Estate of Ballantyne v. Comm'r

T.C. Memo. 2002-160

UNITED STATES TAX COURT

ESTATE OF MELVIN W. BALLANTYNE, DECEASED, JEAN S. BALLANTYNE,
INDEPENDENT EXECUTRIX, AND JEAN S. BALLANTYNE, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

RUSSELL E. BALLANTYNE AND CLARICE BALLANTYNE, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 14848-99, 16346-99. Filed June 24, 2002.

Kevin P. Kennedy, for petitioners in docket No. 14848-99.

Jon J. Jensen, Alexander F. Reichert, and Gary A. Pearson,

for petitioners in docket No. 16346-99.

John C. Schmittdiel and Roberta L. Shumway, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

RUWE, Judge: Respondent determined deficiencies in income

tax and a penalty in docket No. 14848-99 as follows:
 - 2 -

Accuracy-Related
Penalty
Taxpayer Year Deficiency Sec. 6662(a)
Jean S. Ballantyne 1993 $4,998 --

Estate of Melvin W. 1994 10,735 –-
Ballantyne, Jean S.
Ballantyne, Surviving
Spouse

Estate of Melvin W. 1994 172,035 –-
Ballantyne, Jean S.
Ballantyne, Executrix

Estate of Melvin W. 1995 14,562 $2,912
Ballantyne, Jean S.
Ballantyne, Executrix

Respondent determined deficiencies in income tax and

penalties in docket No. 16346-99 for Russell E. Ballantyne and

Clarice Ballantyne as follows:

Accuracy-Related Penalty
Year Deficiency Sec. 6662(a)
1993 $77,672 --
1994 325,761 $63,646.40
1995 47,381 9,476.20

In order to protect the Government from a potential whipsaw,

respondent has taken inconsistent positions in these dockets.1

After concessions, the issues for decision are: (1) The

proper allocation between the Estate of Melvin W. Ballantyne and

petitioner Russell E. Ballantyne of gain from the sale of grain

in 1994; (2) whether petitioner Russell E. Ballantyne had

additional gain in 1994 in the amount of $751,988 which should

1
These cases were consolidated for purposes of trial,
briefing, and opinion.
 - 3 -

have been included in gross income; and (3) whether petitioners

Russell E. Ballantyne and Clarice Ballantyne are liable for the

accuracy-related penalties pursuant to section 6662(a)2 for 1994

and 1995 with respect to certain adjustments contained in the

notice of deficiency.

FINDINGS OF FACT3

Some of the facts have been stipulated and are so found.

The stipulation of facts, the stipulations of settled issues, and

the attached exhibits are incorporated herein by this reference.

Petitioner Jean S. Ballantyne (Jean), who is the surviving spouse

of Melvin W. Ballantyne (Melvin) and the executrix for the Estate

of Melvin W. Ballantyne (the estate), resided in Minot, North

Dakota, at the time the petition in docket No. 14848-99 was

filed. At that time, the estate was under the jurisdiction of

2
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.
3
Russell and Clarice failed to comply with Rule 151(e)(3),
which requires that “In an answering or reply brief, the party
shall set forth any objections, together with the reasons
therefor, to any proposed findings of any other party, showing
the numbers of the statements to which the objections are
directed”. Under the circumstances, we have assumed that Russell
and Clarice do not object to respondent’s or the estate’s
proposed findings of fact except to the extent that their
statements on brief are clearly inconsistent therewith, in which
event we have resolved the inconsistencies on the basis of our
understanding of the record as a whole. Estate of Jung v.
Commissioner, 101 T.C. 412, 413 n.2 (1993); Burien Nissan, Inc.
v. Commissioner, T.C. Memo. 2001-116 n.4.
 - 4 -

Probate Court No. 1 in Bexar County, Texas. The business office

for the estate is located in San Antonio, Texas. Petitioners

Russell E. Ballantyne (Russell) and Clarice Ballantyne (Clarice)

resided in Westhope, North Dakota, at the time they filed their

petition.

Melvin Ballantyne and Russell Ballantyne were brothers. In

1943, they entered into an oral agreement whereby they formed a

general partnership known as Ballantyne Brothers Partnership

(BBP). Melvin and Russell were the only partners of BBP during

its existence, and a written partnership agreement was never

executed.

The partnership was involved in two separate and distinct

business operations. Russell primarily conducted a farming

activity in North Dakota. Russell’s sons, Orlyn and Gary,

assisted Russell in conducting the farming activity.4 Melvin

primarily conducted an oil and gas exploration and production

activity in Canada and various U.S. locations. Melvin employed

two of his sons, Stephen and Kab, to assist in conducting the oil

and gas activity.5 In general, Melvin and Russell allowed each

other to withdraw from the partnership the profits attributable

4
Russell and Clarice also had a daughter, Carolyn Ballantyne
Backelsberg.
5
Melvin and Jean had another son, Todd Ballantyne, who was
involved in the oil and gas activity up until the mid-1970s.
They also had two daughters, Jane Ballantyne Hegler and Sue
Ballantyne.
 - 5 -

to the respective activity each brother primarily conducted.

Melvin and Russell generally paid the expenses related to the

respective activity each conducted. Many of the assets used by

BBP in its activities were not held in the partnership’s name.

Rather, these assets were either jointly owned by Melvin and

Russell or individually owned by one of them.

In late 1993 or early 1994, Melvin was diagnosed with

pancreatic cancer, and he subsequently died on March 4, 1994.

The partnership automatically dissolved upon Melvin’s death. In

the months leading up to Melvin’s death, some of the assets of

BBP were equally distributed between Melvin (or his children) and

Russell. At the time of Melvin’s death, Jean, Stephen, Kab, and

Todd believed that Melvin and Russell were equal partners in BBP.

For at least the taxable years 1980 through 1994, BBP filed

Forms 1065, U.S. Partnership Return of Income. Jules Feldmann

(Mr. Feldmann), a certified public accountant, prepared BBP’s

Federal income tax returns for those years.6 Melvin, Stephen,

and Kab provided Mr. Feldmann with financial information about

the oil and gas activity. Russell, Orlyn, and Gary provided Mr.

Feldmann with financial information about the farming activity.

The Forms 1065 for 1980 through 1994 reported that Melvin and

6
Mr. Feldmann also regularly prepared personal income tax
returns for Melvin and Russell for several years. Mr. Feldmann
prepared Melvin’s return for 1993 and Russell and Clarice’s
returns for the years in issue.
 - 6 -

Russell each were general partners in BBP and that they each held

a 50-percent interest in the profit sharing, loss sharing, and

ownership of capital of the partnership. Additionally, Melvin

and Russell each reported 50-percent of BBP’s income, gain, loss,

deduction, and credit on their individual Federal income tax

returns.

For the taxable year 1994, BBP’s gross income from the

farming activity totaled $1,503,976.58. This amount was

attributable to grain sales by BBP to Bottineau Farmers Elevator

(Bottineau). The grain sold in 1994 was grown in prior years and

was an asset of BBP. The following schedule lists the payments

made by Bottineau in 1994 for the grain:

Date Payee Amount
1/03/94 Ballantyne Bros. $821,565.32
1/17/94 Ballantyne Bros. 250,000.00
2/28/94 Russell Ballantyne 104,181.18
3/04/94 Russell Ballantyne 59,238.79
3/18/94 Ballantyne Bros. 121,816.80
10/18/94 Ballantyne Bros. 73,993.25
10/18/94 Jean Ballantyne 73,181.24
Total 1,503,976.58

On the Schedule F, Profit or Loss from Farming, attached to its

1994 Form 1065, BBP reported depreciation and other farm expenses

of $371,294, resulting in a net farm profit of $1,132,681. On

its Form 1065, BBP reported additional income of $144,046 from

oil revenues, resulting in total income of $1,276,727. After

accounting for miscellaneous deductions, BBP reported ordinary

income of $1,242,710 from trade or business activities. BBP also
 - 7 -

reported net oil royalty income from Canada of $300,115 and

foreign taxes paid in the amount of $182,608. The Schedules K-1,

Partner’s Share of Income, Credits, Deductions, Etc., issued to

the estate and Russell allocated to each, as distributive share

items, one-half of partnership ordinary income, gross farming

income, oil revenue income, and oil royalty income from Canada.7

On a Schedule E, Supplemental Income and Loss, attached to

his 1994 Form 1040, U.S. Individual Income Tax Return, Russell

reported ordinary income of $584,122 from BBP.8 On a Schedule E

attached to its 1994 Form 1041, U.S. Income Tax Return for

Estates and Trusts, the estate reported ordinary income of

$616,423 from BBP.9

During its existence, BBP did not maintain a general ledger,

a balance sheet, a sales journal, or a purchases journal. BBP

7
The 1994 Form 1065, U.S. Partnership Return of Income, also
reported investment income of $13,428 and charitable
contributions of $275. These items were allocated evenly between
the estate and Russell.
8
Attached to the 1994 Form 1040, U.S. Individual Income Tax
Return, was a supplemental statement titled “Schedule E -
Supplemental Information”, which showed ordinary income from BBP
of $621,355, less “depletion cost percentage” totaling $37,233,
resulting in the amount of $584,122 listed on Schedule E.
9
Attached to the 1994 Form 1041, U.S. Income Tax Return for
Estates and Trusts, was a supplemental statement titled “FLOW-
THRU DETAIL REPORT-FORM 1065", listing income from BBP of
$621,355. A depletion deduction of $4,932 was listed on the
supplemental statement. This amount was deducted from the income
listed on the Form 1041 and resulted in the total of $616,423
listed on the Schedule E.
 - 8 -

did not always maintain a cash disbursements journal or a cash

receipts journal. Mr. Feldmann was never provided with a

complete listing of BBP’s assets and liabilities, and he never

prepared a balance sheet for the partnership.10 Neither the

partnership nor Mr. Feldmann prepared yearend trial balances.

