a willing buyer
would pay to a willing seller in an arm’s-length transaction,
with neither party being under compulsion to buy or sell, and
both having reasonable knowledge of the facts. United States v.
Cartwright, 411 U.S. 546, 551 (1973); Morris v. Commissioner, 70
T.C. 959, 988 (1978). A related-party transaction is, by
definition, not an arm’s-length transaction and thus does not
provide reliable evidence of the fair market value of the
“comparable” property. Mr. McIntosh’s inconsistent positions
(continued...)
- 21 -
“the recent lease negotiated with the Nella Oil Company in West
Sacramento * * * gives a Cap Rate of 13%, a 13% range is deemed
reasonable and meaningful for comparable purposes.” Mr. McIntosh
also testified at trial that the Nella Oil lease would result in
a capitalization rate of “someplace in the neighborhood of 12 to
13 percent.”
Mr. McIntosh faced a difficult problem in attempting to
justify petitioner’s rental rates because he had previously
valued the properties for estate-planning purposes at low
values.7 Mr. McIntosh’s fair market value determinations in his
estate-planning appraisal were even lower than respondent’s fair
market value determinations, as shown in the following chart:
6
(...continued)
regarding the comparability of property in Modesto or Stockton
with Sacramento, depending on whether the analysis supports or
contradicts his client’s position, and his suggestion that it
would be proper for an appraiser to rely solely on a single
related-party comparable in determining the fair market value of
the subject property, call into question the independence of his
analysis.
7
Presumably, petitioner and its shareholders wanted
conservative values for estate-planning purposes, so as to
minimize gift and estate taxes. Mr. McIntosh was already bound
by the conservative fair market value determinations he used in
his estate-planning appraisal. It is, of course, easier to
justify higher rental rates with higher property values.
- 22 -
Petitioner’s
Respondent’s “Estate-Planning”
Property Appraisal Appraisal
(Mr. Harris) (Mr. McIntosh)
Watt Avenue $690,000 $674,000
Fee Drive 240,000 225,000
Mother Lode Drive 230,000 60,000
Total 1,160,000 959,000
Mr. McIntosh did not attempt to apply a “capitalization”
rate to his estate-planning values in order to justify
petitioner’s rental rates because such a high “capitalization”
rate could not be supported. Instead, Mr. McIntosh testified
that there is no consistent relationship between the value of
land and the rental value of land, and that “the use of a
hypothetical cap rate * * * can only do one thing, and that’s get
you an inaccurate, unrealistic conclusion.” This is because, Mr.
McIntosh claims, a tenant will pay more than the fair market rent
determined through the application of a “capitalization” rate
applied to the fair market value of the property if the tenant
can earn a profit at the higher rent.
We do not find Mr. McIntosh’s testimony credible in this
respect. The fair market value of the land reflects the highest
and best use of the property. The “capitalization” rate reflects
the rate of return that the owner would require from, and that a
tenant would pay to lease, the land. The “capitalization” rate
reflects prevailing market interest rates for risk-free
investments, together with a risk premium that takes into account
- 23 -
the risks of the transaction, including the risks involved in the
particular real estate activities in which the tenant proposes to
engage. See Narver v. Commissioner, 75 T.C. 53, 91 n.17 (1980),
affd. 670 F.2d 855 (9th Cir. 1982); Lanier v. Commissioner, T.C.
Memo. 1998-7 (“The “capitalization” rate * * * Although basically
related to the rate of interest * * * includes risk and liquidity
factors”). A properly computed fair market value and
“capitalization” rate reflect competitive market conditions. Mr.
McIntosh’s suggestion that a “capitalization” rate is properly
used to determine fair market value from known rental rates but
not the other way around is inconsistent with basic mathematical
and appraisal principles.8 Mr. McIntosh’s testimony is also
inconsistent with the methodology he used in his December 8,
1999, letter criticizing respondent’s methodology.
We have previously recognized the appropriateness of using
“capitalization” rates to determine the fair market rental value
of real estate. For example, in Clairton Slag, Inc. v.
Commissioner, T.C. Memo. 1979-485, we stated:
inasmuch as no comparable leases were available from
which to extrapolate the fair rental value of the
Property, the next best method for determining the fair
rental value of the Property is the “comparable sales”
method (CSM). The CSM requires the identification of
two relevant figures: (1) the rate of return on
8
If the present value of the property equals the rental
value divided by the “capitalization” rate, then, as a matter of
algebra, the rental value must equal the present value multiplied
by the “capitalization” rate.
- 24 -
investment an unrelated lessor of comparable property
would require; and (2) the fair market value of the
subject property at the beginning of each lease year.
* * *
Similarly, in Osterlund, Inc. v. Commissioner, T.C. Memo.
1987-40, we stated:
All three of these experts used essentially the same
method to derive their estimates of the Property's fair
rental value. They first estimated the Property's fair
market value using comparable sales of property. They
then multiplied their estimates of the Property's fair
market value by a rate of return they believed a lessor
of property similar to the Property would have required
during the years in question upon leasing such property
in an arm's-length transaction. We agree with the
parties that this is a reasonable method for
determining the fair rental value of the Property.
We are not bound by the opinion of any expert witness and
may accept or reject expert testimony in the exercise of sound
judgment. Helvering v. Natl. Grocery Co., 304 U.S. 282, 295
(1938); Estate of Hall v. Commissioner, 92 T.C. 312, 338 (1989).
We give very little weight to Mr. McIntosh’s testimony
because his reports contain no analysis and little reliable data
to aid us in determining the fair market rental value of the
subject properties, and because his testimony on a number of
matters was simply not credible.
We also give little weight to Mr. Vanderbundt’s report. Mr.
Vanderbundt’s report was based on a single “comparable” to
support his rental rate conclusions. His “comparable” was a
lease between related parties for a property in Lodi, California,
which had been supplied to him by petitioner. This single
- 25 -
related-party lease does not provide reliable information
concerning fair market values.
However, we do agree with Mr. McIntosh’s and Mr.
Vanderbundt’s testimony that the “capitalization” rate used in
determining the fair market rental value of property should
reflect the additional risks incurred by a landlord in leasing
land to an independent cardlock operator such as petitioner,
rather than a major oil company. We find that a 13-percent
“capitalization” rate is an accurate assessment of the rate of
return that an arm’s-length lessor would have required from
petitioner during 1996 and 1997. A “capitalization” rate of 13
percent is in the range of rates suggested by Mr. McIntosh in his
December 8, 1999, letter, and is in the upper range of rates that
Mr. McIntosh claims would be derived from the Nella Oil lease,
which was entered into in the same general timeframe as
petitioner’s leases and was to a similar independent operator.
Mr. Harris credibly testified that a flat 10-percent rate
would be appropriate for leases to major oil company tenants.
However, the 10-percent rate fails to take into account the
environmental credit risks borne by a landlord when leasing
property to an independent cardlock operator. A 3-percent risk
premium seems appropriate to us, in light of the substantial
additional risks a landlord incurs when leasing property to an
independent operator of underground storage tanks. Therefore, we
- 26 -
will apply a 13-percent “capitalization” rate in determining the
fair rental value of the properties.
Using the market values determined by Mr. Harris (values
that petitioner’s expert, Mr. McIntosh, conceded were, if
anything, on the high side), and using a “capitalization” rate of
13 percent, we conclude that the fair market rental values of the
properties were as follows:
Fair Market Capitalization Fair Market
Property Value Rate Rental Value
Watt Avenue $690,000 13% $89,700
Mother Lode Drive 230,000 13 29,900
Fee Drive 240,000 13 31,200
Petitioner is not entitled to deduct the amounts paid as
rent in excess of the fair market rental value of the property.
The excess amounts paid as rent were in the following amounts:
Property Rent Paid Fair Market Rent Excess
1996 1997 1996 1997
Watt Avenue $120,000 $120,000 $89,700 $89,700 $60,600
Mother Lode
Drive 27,600 28,800 29,900 29,900 ---
1 2
Fee Drive --- 16,000 --- 10,400 5,600
Total 147,600 164,800 119,600 119,602 66,200
1
The Fee Drive property was leased for only 4 months in
1997, at a rent of $4,000 per month.
2
Inasmuch as the Fee Drive property was leased for only 4
months, we have used four-twelfths of the annual fair market
rental value.
- 27 -
B. Fair Market Rental Value of Remaining Properties
To show that the rents petitioner paid on the remaining
properties were fair market rents, petitioner offered the
testimony of its president and shareholder, Randall Dean Hunt,
and the opinions of Messrs. McIntosh and Vanderbundt. Respondent
offered no evidence to contradict petitioner’s position or the
testimony of its expert witnesses. At trial, respondent’s
expert, Mr. Harris, testified that he had appraised all six
properties. When the Court asked respondent how it was to
determine the fair market rental values of the remaining three
properties when respondent had not filed Mr. Harris’s appraisal
reports with respect to these properties, respondent’s counsel
replied:
Your Honor, to be perfectly honest with you,
respondent was prepared to concede that the other three
properties’ rental rates were reasonable.
However, upon receiving Mr. McIntosh’s reports, we
kind of concluded that perhaps looking at just Mr.