Partnership capital accounts for BBP were never maintained. The

1993 and 1994 Forms 1065 reported that Melvin and Russell had

balances of “0" in their respective capital accounts at both the

beginning and the end of those taxable years.11 On the 1993 and

1994 Forms 1065, BBP reported on the Schedules L, Balance Sheet,

that the total assets and total liabilities of the partnership at

the beginning and the end of those taxable years were “None”.12

A calculation of each partner’s capital contributions to the

partnership cannot be made given the state of BBP’s records.

Additionally, a calculation of the distributions made to each

10
In the mid-1980s, Mr. Feldmann recommended that BBP
maintain a balance sheet showing the partnership’s assets and
liabilities.
11
For the taxable years 1980 through 1992, the areas
designated on the Forms 1065 and Schedules K-1, Partner’s Share
of Income, Credits, Deductions, Etc., attached to the Forms 1065
pertaining to information concerning Melvin’s and Russell’s
respective capital accounts were left blank. For the taxable
years 1993 and 1994, the Forms 1065 were also left blank;
however, the Schedules K-1 listed the amounts in Melvin’s and
Russell’s respective capital accounts at the beginning and end of
those taxable years as “0". Russell signed BBP’s partnership tax
returns for the years 1993 and 1994.
12
For the taxable years 1980 through 1992, the Schedules L,
Balance Sheet, on BBP’s Forms 1065 were left blank.
 - 9 -

partner cannot be made. The partnership tax returns for the

years 1980 through 1994 reflect that the oil and gas activity was

more profitable overall than the farming activity during that

period.

After Melvin’s death, a dispute arose concerning BBP. On

April 19, 1995, Jean, individually and in her capacity as

independent executrix of the estate, filed suit against Russell

and other parties. The original and amended petitions sought,

among other things, an accounting of the assets and liabilities

of BBP in order to establish the value of BBP’s assets and

liabilities and the respective interests of Melvin and Russell as

of the date of Melvin’s death. The dispute was also outlined in

the estate’s 1994 Form 1041. On a Form 4684, Casualties and

Thefts, attached to the 1994 Form 1041, the estate reported a

casualty/theft loss of $560,900. In an attachment to the Form

4684, the estate alleged that Russell had embezzled cash from BBP

bank accounts and transferred it to his own business and personal

accounts, resulting in a casualty/theft loss of $560,900. The

estate further alleged:

A portion of the amount of cash embezzled from the
partnership in 1994 has been ascertained from the
partnership tax return. The estate received its 50%
portion of the income distributions for oil properties
in the U.S. and Canada. The Estate has not received
its 50% of the distribution from the farm operations
because Russell Ballantyne, the general partner has
taken the money.
 - 10 -

The loss calculation for 1994 is calculated as follows:

Net farm revenues $1,132,681
add: depreciation 135,317
less: distribution (10/94) (147,174)
Interest income 13,057
Interest expense (12,082)

Total cash embezzled $1,121,799

50% Share $ 560,900

On both its original and amended Forms 1041 for the taxable

year 1995, the estate claimed that as a result of Melvin’s death

it acquired a 50-percent interest in BBP. In a document attached

to both the original and amended Forms 1041, the estate made the

following statement:

[The estate] acquired a 50% interest in Ballantyne
Brothers on March 4, 1994 as a result of the death of
Melvin Ballantyne. The interest in the partnership was
valued at $731,509 on the 706.

On March 4, 1994, the assets of Ballantyne Brothers
consisted of cash, marketable securities, notes
receivable, oil and gas properties, office furniture
and fixtures, farm inventory, seed, buildings and
equipment having a fair market value of $1,463,019.
Taxpayer has been unable to obtain the basis amounts
for these assets. Currently there is legal action
against the partnership to obtain such information.

On August 24, 1998, a settlement agreement was executed

which resolved the dispute concerning BBP. In negotiating the

settlement, representatives of the estate relied on the advice of

a certified public accountant as to the value of BBP’s assets.

The goal of the estate’s representatives was to obtain 50 percent

in value of the partnership’s assets. Under the settlement
 - 11 -

agreement, Russell agreed to transfer $2 million to the estate to

be deposited in a trust account to be held in trust for the

benefit of the estate pending the execution of certain releases

attached to the settlement agreement. All interests in oil

properties held on March 4, 1994, by BBP and/or Melvin or

Russell, individually, jointly, or as tenants in common, were

divided equally between the estate and Russell. Various bank and

stock accounts held in the name of BBP and Melvin and Russell

were to be closed within 30 days with the assets’ being

distributed equally between the estate and Russell.13 All debts

owed by Verde Oil Company to BBP on or after March 4, 1994, were

assigned to the estate. The estate agreed to drop its

embezzlement loss claim against Russell, and the parties

stipulated that all grain, and any proceeds therefrom, held on or

after November 1993 in the name of BBP were to be the sole

property of Russell. Finally, the parties stipulated that,

subject to the terms and conditions stated in the settlement

agreement and stipulations of ownership, all assets and

liabilities of BBP held on or after March 4, 1994, would be the

sole property of Russell.

After Melvin’s death, Mr. Feldmann received information

regarding the oil and gas activity primarily from Carolyn

13
Title and possession of three vehicles were transferred
from BBP to Jean Ballantyne.
 - 12 -

Ballantyne Backelsberg (Carolyn), Russell and Clarice’s daughter.

For the taxable year 1995, Carolyn provided Mr. Feldmann with

information regarding intangible drilling costs (IDCs) paid by

Russell in the taxable year 1995. A portion of the IDCs deducted

by Russell in 1995 had actually been reimbursed to him by

Ballantyne Oil and Gas, Inc. during that year. Mr. Feldmann was

not informed that Russell had been reimbursed for approximately

$97,790 of those expenses. The amount Russell claimed as a

Schedule E deduction for production taxes in the taxable year

1995 was based on the information provided to Mr. Feldmann.

On June 16, 1999, respondent issued notices of deficiency to

the estate for its taxable years 1994 and 1995. In addition to

other adjustments, respondent disallowed the estate’s claimed

theft loss of $560,900 in 1994 on the grounds that the estate had

not established (1) there was a theft loss and (2) the theft loss

was the estate’s to claim. In its petition, the estate alleged

that respondent erred in increasing its income by $560,900

because that amount was the income of Russell and was not taxable

to the estate.

On July 21, 1999, respondent issued a notice of deficiency

to Russell and Clarice for their taxable years 1993, 1994, and

1995. In addition to other adjustments, respondent increased

Russell and Clarice’s gross income for 1994 by $751,988.

Respondent identified this adjustment under the heading “ORDINARY
 - 13 -

INCOME (WHIPSAW)” and stated that “We have adjusted your gross

income to include amounts received for grain income for

$751,988.00 in 1994.” No further explanation was provided.

Respondent also determined that Russell and Clarice were liable

for the accuracy-related penalties pursuant to section 6662(a)

for 1994 and 1995 with respect to certain adjustments contained

in the notice of deficiency. These adjustments included the

increase in gross income for grain income, issues subsequently

conceded by Russell and Clarice relating to oil and gas

activities, and an issue subsequently conceded by respondent

relating to certain royalty income.

In their petition, Russell and Clarice alleged that

respondent “erroneously included within the taxpayers’ gross

income grain income in the amount of $751,988 for the tax year

1994". In his answer, respondent denied this allegation but did

not elaborate on the reason for the inclusion of the additional

amount in gross income.

OPINION

The primary issue in this case involves the proper

allocation between the estate and Russell of the grain sales

income for 1994. Respondent has protected the Government from a

potential whipsaw by taking inconsistent positions in his notices

of deficiency. Respondent’s primary argument is that the estate

and Russell are each liable for income tax on their respective
 - 14 -

50-percent distributive shares of income from BBP in 1994 from

the sale of grain. Alternatively, respondent contends that the

grain sold in 1994 was owned solely by Russell, and, thus, he had

additional gross income of $751,988 in 1994. Respondent also

argues that, to the extent the distribution of grain sales

proceeds and other money to Russell exceeded his adjusted basis

in BBP, Russell had gain on the distribution pursuant to section

731(a). Finally, respondent contends that Russell and Clarice

are liable for the accuracy-related penalties for 1994 and 1995

with respect to the grain sales income item and certain erroneous

deduction items.

Russell contends that he is responsible for only 50 percent

of the income tax on the grain sales income for 1994 because he

and Melvin agreed to share equally all the income and expenses of

BBP. Russell relies on the fact that tax returns filed by BBP

for the taxable years 1980 through 1994 show that all the income

and expenses were shared equally by the partners for income tax

purposes. Russell also contends that he possessed sufficient

basis to withdraw the cash from the grain sales without incurring

any additional tax liability. Finally, Russell and Clarice claim

that they are not liable for the accuracy-related penalties for
 - 15 -

1994 and 1995 because they relied in good faith on the advice of

their accountant.14

The estate argues that all grain sales income is

attributable to Russell because he was entitled to receive all

the farm income as his distributive share of BBP income.15 In

its reply brief, the estate for the first time joins respondent’s

alternative argument that the grain was the sole property of

14
On brief, Russell and Clarice argue that sec. 7491 applies
and that respondent has the burden of proof with respect to the
issues for decision. In certain circumstances, if the taxpayer
introduces credible evidence with respect to any factual issue
relevant to ascertaining the proper tax liability, sec. 7491
places the burden of proof on respondent. Sec. 7491(a); Rule
142(a)(2). Sec. 7491(c) operates to place the burden of
production on respondent in any court proceeding with respect to
the liability of the taxpayer for penalties and additions to tax.
Sec. 7491 is effective with respect to court proceedings arising
in connection with examinations commencing after July 22, 1998.
Internal Revenue Service Restructuring and Reform Act of 1998,
Pub. L. 105-206, sec. 3001(c), 112 Stat. 727. Russell and
Clarice have introduced no evidence to establish whether the
examination in this case commenced after July 22, 1998, and,
consequently, they have failed to show that sec. 7491 applies.
Eddie Cordes, Inc. v. Commissioner, T.C. Memo. 2001-265. We note
that the evidence that is in the record establishes that the
examination of the estate, as well as an examination of BBP,
began before July 23, 1998.
15
We note that the estate, in arguing that Melvin’s and
Russell’s distributive shares were the profits from the
respective activity each conducted, has not discussed the fact
that this finding would mean that the estate should have reported
100 percent of the income from the oil and gas activity instead
of only 50 percent of the income. It appears that the estate is
arguing that it should be liable for only 50 percent of the
income from the oil and gas activity and no portion of the income
from the farming activity. This conflicts with the estate’s
primary argument that its distributive share was the profits from
the oil and gas activity.
 - 16 -

Russell. Alternatively, the estate argues that the grain sales

income is attributable to Russell because he received it under a

claim of right and without any restriction on his right to

dispose of the income.

I. Ownership of Grain at Time of Sale

Initially, we must decide whether the grain sold in 1994 was

owned by Russell or BBP. If the grain sold in 1994 was owned

solely by Russell and was not partnership property, then he will

be liable for any tax attributable to the entire amount of grain

sales proceeds in 1994.

The grain that was sold in 1994 was grown in prior years and

was an asset of BBP. The parties do not dispute that the grain

was part of the farming activity which was an operation of BBP.

BBP’s 1994 Form 1065 reported the grain sales gain as income to

the partnership and the estate and Russell each were allocated

one-half of the gain. The estate and Russell each reported one-

half of the grain sales income on their respective 1994 tax

returns.

In the settlement agreement signed August 24, 1998, it was

stipulated that all grain proceeds held on or after November 1993

in the name of BBP were the sole property of Russell.

Handwritten notes of Stephen Ballantyne, dated August 23, 1998,

and entitled “Plaintiff’s Settlement Proposal”, state that the

plaintiffs “need to word agreement so that Estate will not pay
 - 17 -

taxes on the 1994 K-1" and “word that cash is estate’s share of

ptnrsp [sic]”. The evidence in the record reflects that, at the

time the grain sales were made in 1994, the grain was owned by

BBP. It was not until the settlement agreement in 1998 that the

grain was labeled as the sole property of Russell. It is well

settled that taxpayers lack the privilege of retroactively

allocating between themselves tax obligations owed to the United

States. United States v. Little, 753 F.2d 1420, 1430 (9th Cir.

1984); Moore v. Commissioner, 70 T.C. 1024, 1032 (1978); Curtis

v. Commissioner, T.C. Memo. 1995-344; Jacobellis v. Commissioner,

T.C. Memo. 1988-315; see also Pesch v. Commissioner, 78 T.C. 100,

128-129 (1982); Bonner v. Commissioner, T.C. Memo. 1979-435 (“an

agreement to which respondent is not a party cannot force him to

collect taxes from someone other than the person upon whom taxes

are imposed” (citing Neeman v. Commissioner, 13 T.C. 397 (1949),

affd. per curiam 200 F.2d 560 (2d Cir. 1952))). On the basis of

the evidence in the record, we hold that the grain sold in 1994

was BBP’s property and that the income from the grain sales was

therefore BBP’s. We now turn to the question of the proper

allocation between the estate and Russell of the partnership

income from the grain sales in 1994.

II. Allocation of Gain From Sale of Grain

A partner must take into account his “distributive share” of

each item of partnership income, gain, loss, deduction, and
 - 18 -

credit, when determining his income tax. Sec. 702(a); Vecchio v.

Commissioner, 103 T.C. 170, 185 (1994). Each partner is taxed on

his distributive share of partnership income regardless of

whether the amount is actually distributed to him. United States

v. Basye, 410 U.S. 441, 454 (1973) (“Few principles of

partnership taxation are more firmly established than that no

matter the reason for nondistribution each partner must pay taxes

on his distributive share.”); Vecchio v. Commissioner, supra at

185; sec. 1.702-1(a), Income Tax Regs. A partner’s distributive

share of income or loss is generally determined by the

partnership agreement. Sec. 704(a). The partnership agreement

may be written or oral. Stern v. Commissioner, T.C. Memo. 1984-

383; sec. 1.761-1(c), Income Tax Regs. In the case of an oral

partnership agreement, all the facts and circumstances

surrounding the formation and operation of the partnership are

relevant in determining the sharing ratios of the partners.

Barron v. Commissioner, T.C. Memo. 1992-598; Hogan v.

Commissioner, T.C. Memo. 1990-295 n.7; Reed v. Commissioner, T.C.

Memo. 1978-58; Ryza v. Commissioner, T.C. Memo. 1977-64. If the

partnership agreement does not provide as to a partner’s

distributive share, or if the partnership agreement provides for

an allocation that does not have substantial economic effect,

then a partner’s distributive share is determined by the

partner’s “interest in the partnership.” Sec. 704(b).
 - 19 -

Determinations of substantial economic effect, as well as

determinations of a partner’s interest in the partnership, are

dependent upon an analysis of the partners’ capital accounts.

Interhotel Co., Ltd. v. Commissioner, T.C. Memo. 2001-151.

A. Partnership Agreement and Substantial Economic Effect

The estate argues that the oral partnership agreement was

that Russell’s distributive share was the income or loss from the

farming activity, and Melvin’s distributive share was the income

or loss from the oil and gas activity. Russell and respondent

argue that the oral partnership agreement was that Russell’s and

Melvin’s distributive shares were equal but that each brother was

entitled to draw from the profits of the activity he operated.

As explained below, either a 50-percent allocation (as

advocated by Russell and respondent) or an allocation based on

the profits of the respective activities (as advocated by the

estate) lacks substantial economic effect and, therefore, the

distributive shares must be determined in accordance with the

partners’ interest in BBP. Thus, regardless of whether the

partnership agreement contained an allocation of items and what

that allocation was, the partners’ distributive shares are to be

determined in accordance with the partners’ interests in the

partnership.

If the partnership agreement provides for the allocation of

income, gain, loss, deduction, or credit (or item thereof) among
 - 20 -

partners, then the allocation will be recognized provided it has

substantial economic effect.16 Sec. 1.704-1(b)(1)(i), Income Tax

Regs. Substantial economic effect requires that (1) the

allocation have economic effect and (2) such effect is

substantial. Sec. 1.704-1(b)(1)(i) and (2), Income Tax Regs.

An allocation has economic effect if, and only if,

throughout the full term of the partnership, the partnership

agreement provides: (1) The partners’ capital accounts be kept in

accordance with the regulations; (2) liquidating distributions be

made in accordance with positive capital account balances; and

(3) a partner must be required to restore a deficit capital

account balance following the liquidation of the partnership or

of his interest in the partnership. Vecchio v. Commissioner,

supra at 189; sec. 1.704-1(b)(2)(ii)(b), Income Tax Regs. An

allocation does not have economic effect if it fails to satisfy

any of the three parts of the test. Vecchio v. Commissioner,

supra at 189. In the instant case, capital accounts were never

maintained; thus, the proffered allocations fail the economic

effect test.