McIntosh’s reports, and Mr. Vanderbundt’s report, that
maybe they weren’t so reasonable. And that’s why we’re
not willing to concede that point at this point.
But I think Mr. Harris concluded that they were
reasonable, and we didn’t feel that there was any need
to submit his reports to the Court.
Respondent offered no evidence to suggest that the rents paid by
petitioner on the remaining three properties exceeded their fair
market rental values. Respondent asks us to infer that
petitioner must also have paid excess rents on the other three
- 28 -
properties because petitioner paid rents in excess of fair market
rental value on two of the three properties for which respondent
submitted evidence.9 We do not draw the inference respondent
asks for.
Petitioner is entitled to prevail if a preponderance of the
evidence shows that the rents paid were not in excess of the
respective fair market rental values of the remaining properties.
Petitioner has come forward with evidence to show that the rental
rates it paid represented fair market rental values for the
remaining three properties. Petitioner submitted testimony from
its president and two expert witnesses to support its rental
values. Because respondent failed to submit any contrary direct
evidence, a preponderance of the evidence supports petitioner’s
position.
While the preponderance of the evidence supports
petitioner’s rental rates, we are not entirely satisfied by the
evidence presented by the parties. Petitioner’s evidence was
subject to all the infirmities noted above with respect to the
expert testimony of Messrs. McIntosh and Vanderbundt. We refer
specifically to the fair market values of the remaining
properties found by Mr. McIntosh in his original report for
estate planning purposes, which, we have no doubt, were
9
Of course, respondent asserted at trial and on brief,
without submitting any evidence to support his assertion, that
the rents for the three remaining properties were excessive.
- 29 -
substantially understated, and to the complete lack of data and
analysis contained in the expert reports offered by petitioner.
Using Mr. McIntosh’s “estate-planning” appraisal values, as
respondent requests, and our 13-percent “capitalization” rate
would have resulted in very substantial excessive rents.10 We
believe this is attributable to Mr. McIntosh’s undervaluing of
the properties for estate-planning purposes rather than to
petitioner’s overstating of the rents.
While we would have preferred to base our decision on a
record containing expert testimony supported by complete data and
thorough, unbiased analysis, we must to do the best we can with
the evidence presented by the parties. We are comforted in the
correctness of our conclusion that petitioner paid fair market
rents for the remaining three properties by respondent’s
admission that Mr. Harris, respondent’s expert, had concluded
that the rents for these three properties were not excessive.11
10
Applying a 13-percent “capitalization” rate to Mr.
McIntosh’s fair market values would have resulted in fair market
rent of $18,200 per year for Mosquito Road, $32,500 for Roseville
Road, and $33,800 for White Rock Road. Using these fair market
rental values, petitioner would have overstated the fair market
rents for these three properties for the 2 years in issue by
$151,100.
11
Because respondent’s appraiser used a flat 10-percent
“capitalization” rate to determine fair market rental value,
respondent’s expert must have determined fair market values
exceeding $530,000 for Mosquito Road, $540,000 for Roseville
Road, and $550,500 for White Rock Road--many times the values
determined by Mr. McIntosh (who valued the properties at
(continued...)
- 30 -
We therefore find that the rents petitioner paid on the remaining
properties did not exceed the fair market rental values of the
properties.
III. Penalties
Respondent argues that petitioner should be liable for a 20-
percent accuracy-related penalty by reason of petitioner’s
negligence under section 6662(a)(1). Respondent claims that the
magnitude of the discrepancy between the rent paid and the fair
market rental value of the properties establishes negligence.
Respondent offers no other evidence of negligence than the
magnitude of the discrepancy.12
Respondent argues that a negligence penalty is mandated
where the taxpayer fails to offer credible independent evidence
11
(...continued)
$140,000, $250,000, and $260,000, respectively). Even using a
13-percent “capitalization” rate would result in values of
$410,769, $415,384, and $426,923 for Mosquito Road, Roseville
Road and White Rock, respectively. Under any scenario, Mr.
McIntosh’s “estate-planning” appraisal substantially undervalued
the properties.
12
In connection with additions to tax and penalties, sec.
7491(c) places a burden of production on the Commissioner in
cases involving examinations commenced after July 22, 1998.
Internal Revenue Service Restructuring and Reform Act of 1998,
Pub. L. 105-206, sec. 3001, 112 Stat. 726. Neither party offered
evidence to show when the audit was commenced. However,
respondent claimed in his pretrial memorandum that the audit was
commenced before July 23, 1998, and petitioner in its opening
brief appeared to accept the burden of proof. Whether sec.
7491(c) applies here is irrelevant because petitioner is entitled
to prevail on a preponderance of the evidence.