The regulations under section 704 also provide an alternate

test for economic effect, contingent on satisfaction of

requirements (1) and (2) above. Sec. 1.704-1(b)(2)(ii)(d),

16
The “substantial economic effect” test is applicable to
all partnership allocations, not just “special allocations”.
Hogan v. Commissioner, T.C. Memo. 1990-295.
 - 21 -

Income Tax Regs. BBP does not meet requirements (1) and (2)

because BBP did not maintain any capital accounts. Thus, the

proffered allocations fail the alternate test for economic

effect.

Allocations which fail the economic effect test may be

deemed to have economic effect if they pass the economic effect

equivalence test. In Vecchio v. Commissioner, supra at 192, we

stated:

Allocations made to a partner that do not
otherwise satisfy the economic effect test,
nevertheless, are deemed to have economic effect,
provided that, as of the end of each partnership
taxable year, a liquidation of the partnership at the
end of such year or at the end of any future year would
produce the same economic results to the partners as
would occur if all the requirements of the economic
effect test had been satisfied, regardless of the
economic performance of the partnership. Sec. 1.704-
1(b)(2)(ii)(i), Income Tax Regs.; see also Elrod v.
Commissioner, 87 T.C. 1046, 1086 n.23 (1986). * * *

None of the parties have argued or demonstrated that either of

the proffered allocations satisfies this economic effect

equivalence test.

As mentioned earlier, where the partnership agreement does

not provide as to a partner’s distributive share, or where the

partnership agreement provides for an allocation that does not

have substantial economic effect, a partner’s distributive share

is determined by the partner’s “interest in the partnership.”

Sec. 704(b). As stated above, the allocations proposed by the

parties lack economic effect. Thus, the gain from the grain
 - 22 -

sales must be allocated in accordance with the partners’

interests in BBP.

We note that the estate relies on the following language in

Boynton v. Commissioner, 72 T.C. 1147 (1979), affd. 649 F.2d 1168

(5th Cir. 1981), to support its position and define the term

“distributive share”:

However, the power of the partners to fix their overall
“distributive” shares is subject to another and more
sweeping limitation, namely, that the purported
allocations of income and losses nominally made in the
partnership agreement must be bona fide in the sense
that they are genuinely in accord with the actual
division of profits and losses inter sese which the
partners have in fact agreed upon among themselves.
Thus, if provisions of the partnership agreement itself
effectively spell out how the profits are required to
be divided and how the losses are required to be borne,
the “distributive” shares of the partners will be
determined in accordance with such provisions, rather
than by an artificial label in the agreement which
characterizes as “distributive” an entirely different
allocation of profits and losses, and which has meaning
in terms of the partnership agreement only in respect
of the partners’ liability to the Internal Revenue
Service. This does not mean that the partners are
precluded from fixing their distributive shares in any
manner they choose. What it does mean is that in
construing the partnership agreement, the formula which
they select for actually dividing profits and
apportioning losses among themselves will be
determinative of their “distributive” shares, rather
than a different formula arbitrarily included in the
agreement which is to be applicable only for the
purpose of filing income tax returns, and which is to
have no legal consequences in respect of their rights
against one another. In short, where one provision of
the agreement which purports to characterize as
“distributive” a certain division of profits and losses
is contradicted by another provision which legally
fixes the rights of the partners inter sese, it is the
latter provision, rather than the former, which
establishes the “distributive” shares of the partners
 - 23 -

within the meaning of the statute. The overriding
principal is sometimes referred to as the doctrine of
“substance over form,” or is alternatively described as
the “economic substance” test. See, e.g., 1A. Willis,
Partnership Taxation, sec. 25.11, pp. 316-319 (1976).
[Boynton v. Commissioner, supra at 1158-1159.]

Our decision in Boynton v. Commissioner, supra, dealt with

section 704(b) as in effect in 1974. As in effect at that time,

and as interpreted in Boynton, section 704(b) generally provided

that if the partnership agreement did not provide as to the

partners’ distributive shares, or the principal purpose of any

provision of the partnership agreement with respect to the

partners’ distributive share of the item was avoidance or evasion

of tax described in that subtitle, then the partners’

distributive shares were determined with reference to each

partner’s agreed-upon share of the economic profits and losses,

not the basis upon which the partners might agree to report

income or claim losses on their individual returns. Boynton v.

Commissioner, supra at 1157 n.12, 1159. Section 704(b) was

subsequently amended for taxable years beginning after December

31, 1975, and now provides that if the partnership agreement does

not provide as to the partners’ distributive shares, or the

allocations to the partners under the partnership agreement lack

substantial economic effect, then the partners’ distributive

shares will be determined in accordance with the partners’

interests in the partnership. Sec. 704(b); Tax Reform Act of

1976, Pub. L. 94-455, sec. 213(d), 90 Stat. 1548. Thus, in the
 - 24 -

instant case, the statute currently requires that the partners’

distributive shares be determined in accordance with the

partners’ interests in the partnership. We note that the

regulations promulgated under current section 704(b) provide that

among the factors to be considered is the partners’ interests in

the economic profits and losses of the partnership. Sec. 1.704-

1(b)(3)(ii)(b), Income Tax Regs.17

B. Partners’ Interests in the Partnership

All partners’ interests in the partnership are presumed to

be equal. Sec. 1.704-1(b)(3)(i), Income Tax Regs. This

presumption may be rebutted upon the establishment of facts and

circumstances that the partners’ interests in the partnership are

otherwise. Id. A “partner’s interest in the partnership” is

defined as the “manner in which the partners have agreed to share

the economic benefit or burden (if any) corresponding to the

income, gain, loss, deduction, or credit (or item thereof) that

17
The final regulations promulgated under sec. 704(b) were
filed on Dec. 24, 1985, and published on Dec. 31, 1985. T.D.
8065, 1986-1 C.B. 254. The final regulations are effective
generally for partnership taxable years beginning after Dec. 31,
1975. For partnership taxable years beginning after Dec. 31,
1975, but before May 1, 1986 (or before Jan. 1, 1987, with
respect to special allocations of nonrecourse debt), however, a
special allocation that does not satisfy the requirements
nevertheless will be respected for purposes of the final
regulations if the allocation has substantial economic effect as
interpreted under the relevant caselaw and the legislative
history of the Tax Reform Act of 1976, Pub. L. 94-455, 90 Stat.
1520. Sec. 1.704-1(b)(1)(ii), Income Tax Regs.; see also Elrod
v. Commissioner, 87 T.C. 1046, 1086 n.23 (1986); Hogan v.
Commissioner, T.C. Memo. 1990-295 n.8.
 - 25 -

is allocated.” Sec. 1.704-1(b)(3)(i), Income Tax Regs. All

facts and circumstances relating to the economic arrangement of

the partners are taken into account. Id. The following factors

are considered relevant in determining a partner’s interest in

the partnership: (1) The partners’ relative contributions to

capital; (2) the partners’ interests in economic profits and

losses; (3) the partners’ interests in cashflow and other

nonliquidating distributions; and (4) the rights of the partners

to distributions of capital upon liquidation of the partnership.

Sec. 1.704-1(b)(3)(ii), Income Tax Regs.

The first factor to consider is the partners’ relative

contributions to capital. Melvin and Russell formed BBP in 1943,

and the partnership became involved in an oil and gas activity

and a farming activity. In general, Melvin paid the expenses

related to the oil and gas activity, while Russell did the same

with respect to the farming activity. Many of the assets used by

BBP in its activities were not held in the partnership’s name.

Rather, these assets were either jointly owned by Russell and

Melvin or individually owned by one of them. During its

existence, BBP did not maintain a general ledger, a balance

sheet, a sales journal, or a purchases journal. BBP did not

always maintain a cash disbursements journal or a cash receipts

journal. Partnership capital accounts for BBP were never

maintained. A calculation of each partner’s capital
 - 26 -

contributions to the partnership cannot be made given the state

of BBP’s records. Thus, the evidence in the record is

insufficient to determine the partners’ relative contributions to

capital.

The second factor to consider is the partners’ interests in

the economic profits and losses of the partnership. Melvin and

Russell generally allowed each other to withdraw the profits from

the respective activity each brother primarily conducted. Both

Russell and Mr. Feldmann testified that they believed that Melvin

withdrew more money from BBP over the years than Russell did.

Russell testified that he and Melvin had a great working

relationship and that they agreed that they would report the

income and loss from BBP equally on both the partnership and

their individual income tax returns. Russell testified that the

amount of income from each activity varied because sometimes the

price of grain was good and other times the price of oil was

good. The amount of profits earned by each activity varied year

to year depending on various factors, including the market prices

for grain or oil. For the taxable years 1980 through 1994, the

evidence in the record reflects that the oil and gas activity was

more profitable overall than the farming activity during this

period. The profits and losses varied from year to year as

between the two activities, and the evidence in the record is

insufficient from which to define the partners’ interests in the
 - 27 -

partnership according to any arbitrary percentage of the profits

or losses of the entire partnership.

The third factor to consider is the partners’ interests in

cashflow and other nonliquidating distributions. In general,

Melvin and Russell agreed to allow each other to withdraw the

portion of proceeds generated by their respective activities.

The evidence in the record indicates that different bank accounts

were maintained for the two activities, with Melvin primarily in

charge of the oil and gas accounts and Russell primarily in

charge of the farm accounts. Russell testified that he wrote

checks on the BBP farm account as he needed the money, not as the

income was received by BBP. He further testified that although

he felt he was entitled to farm income, there was nothing that

prohibited Melvin from writing a check from the BBP farm account

and that if Melvin wanted money from the farming activity then

Russell would write him a check. Russell testified that Melvin

stated several times that he would take $200,000 a month out of

BBP. Russell believed that this amount was more than Russell

withdrew from the partnership. Additionally, Russell and Mr.

Feldmann both testified that over the life of the partnership,

Melvin probably withdrew more money from the partnership than

Russell did.18

18
We note that, with respect to the grain sales made in
1994, Jean Ballantyne was listed as the payee for a $73,181.24
(continued...)
 - 28 -

As mentioned earlier, BBP did not maintain a general ledger,

a balance sheet, a sales journal, or a purchases journal. The

partnership did not always maintain a cash disbursements journal

or a cash receipts journal. A calculation of the distributions

made to each partner over the years cannot be made given the

state of BBP’s records. However, we note that the parties agree

that each partner generally withdrew funds from the respective

activity he conducted, and our review of BBP’s tax returns for

the years 1980 through 1994 indicates that the oil and gas

activity was more profitable overall than the farming activity

during this period. Additionally, in the months before Melvin’s

death, some of the assets of BBP were equally distributed between

Melvin (or his children) and Russell.

The fourth factor to consider is the partners’ rights to

distributions of capital upon liquidation of the partnership. At

trial, all the witnesses testified that, prior to Melvin’s death,

they believed that Melvin and Russell shared in the partnership

equally. Stephen testified that, as of Melvin’s date of death,

he believed that BBP was a 50-50 partnership. He further

testified that he believed this because Melvin and Russell each

18
(...continued)
payment made on Oct. 18, 1994. Russell Ballantyne was listed as
the payee for two payments totaling $163,419.97. The remaining
payments were made to BBP. Thus, it appears that a portion of
the farm income for 1994 was paid directly to Jean, either to her
personally or on behalf of the estate.
 - 29 -

had 50-percent ownership in land. Jean testified that, although

she generally did not discuss business with Melvin, she “just

thought that everything was 50-50" in BBP. Kab testified that,

at the time of Melvin’s death, he believed that Melvin and

Russell shared BBP profits on an equal basis. Todd testified

that he understood that Melvin and Russell had an agreement that

all property was owned equally and income taxes were split

evenly. After Melvin’s death, a dispute arose concerning BBP.

The parties eventually negotiated a settlement agreement

resolving the dispute concerning BBP. In negotiating the

settlement agreement, the goal of the estate’s representatives

was to obtain 50 percent in value of the partnership assets. The

parties stipulated that the grain income was the sole property of

Russell; however, Russell was also required to pay $2 million to

be held in trust for the benefit of the estate. The evidence in

the record indicates that the remaining assets and liabilities of

BBP were split approximately equally between the estate and

Russell. Thus, the evidence generally indicates that each

partner had equal rights to distributions of capital upon

liquidation of BBP.

In addition to the four factors above, we also note that

other evidence bears on the partners’ interests in BBP. For at

least the years 1980 through 1994, BBP reported all partnership

items equally, and a dispute never arose as to the proper
 - 30 -

allocation of items until after Melvin died.19 The testimony at

trial indicated that all witnesses believed that Melvin and

Russell had a close relationship and shared equally in

partnership items. In fact, the estate’s original and amended

Forms 1041 for 1994 and 1995 reflect the estate’s belief that it

acquired a 50-percent interest in BBP as a result of Melvin’s

death.20 No evidence was presented suggesting that either

brother had a problem with the partnership arrangement or the way

partnership items were reported. Each brother appeared to have

been content with the equal reporting arrangement and held

himself out as owning an equal interest in the partnership. The

tax returns for the years 1980 through 1994 indicate that in some

years the income from the oil and gas activity was more than the

income from the farming activity and vice versa.

All partners’ interests in a partnership are considered

equal. Sec. 1.704-1(b)(3)(i), Income Tax Regs. It is undisputed

19
Consistent with allocations reported on BBP’s partnership
returns, Melvin and Russell reported one-half of partnership
items on their individual Federal income tax returns. This Court
has previously recognized that statements made in a Federal tax
return are generally considered an admission by the taxpayer and
will not be overcome without cogent evidence that they are wrong.
Estate of Hall v. Commissioner, 92 T.C. 312, 337-338 (1989); Lare
v. Commissioner, 62 T.C. 739, 750 (1974), affd. without published
opinion 521 F.2d 1399 (3d Cir. 1975); Gale v. Commissioner, T.C.
Memo. 2002-54.
20
The estate’s amended Form 1041 for 1995 was stamped
received by the Internal Revenue Service in Austin, Texas, on
Mar. 7, 1997, more than 3 years after the date of Melvin’s death.
 - 31 -

that Melvin and Russell agreed to report all items of BBP equally

for Federal income tax purposes. The brothers adhered to this

agreement throughout the existence of the partnership, and the

evidence in the record reflects that neither brother objected to

the arrangement. There is no evidence to indicate that either

Melvin or Russell was attempting to divide profits and apportion

losses solely to avoid undesirable tax consequences. Mr.

Feldmann, who regularly prepared BBP’s partnership returns as

well as Melvin’s and Russell’s individual returns, testified that

it was his understanding that Melvin and Russell had an oral

agreement that they were equal partners in BBP and they each had

50-percent distributive shares. After considering all the facts

and circumstances relating to the economic arrangement of Melvin

and Russell, including the four factors listed in section 1.704-

1(b)(3)(ii), Income Tax Regs., we conclude that each partner had

a 50-percent interest in BBP. Accordingly, the gain from the

sale of grain in 1994 must be allocated equally between the

estate and Russell.

C. Whether the Estate Can Avoid Reporting Grain Sales
Income in 1994 If Russell Received the Entire Grain Sales
Income Under a Claim of Right

The estate argues that all the gain from the sale of grain

in 1994 is attributable to Russell because he received it under a

claim of right and without any restriction on his right to

dispose of the income. The estate cites Estate of Kahr v.
 - 32 -

Commissioner, 48 T.C. 929 (1967), affd. in part and revd. in part

on another issue 414 F.2d 621 (2d Cir. 1969), and Estate of Etoll

v. Commissioner, 79 T.C. 676 (1982), to support its argument that

Russell should have included all the farm income in his gross

income for 1994 and that none of the farm income is includable in

the gross income of the estate for 1994. Respondent argues that

regardless of whether the claim of right doctrine applies and

whether Russell received the grain sales income under the claim-

of-right doctrine, the estate is not relieved from reporting one-

half of the gain from the grain sales.21

In Estate of Kahr v. Commissioner, supra, the taxpayer, a

50-percent interest holder in a partnership, diverted large

amounts of partnership income from the partnership to himself.

Id. at 930. The taxpayer did not report the diverted funds in

the partnership returns of the company. Id. at 931. The

Commissioner determined that the taxpayer was liable for income

tax on one-half of the amount of the diverted funds as his

distributive share of partnership income and that he was taxable

on the other half of the amount of the diverted funds as

embezzlement income. Id. at 933. We held that the taxpayer

21
Respondent has not asserted that Russell is required to
include the gain from the grain sales in 1994 under the claim of
right doctrine. Respondent’s contention that Russell is liable
for income tax on the entire amount of grain sales income is only
on the grounds that (1) the grain was the sole property of
Russell or (2) Russell received distributions in excess of his
basis in his partnership interest.
 - 33 -

“embezzled company funds in the amounts determined, and it is the

law that embezzled funds are income to the embezzler in the year

in which they are misappropriated.” Id. at 934. We did not

explain whether our holding was based on the reasoning that all

the diverted funds were income to the taxpayer as embezzled

funds, or whether one-half was income to the taxpayer as his

distributive share and the other half was income as embezzled

funds.

In Estate of Etoll v. Commissioner, supra, three partners,

one of whom was the taxpayer, were engaged in a partnership. The

partnership was a successor to another partnership which had

operated under an agreement containing a provision that all

assets, including accounts receivable, would become the property

of the taxpayer upon the partnership’s dissolution. Id. at 676-

677. A new partnership agreement was prepared and contained a

different provision in respect of the distribution of the assets

upon dissolution. Id. at 677. However, that agreement was never

executed by one of the partners and never became effective. Id.

Subsequently, the partnership dissolved, and the taxpayer

collected partnership accounts receivable and used a portion to

pay personal expenses and deposited a portion into a bank account

from which only he was authorized to make withdrawals. Id. The

other partners initiated an action against the taxpayer seeking a

portion of the amount of the accounts receivable. Id. One of
 - 34 -

the issues was whether the original agreement that the taxpayer

was entitled to all assets upon dissolution was binding on the

partners at the time of the actual dissolution. Id. The

Commissioner determined that, in accordance with the claim-of-

right doctrine, the entire amount of collected receivables

constituted income to the taxpayer. Id.