- 31 -
to show how the lease rents were determined, citing Duplicating
Supply Co. v. Commissioner, T.C. Memo. 1993-451.
In Duplicating Supply, the Court recognized that the
taxpayer had the burden of establishing that it was not negligent
in setting the rent for the property, as the Commissioner had
determined in the notice of deficiency. The taxpayer had
substantially overstated rent (charging for 1 year’s rent 44
percent of the fair market value of the property), had made no
investigation of the market before setting the rent, and offered
no explanation to show how the rental figure had been determined.
The case at hand is easily distinguished from Duplicating
Supply. The uncontradicted evidence indicates that petitioner
made efforts to determine the correct rents by contacting real
estate agents before setting the rents. Petitioner’s president
and shareholder, Randall Dean Hunt, testified that before
entering into each of the leases, he (or his father before him)
asked several different brokers whether the rental rate was
reasonable.
Respondent argues that even though Mr. Hunt named the
brokers he and his father spoke with, Mr. Hunt’s testimony was
self-serving and should be disregarded because petitioner did not
call the brokers as witnesses. Respondent asks us to disregard
Mr. Hunt’s testimony because it is self-serving and
uncorroborated by any independent witnesses, citing Wichita
- 32 -
Terminal Elevator Co. v. Commissioner, 6 T.C. 1158, 1165 (1946),
affd. on other grounds 162 F.2d 513 (10th Cir. 1947).
In Wichita Terminal, we recognized that the Commissioner has
no obligation to introduce evidence to rebut an allegation by the
taxpayer where the taxpayer failed to introduce “one scintilla of
evidence” to support its allegation. In that case, we stated:
“The rule is well established that the failure of a party to
introduce evidence within his possession and which, if true,
would be favorable to him, gives rise to the presumption that if
produced it would be unfavorable.” Id. However, as we stated in
Sisson v. Commissioner, T.C. Memo. 1994-545:
This rule originates in Lord Mansfield’s observation
that “all evidence is to be weighed according to the
proof which it was in the power of one side to have
produced, and in the power of the other to have
contradicted.” Mammoth Oil Co. v. United States, 275
U.S. 13, 51 (1927) (quoting Blatch v. Archer, 1 Cowper
63, 65 (1774)); Kirby v. Tallmadge, 160 U.S. 379, 383
(1895). What Lord Mansfield did not say, but what the
Supreme Court added, is that the rule is to be applied
cautiously, and only in cases where the evidence is
possessed by one party and not accessible to the other
party. Mammoth Oil Co. v. United States, supra at 51.
This qualification mitigates the rigor with which the
rule might otherwise restrict the ability of the
parties to present their cases as they choose; the
qualification makes clear that, in our judicial system,
the trial court’s role is to decide cases on the
evidence presented, not on imaginable “evidence” not
presented. Fuller, The Problems of Jurisprudence 706
(Temp. ed. 1949) (“the moral force of a judgment of
decision will be at a maximum when * * * The judge
decides the case solely on the basis of the evidence
and arguments presented to him”).
- 33 -
In the case at hand, the witnesses to the conversations were
equally available to petitioner and respondent. Petitioner was
not required to call witnesses to corroborate the testimony it
offered. If respondent did not believe the testimony, he should
have called witnesses or taken other discovery to impeach Mr.
Hunt’s testimony. Respondent offered no evidence to call into
question the truth of Mr. Hunt’s testimony.
In addition, the magnitude of the discrepancy is not nearly
as significant as it was in Duplicating Supply Co. v.
Commissioner, supra. We have found that petitioner overstated
rent on only two of the six properties and charged as total
annual rent less than 20 percent of what we have found (and what
respondent’s expert claimed) to be the fair market value of these
properties.13 Petitioner’s rental payments exceeded the fair
market rental value of the Watt Avenue property by approximately
33 percent and the Fee Drive property by approximately 53
percent. While petitioner did overstate rental deductions on
these two properties, we do not find that the overstatements were
of sufficient magnitude to mandate a determination that
petitioner was negligent in setting the rents. We therefore
13
In 1996, petitioner charged rent of $120,000 for Watt
Avenue on a value of $690,000, resulting in a rental rate of 17
percent of value. In 1997, petitioner charged $120,000 in rent
for Watt Avenue and annualized rent of $48,000 on Fee Avenue, for
total rent of $168,000 on a value of $930,000 or approximately 18
percent of value.
- 34 -
conclude that petitioner is not liable for an accuracy-related
penalty on the grounds of negligence under section 6662(a)(1).
After giving effect to the parties’ concessions,
Decision will be entered
under Rule 155.