Initially, we addressed whether the amounts collected by the

taxpayer would be taxable to him if he received them in a

nonpartner capacity as the result of the dissolution of the

partnership and where the amounts were clearly received under a

claim of right by virtue of the original agreement and without

restriction as to their disposition. Id. at 678. We found that

if that were the case, the amounts were clearly taxable to the

taxpayer. Id. Next, we addressed whether, assuming the amounts

were partnership income, the claim-of-right doctrine applied. We

stated:

When a dispute arises over how much partnership
income a partner is entitled to, we do not believe that
section 702(c), or any other provision of subchapter K,
changes the general principle that a taxpayer must
include in income funds which he acquires under a claim
of right and without restriction as to their
disposition. * * * [Id. at 679 (citing Estate of Kahr
v. Commissioner, supra at 934).]

We assumed without deciding that if the amounts were partnership

income taxable in part to the other partners, then those partners

would appear to have offsetting losses, and the taxpayer would

still be considered as having income to the full extent of the
 - 35 -

amounts collected. Id. at 679. We did not render a holding as

to whether the other partners were relieved of their

responsibility of reporting their distributive shares of the

receivables.

In the instant case, assuming that the claim-of-right

doctrine may apply in this situation, we are not convinced that

Russell acquired the proceeds from the grain sales under a claim

of right and without restriction as to their disposition. The

evidence reflects, and we have found, that the grain sold in 1994

was partnership property. The evidence in the record reflects

that Melvin and Russell allowed each other to withdraw the

profits from the respective activity each brother primarily

conducted, not that each partner was entitled to dispose of the

income from his respective activity without restriction. Russell

testified that there was nothing to prevent Melvin from writing a

check on the BBP farm account and that if Melvin wanted some

money from the farming activity, then Russell would either write

a check or Melvin would sign a note and Russell would pay the

note.22 In the lawsuit, which included the dispute concerning

BBP, the estate sought to enforce its legal rights against

Russell to recover one-half of the farm income. The estate also

originally claimed on its 1994 tax return that it was entitled to

22
Additionally, the evidence in the record indicates that a
payment of $73,181.24 was made to Jean Ballantyne on Oct. 18,
1994, from Bottineau for the sale of grain.
 - 36 -

a theft loss for one-half of the farm income on the grounds that

Russell embezzled the income. However, the estate dropped its

embezzlement claim against Russell in exchange for $2 million and

approximately one-half of the remaining partnership property, and

the estate has not argued, nor does the record establish, that

Russell embezzled the proceeds from the grain sales. Thus, we

hold that Russell did not have a claim of right to the grain

sales proceeds, and the estate is not relieved of its obligation

to report one-half of the grain sales for 1994 proceeds in its

gross income for that year.23

23
Even if we were to find that Russell acquired the grain
sale proceeds under a claim of right and without restriction as
to their disposition, it appears that the estate would still be
required to report the full amount of its 50-percent distributive
share in BBP. In Cipparone v. Commissioner, T.C. Memo. 1985-234,
we stated:

Partners are taxable on the full amount of their
distributive share even where a partner is unaware that
partnership income has been earned, and another partner
has embezzled it without his knowledge. Commissioner
v. Estate of Goldberger, 213 F.2d 78 (3d Cir. 1954),
affg. in part and revg. in part sub nom. Trounstine v.
Commissioner, 18 T.C. 1233 (1952); Stoumen v.
Commissioner, 208 F.2d 903 (3d Cir. 1953). This Court
has expressly followed Goldberger and Stoumen in Beck
Chemical Equipment Corp. v. Commissioner, 27 T.C. 840,
855-856 (1957).

We have already found that the grain sold in 1994 was partnership
property. Thus, because the estate’s distributive share was one-
half of all the partnership items, it would have to include one-
half of the grain sales proceeds in gross income. The estate has
not otherwise argued or presented evidence in this proceeding to
establish that it is entitled to deduct one-half of the grain
sales proceeds as a theft loss.
 - 37 -

III. Distributions in Excess of Basis

Respondent argues that, to the extent that the grain sales

proceeds and other money Russell received from BBP in 1994

exceeded his adjusted basis in the partnership, Russell had

additional taxable income. Russell maintains that he possessed

sufficient basis to withdraw the cash from the grain sales

without incurring any additional tax liability.

As a preliminary matter, we must determine which party bears

the burden of proof on this issue. Russell argues that the

notice of deficiency containing the adjustment for grain income

did not raise the issue of withdrawal in excess of basis as a

theory for increasing Russell’s gross income by $751,988.

Russell maintains that this alternate theory was not tried by the

implied consent of the parties. In the event the issue was tried

by the implied consent of the parties, Russell contends that

resolution of the issue requires the presentation of evidence

that is different from that which would be necessary to resolve

the proper reporting of grain sales income as between the estate

and Russell.

Respondent recognizes that this issue was not expressly

raised in the notice of deficiency. On brief, respondent states:

Although not expressly set forth in the notice of
deficiency, this argument is an additional ground for
the $751,988.29 adjustment to Russell Ballantyne’s
taxable income in 1994. It was addressed by both
respondent and Russell Ballantyne in the parties’ trial
memoranda and evidence applicable to the argument was
 - 38 -

presented at trial. Thus, even if not specifically
raised in the pleadings, the matter has been tried by
the implied consent of the parties. T.C. Rule 41(b).

Rule 41(b) states that “When issues not raised by the

pleadings are tried by express or implied consent of the parties,

they shall be treated in all respects as if they had been raised

in the pleadings.” In the instant case, respondent admits that

the issue of whether Russell withdrew cash in excess of his basis

was not specifically raised in the pleadings. However, the

evidence reflects that both parties were aware, before trial,

that respondent was pursuing this alternative argument.

Respondent alleges that, before trial, he repeatedly requested

information from Russell regarding his basis in BBP. This

allegation is supported by respondent’s interrogatories to

Russell which requested information necessary to calculate

Russell’s basis in BBP during the years in issue and by Mr.

Feldmann’s testimony at trial that an agent of respondent brought

up the issue of Russell’s basis in BBP during the audit process.

Additionally, respondent’s trial memorandum lists one of the

issues in this case as:

Whether Russell Ballantyne had additional income in
1994 from the sale of grain in the amount of
$751,988.00. Alternatively, whether Russell Ballantyne
received a distribution from BBP in 1994 that exceeded
his basis in the partnership by $751,988.00.

Russell’s trial memorandum states that “Russell Ballantyne has

sufficient basis for his withdrawal of grain income.” Russell
 - 39 -

also provided a short analysis of legal authorities governing the

determination of a partner’s basis. At trial, testimony was

elicited from various witnesses as to Russell’s basis in BBP and

whether he withdrew amounts in excess of his basis. Finally,

both parties specifically addressed this issue in their opening

and reply briefs. Thus, we find that this issue was tried by the

implied consent of the parties.

As a general rule, the Commissioner’s determination bears a

presumption of correctness, and the burden of proof rests with

the taxpayer.24 Rule 142(a); Welch v. Helvering, 290 U.S. 111,

115 (1933). However, section 7522 requires that a notice of

deficiency “describe the basis” for the tax deficiency. In

certain circumstances, the failure to “describe the basis” for

the tax deficiency results in the raising of a new matter under

Rule 142(a). Shea v. Commissioner, 112 T.C. 183, 197 (1999);

Wayne Bolt & Nut Co. v. Commissioner, 93 T.C. 500, 507 (1989).

In Shea v. Commissioner, supra at 197, we stated:

We have previously held that new matter is raised
when the basis or theory on which the Commissioner
relies was not stated or described in the notice of
deficiency and the new theory or basis requires the
presentation of different evidence. Wayne Bolt & Nut
Co. v. Commissioner, 93 T.C. at 507. This rule for
determining whether a new matter has been raised by the
Commissioner is consistent with, and supported by, the
statutory requirement that the notice of deficiency

24
As we noted earlier, it has not been established that the
examination of Russell and Clarice began after July 22, 1998, or
that sec. 7491 applies. See supra note 14.
 - 40 -

“describe the basis” for the Commissioner’s
determination. This rule also provides a reasonable
method for enforcing the requirements of section 7522.
[Fn. ref. omitted.]

We then held that where the notice of deficiency fails to

describe the basis on which the Commissioner relies to support a

deficiency determination and that basis requires the presentation

of evidence that is different from that which would be necessary

to resolve the determinations described in the notice of

deficiency, the burden of proof will be placed on the

Commissioner with respect to that issue. Id.

In the instant case, the notice of deficiency increased

Russell and Clarice’s gross income for 1994 by $751,988.

Respondent identified this adjustment under the heading “ORDINARY

INCOME (WHIPSAW)” and explained that “We have adjusted your gross

income to include amounts received for grain income for

$751,988.00 in 1994.” No further explanation was provided

regarding the reason for including the additional amount in gross

income. In their petition, Russell and Clarice alleged that

respondent “erroneously included within the taxpayers’ gross

income grain income in the amount of $751,988 for the tax year

1994". In his answer, respondent denied this allegation but did

not elaborate on the reason for the inclusion of the additional

amount in gross income. Thus, neither the notice of deficiency

nor respondent’s answer to Russell and Clarice’s petition

describes distributions in excess of basis as respondent’s reason
 - 41 -

for increasing gross income. Indeed, respondent acknowledges on

brief that the distributions in excess of basis theory was not

set forth in the notice of deficiency. The evidence in the

record demonstrates that the adjustment in the notice of

deficiency was based on respondent’s whipsaw position that

Russell should have reported all the grain sales proceeds in

income because the grain was solely Russell’s property, not

partnership property. In the instant case, the determination of

whether the grain sold in 1994 was Russell’s sole property is not

dependent on, and does not require a determination of, the amount

of Russell’s basis in his partnership interest. The evidence

necessary to establish Russell’s basis in his partnership

interest is different from the evidence necessary to establish

that the grain sold in 1994 was solely Russell’s property.

Accordingly, respondent bears the burden of proof on this issue.

Shea v. Commissioner, supra at 197; Wayne Bolt & Nut Co. v.

Commissioner, supra at 507.

Section 731(a) defines the circumstances under which a

partner recognizes gain or loss from partnership distributions.

In the case of a distribution by a partnership to a partner, gain

is recognized only to the extent that any money distributed

exceeds the adjusted basis of a partner’s interest in the

partnership immediately before the distribution. Sec. 731(a)(1);

Jacobson v. Commissioner, 96 T.C. 577, 584 (1991), affd. 963 F.2d
 - 42 -

218 (8th Cir. 1992). Any gain recognized under section 731(a) is

considered as gain from the sale or exchange of the partnership

interest of the distributee partner. Sec. 731(a); P.D.B. Sports,

Ltd. v. Commissioner, 109 T.C. 423, 441 (1997). In the case of a

sale or exchange of an interest in a partnership, gain recognized

to the transferor partner is generally treated as gain from the

sale or exchange of a capital asset. Sec. 741; Colonnade Condo.,

Inc. v. Commissioner, 91 T.C. 793, 814 (1988).

Section 722 provides that the basis of a partnership

interest acquired by contribution of property, including money,

is “the amount of such money and the adjusted basis of such

property to the contributing partner at the time of the

contribution”. For purposes of section 722, a contribution of

money includes “Any increase in a partner’s share of the

liabilities of a partnership, or any increase in a partner’s

individual liabilities by reason of the assumption by such

partner of partnership liabilities”. Sec. 752(a). Section

705(a) provides the general rule for determining the adjusted

basis of a partner’s interest as determined under section 722.

In relevant part, section 705(a) provides that the adjusted basis

of a partner’s interest in a partnership is the basis determined

under section 722 (1) increased by the partner’s distributive

share of partnership income for the tax year and prior years and

(2) decreased (but not below zero) by distributions from the
 - 43 -

partnership under section 733 and by his distributive share of

partnership losses for the tax year and prior years. Section 733

provides that, in the case of a distribution by a partnership to

a partner other than in liquidation of a partner’s interest, the

adjusted basis of the partner is reduced by the amount of money

distributed to that partner. Additionally, any decrease in a

partner’s share of the liabilities of a partnership is considered

a distribution of money to the partner by the partnership. Sec.

752(b).

Respondent claims that BBP maintained inadequate accounting

records and that there is no direct evidence establishing each

partner’s basis in BBP. Respondent argues that in a situation

such as this one, it is appropriate to apply the alternative rule

set forth in the regulations under section 705 to determine

Russell’s adjusted basis in his partnership interest.

Section 705(b) grants the Secretary the authority to

prescribe regulations under which the adjusted basis of a

partner’s interest in a partnership may be determined by

reference to his proportionate share of the adjusted basis of

partnership property upon a termination of the partnership.

Section 1.705-1(b), Income Tax Regs., provides that “the adjusted

basis of a partner’s interest in a partnership may be determined

by reference to the partner’s share of the adjusted basis of

partnership property which would be distributable upon
 - 44 -

termination of the partnership.” This alternative rule may be

used in circumstances where a partner cannot practicably apply

the general rule set forth in section 705(a) and section 1.705-

1(a), Income Tax Regs., or where, from a consideration of all the

facts, the Commissioner reasonably concludes that the result will

not vary substantially from the result obtainable under the

general rule. Sec. 1.705-1(b), Income Tax Regs. Where the

alternative rule is used, certain adjustments may be necessary in

order to ensure the proper determination of the adjusted basis of

a partner’s interest in a partnership. Id.

In the instant case, BBP was formed in 1943. The records of

the partnership do not show the amount of cash contributions, or

the basis in property contributed by Melvin or Russell to BBP.

Additionally, a calculation of the distributions made to each

partner cannot be made. The partnership tax returns in the

record cover only the years 1980 through 1994. Under these

circumstances, it is appropriate for respondent to apply the

alternative rule set forth in section 1.705-1(b), Income Tax

Regs., in order to attempt to establish Russell’s adjusted basis

in his 50-percent partnership interest.

Respondent points out that BBP reported that the total

assets and total liabilities of the partnership at both the

beginning and the end of the taxable year 1994 were “None”.

Additionally, respondent notes that BBP’s 1994 return reported
 - 45 -

that Russell’s capital account had a balance of zero at both the

beginning and the end of the taxable year. The Schedule K-1

attached to the 1994 Form 1065 listed the amounts in Melvin’s and

Russell’s capital accounts at the beginning and end of the

taxable year as “0". Russell signed BBP’s 1994 tax return.

Respondent claims that Russell should not be lightly relieved of

the sworn representations he made in BBP’s 1994 tax return.

Mr. Feldmann explained that the word “None” that was listed

on BBP’s tax returns for total assets and total liabilities for

1993 and 1994 did not mean that there were zero assets and

liabilities; rather the word “None” was the default position

generated by the computer software he used when no entry was

made. Likewise, Mr. Feldmann testified that the amount “zero”

for the capital accounts was also a default position when no

entry was made. Mr. Feldmann testified that he left these areas

blank because he did not have the information necessary to fill

in these areas on the tax returns. Mr. Feldmann explained that

had he made an entry, he would have put “not available” or

“information not available” in order to reflect the fact he did

not have the necessary information. BBP’s records were not

maintained in a manner sufficient to determine the partnership’s

assets and liabilities.25 Consequently, Mr. Feldmann did not

25
We note that the estate claimed in its original and
amended returns for the taxable year 1995 that as of the date of
(continued...)
 - 46 -

have the necessary information to provide specific amounts when

he prepared BBP’s tax returns. However, the fact that the

partnership returns failed to report specific amounts of assets

and liabilities does not mean that Russell did not have a

positive basis in his partnership interest. It is evident that

the partnership returns are incorrect, and respondent cannot rely

upon them to meet his burden.

At trial, Russell introduced two loan statements addressed

to BBP. The first statement, from FCS of NW North Dakota,

reflects an operating loan with a principal balance of

$678,860.67 as of January 1, 1994, and $649,537.49 as of December

31, 1994. The second statement, from the First Bank Minot,

reflects a loan with a balance of $157,803.26 as of March 31,

1994. Russell claims that these loans reflect a basis of at

least one-half of the combined loan balances, or $403,670,

because he obligated himself for the partnership debt.26 Russell

claims that he had additional basis as a result of certain

adjustments contained in the notice of deficiency. Russell also

contends that Melvin withdrew more money from BBP over the years

25
(...continued)
Melvin’s death, the assets of BBP “consisted of cash, marketable
securities, notes receivable, oil and gas properties, office
furniture and fixtures, farm inventory, seed, buildings and
equipment having a fair market value of $1,463,019.”
26
At trial, Russell and Mr. Feldmann testified that these
loans were fully paid in 1998, one-half by Russell and one-half
by a limited partnership formed for Melvin’s children.
 - 47 -

than he did and that this supports his arguments that Russell had

sufficient basis in BBP in 1994 to avoid being taxed on the

amounts distributed in excess of his distributive share.

Finally, Russell relies on Mr. Feldmann’s testimony that he had

withdrawn considerably less money from BBP than Melvin had and

that Russell would have had a positive basis after receiving the

grain sales proceeds in 1994.

Respondent argues that Russell has not shown that the basis

imputed to his partnership interest from the liabilities still

existed in 1994 or had not been used up by prior distributions.

Respondent claims that intervening events likely affected

Russell’s basis in BBP and that the existence of the loans does

not establish that Russell had any basis in BBP. Respondent

contends that as a result of partnership adjustments proposed to

Russell and settled for 1993 and 1994, Russell’s basis in the

partnership would have increased at most by $143,203. However,

respondent claims that without further information as to prior

distributions made to Russell, it cannot be determined that

Russell had sufficient basis in BBP to withdraw the entire grain

proceeds in 1994 as a tax-free distribution. Respondent claims

that Mr. Feldmann’s testimony that he was aware of the two loans

is inconsistent with his preparation of BBP’s 1994 return in

which each partner’s capital account was reported as being zero

at both the beginning and the end of 1994. Finally, respondent
 - 48 -

contends that any basis Russell had in his partnership interest

as of January 1, 1994, would have been rapidly depleted by the

partners’ distribution of assets in anticipation of Melvin’s

death.

At trial, both Russell and Mr. Feldmann testified that

Russell had withdrawn considerably less money than Melvin had

from BBP. Mr. Feldmann testified that he was aware of the two

loans totaling approximately $800,000 and that he believed that

Russell paid off one-half of the debt sometime after Melvin’s

death. Mr. Feldmann testified that he attempted to calculate

Russell’s basis in BBP, and, although he could not determine a

specific amount, he believed that Russell had a positive basis in

BBP after receiving the grain sales proceeds in 1994.

BBP’s records are insufficient to determine each partner’s

relative capital contributions and the amount of distributions

made to each partner over the life of the partnership. The

evidence in the record reflects that, during BBP’s existence,

Melvin and Russell generally allowed each other to withdraw the

profits from the respective activities they conducted, and, at

least for the years 1980 through 1994, the oil and gas activity

was more profitable overall than the farming activity. The

partnership tax returns and the fact that Melvin and Russell

generally kept the profits from their respective activities

support Russell’s and Mr. Feldman’s testimony that, with respect
 - 49 -

to the amounts withdrawn or distributed from BBP over the

existence of the partnership, Melvin withdrew more money from the

partnership than Russell did. Overall, the evidence supports

Russell’s argument that he had a positive basis in his

partnership interest in 1994 after receiving the grain sales

proceeds.

It is respondent’s burden to prove that Russell received

distributions from BBP in excess of his basis in his partnership

interest. See Shea v. Commissioner, 112 T.C. at 197; Wayne Bolt

& Nut Co. v. Commissioner, 93 T.C. at 507. After reviewing all

the evidence in the record, including Russell’s and Mr.

Feldmann’s testimony on the issue and the effect of the

stipulated adjustments on Russell’s basis, we conclude that

respondent has failed to establish that Russell received money

from BBP in 1994 in excess of his basis in his partnership

interest. Accordingly, we hold for Russell on this issue.

IV. Accuracy-Related Penalties for 1994 and 1995

In the notice of deficiency, respondent determined that

Russell and Clarice were liable for the accuracy-related

penalties pursuant to section 6662(a) on the portions of their

underpayments attributable to the following adjustments contained

in the notice of deficiency:
 - 50 -

Amount of Adjustment
Adjustment 1994 1995
Schedule E - depletion $51,627 $101,923
Ordinary income 751,988 --
Canadian royalty -- 56,504
Schedule C - production tax -- 5,353
Schedule C - IDC -- 97,790
Schedule C - depletion -- 53,067

Respondent subsequently conceded the Canadian royalty adjustment.

Russell and Clarice conceded the Schedule C and Schedule E

adjustments. Our decision on the ordinary income adjustment is

in Russell and Clarice’s favor. Consequently, we must decide

whether Russell and Clarice are liable for the accuracy-related

penalties with respect to the Schedule C and Schedule E

adjustments.

Section 6662(a) imposes a penalty equal to 20 percent of the

portion of an underpayment of tax attributable to a taxpayer’s

negligence, disregard of rules or regulations, or substantial

understatement of income tax. Sec. 6662(a), (b)(1), and (2).

“Negligence” has been defined as the failure to do what a

reasonable and ordinarily prudent person would do under the

circumstances. Neely v. Commissioner, 85 T.C. 934, 947 (1985).

The term “disregard” includes any careless, reckless, or

intentional disregard of rules or regulations. Sec. 6662(c). An

understatement is “substantial” if it exceeds the greater of

$5,000 or 10 percent of the tax required to be shown on the

return. Sec. 6662(d)(1) and (2). The Commissioner’s

determination that a taxpayer was negligent is presumptively
 - 51 -

correct, and the burden is on the taxpayer to show a lack of

negligence. Hall v. Commissioner, 729 F.2d 632, 635 (9th Cir.

1984), affg. T.C. Memo. 1982-337.27

Section 6664(c) provides an exception to the accuracy-

related penalty under section 6662(a). The exception applies if

it is shown that there was reasonable cause for the underpayment

and that the taxpayer acted in good faith with respect to the

underpayment. Sec. 6664(c). The determination of whether a

taxpayer acted with reasonable cause and good faith is made on a

case-by-case basis, taking into account all the pertinent facts

and circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs. The

extent of the taxpayer’s effort to assess his proper tax

liability is the most important factor. Id.

Russell claims that he is not liable for the section 6662(a)

penalties because he relied in good faith on the advice of his

accountant, Mr. Feldmann, and most of the adjustments relate to

oil and gas transactions which were handled by Melvin and his

family. The accuracy-related penalty under section 6662(a) may

be avoided if the taxpayer shows reliance on the advice of a

professional which was reasonable and in good faith. Sec.

1.6664-4(b)(1), Income Tax Regs. Reasonable cause can be

established if a taxpayer can show reasonable reliance on the

27
As previously noted, sec. 7491 does not apply in this
case. See supra note 14.
 - 52 -

advice of a competent and experienced accountant or attorney in

the preparation of the tax return. Weis v. Commissioner, 94 T.C.

473, 487 (1990); Griffin v. Commissioner, T.C. Memo. 2001-5. In

order to show good faith reliance, the taxpayer must establish

that all necessary information was supplied to the return

preparer and that the incorrect return resulted from the

preparer’s mistakes. Weis v. Commissioner, supra at 487; Pessin

v. Commissioner, 59 T.C. 473, 489 (1972).

Mr. Feldmann prepared BBP’s 1994 return and Russell and

Clarice’s 1994 and 1995 returns. In preparing the returns, Mr.

Feldmann relied on information provided to him by Russell and his

family and Melvin’s family. With respect to the oil and gas

activity conducted by BBP, Mr. Feldmann testified that he relied

on Forms 1099-MISC, Miscellaneous Income, issued by oil

purchasers in determining income and information provided by

Carolyn in determining expenses. At trial, Russell testified

that he did not know anything about the information regarding the

oil and gas interests which were reported on his and Clarice’s

1994 and 1995 returns because this information was provided to

Mr. Feldmann by other persons.

With respect to the Schedule E and Schedule C depletion

deductions for 1994 and 1995, Mr. Feldmann testified that he

erroneously computed the amounts of these deductions and that the

errors were not a result of any action by Russell. Mr. Feldmann
 - 53 -

testified that he had the correct information to compute the

amounts of the deductions, but he explained that the law

governing these deductions had changed in previous years and that

he had not updated himself on the change. Overall, the evidence

reflects that Mr. Feldmann was provided with all the necessary

information to compute the correct amounts of the depletion

deductions for 1994 and 1995 and that the incorrect amounts

reported on the returns were solely attributable to his failure

to apply the law correctly. Accordingly, we hold that Russell

and Clarice are not liable for the accuracy-related penalties on

the portions of the underpayments attributable to the depletion

deduction adjustments.

For the taxable year 1995, Carolyn provided Mr. Feldmann

with the information regarding IDCs paid by Russell in 1995. A

portion of the IDCs deducted by Russell in 1995 had actually been

reimbursed to him by Ballantyne Oil and Gas, Inc., during that

year. Mr. Feldmann was not informed that Russell had been

reimbursed for approximately $97,790 of those expenses, and he

did not account for the amount reimbursed when he computed the

amount of the IDC deduction. At trial, Russell acknowledged that

he knew that a portion of IDCs was sometimes reimbursed later.

However, Russell claimed that he would not have been aware of any

reimbursement because the amount reimbursed was automatically

deposited in his bank account, and he would not have received a
 - 54 -

check. Russell testified that he thought Mr. Feldmann was aware

of any reimbursements for the drilling costs when the oil and gas

information was provided to him.

Russell has not shown that there was reasonable cause for

the underpayment attributable to the overstated IDC deduction and

that the he acted in good faith with respect to the underpayment.

Russell was aware that a portion of IDCs might be reimbursed to

him, yet he did not take steps to inquire as to whether any

amount was reimbursed to him in 1995. In the instant situation,

he cannot avoid his duty to file an accurate tax return by

placing the responsibility with Carolyn to provide Mr. Feldmann

with the correct information regarding the amount of IDCs.

Accordingly, we hold that Russell and Clarice are liable for the

accuracy-related penalty on the portion of the underpayment

attributable to the IDC adjustment.

With respect to the Schedule C production tax deduction, Mr.

Feldmann testified that he would have calculated this based on

the information he received from Russell’s family or Melvin’s

family. Russell’s only claim with respect to this adjustment is

that he reasonably relied on the advice of Mr. Feldmann. He has

not shown that all necessary information was supplied to Mr.

Feldmann and that the overstated deduction resulted from Mr.

Feldmann’s mistake. Russell and Clarice have not established

that they had reasonable cause or good faith with respect to this
 - 55 -

adjustment. Accordingly, we hold that Russell and Clarice are

liable for the accuracy-related penalty on the portion of the

underpayment attributable to the production tax adjustment.

Decisions will be entered

under Rule 155.