T.C. Memo. 2007-79
UNITED STATES TAX COURT
PATRICK G. & VALERIE V. O’MALLEY, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 23582-04. Filed April 3, 2007.
Thomas J. Renner, for petitioners.
Chang Teddy Li, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
CHIECHI, Judge: Respondent determined the following defi-
ciencies in, and accuracy-related penalties under section
6662(a)1 on, petitioners’ Federal income tax (tax):
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code (Code) in effect for the years at
issue. All Rule references are to the Tax Court Rules of Prac-
tice and Procedure.
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Accuracy-Related Penalty
Year Deficiency Under Sec. 6662(a)
1999 $16,654 $3,331.00
2000 32,677 3,517.20
The issues remaining for decision are:
(1) Did petitioners sell certain property on December 2,
1999, for $318,000? We hold that they did.
(2) Did petitioners sell certain property on June 14, 2000,
for $225,000? We hold that they did not.
(3) Are petitioners liable for each of their taxable years
1999 and 2000 for the accuracy-related penalty under section
6662(a)? We hold that they are for 1999 and that they are not
for 2000.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found
except as stated herein.
Petitioners resided in Crownsville, Maryland, at the time
they filed the petition in this case.
In 1981, petitioner Patrick G. O’Malley (Mr. O’Malley)
received a bachelor of science degree in accounting from the
University of Maryland. After graduating from college, Mr.
O’Malley worked for one year for Price Waterhouse. Shortly after
leaving Price Waterhouse, Mr. O’Malley held various jobs in the
food service industry. During 1999 and 2000, the years at issue,
Mr. O’Malley operated various businesses, including a consulting
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business, an equestrian facility, and a telescope pictures busi-
ness.
On September 5, 1997, Mr. O’Malley, petitioner Valerie V.
O’Malley, and Dorothy Galvin (Ms. Galvin),2 Mr. O’Malley’s mother,
purchased for $1,000,000 certain real property located at 1761
Severn Chapel Road, Anne Arundel County, Crownsville, Maryland
(Severn Chapel Road property). Farmers and Mechanics Bank (F&M
Bank) financed in part the purchase of the Severn Chapel Road
property by lending $499,950 to petitioners. F&M Bank held a
mortgage on that property with respect to that loan. The sellers
of the Severn Chapel Road property financed all but $50 of the
balance of the purchase price of that property (petitioners’
second loan on the Severn Chapel Road property) and held a second
mortgage on that property with respect to that loan.
At the time petitioners purchased the Severn Chapel Road
property, that property consisted of approximately 48.5 acres of
undivided land on which there were three houses. Around Septem-
ber 1997, petitioners moved into one of the houses located on the
Severn Chapel Road property and have lived there at all relevant
2
Although Ms. Galvin was a party to the purchase of the
Severn Chapel Road property and various other agreements and
transactions into which petitioners entered relating to that
property (discussed below), her role as such is not material to
our resolution of the issues presented. When discussing any
agreements and transactions into which petitioners and Ms. Galvin
entered relating to the Severn Chapel Road property, we shall for
convenience generally refer only to petitioners, and not to Ms.
Galvin.
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times.
Shortly after petitioners purchased the Severn Chapel Road
property, Mr. O’Malley considered subdividing that property in
order to increase its value. To that end, in 1998, petitioners
retained Ed Brown & Associates, Inc. (Ed Brown and Associates), a
consulting company in land surveying, land planning, and land
development. Petitioners asked Ed Brown and Associates to pre-
pare a plan (petitioners’ subdivision plan) and a plat (petition-
ers’ subdivision plat) for the subdivision of the Severn Chapel
Road property into 13 lots under the family conveyance subdivi-
sion provisions of section 4-301 of article 26 of the Anne
Arundel County Code (family conveyance subdivision provisions of
the Anne Arundel County Code). Around May 1999, Ed Brown and
Associates completed its work.
On September 29, 1999, Anne Arundel County approved peti-
tioners’ subdivision plan, and petitioners had petitioners’
subdivision plat recorded in the land records of Anne Arundel
County. Petitioners’ subdivision plat provided in pertinent
part:
The family members listed below must retain the lots for a period
of five (5) years per the notarized and signed intrafamily trans-
fer declaration of intent on file with planning and code enforce-
ment and in accordance with article 26, section 304.1(9) and 4-103
(Bill 33-96)
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Lot Name Relationship[3] Area
1 Megan O’Malley Granddaughter 2.00 acres
2 Thomas Galvin Stepson 2.09 acres
3 Dorothy O’Malley Galvin Self 2.43 acres
4 Patrick G. O’Malley Son 21.99 acres
5 Kevin R. O’Malley Son 2.04 acres
6 Bradley Galvin Grandson 2.15 acres
7 Kevin J. O’Malley Grandson 2.13 acres
8 Hannah Galvin Granddaughter 2.00 acres
9 Edward P. O’Malley Grandson 2.02 acres
10 Tara O’Malley Granddaughter 2.01 acres
11 Bonus Lot N/A 1.37 acres
12 Edward P. O’Malley, Jr. Son 2.03 acres
13 Connor O’Malley Grandson 2.01 acres
On October 4, 1999, in conformity with the family conveyance
subdivision provisions of the Anne Arundel County Code, petition-
ers entered into a family conveyance subdivision agreement with
Anne Arundel County (petitioners’ family subdivision agreement).4
That agreement provided in pertinent part:
Subdivider has applied to the County for approval
of the family conveyance subdivision (Subdivision) to
be known as O’Malley Property Family Conveyance. * * *
In order for the County to approve the subdivision,
Subdivider is required by Anne Arundel County Code,
Article 26.S4-301(a)(4) to enter into an agreement that
contains the subdivider’s obligations with regard to
the Subdivision, is shown on the subdivision plat and
is recorded among the Land Records of Anne Arundel
3
The relationships of the individuals listed are their
respective relationships to Ms. Galvin.
4
On Oct. 7, 1999, the family subdivision agreement was
recorded in the land records of Anne Arundel County.
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County. Therefore, the intent of this Agreement is to
give Subdivider the opportunity to comply with the
County law an subsequently obtain approval of the Sub-
division.
NOW, THEREFORE, WITNESSETH. That for and in con-
sideration of the natural promises and covenants herein
contained, Subdivider and County hereby agree as fol-
lows:
1. Subdivider shall convey the lots created in
the Subdivision only to the Subdivider’s father,
mother, son, daughter, stepson, stepdaughter, grandson
or granddaughter.
2. After conveyance of a lot to a party listed in
paragraph 1 above, the grantee of that lot may not
transfer it to a third party for at least five (5)
years from the date of final approval of the Subdivi-
sion except in the case of severe financial hardship,
as determined by the Director of Planning and Code
enforcement.
3. The parcel of land, out of which the Subdivi-
sion has been created, may not be further subject to a
subdivision as a family conveyance.
4. Each lot created in the Subdivision may not be
further subject to a family conveyance subdivision.
5. If a lot in the Subdivision is not conveyed to
an eligible grantee as set forth in paragraph 1 above,
including a custodian under the Uniform Transfers to
Minors Act or a trusteeship within two (2) years after
final approval of the Subdivision, the final plat or
plats for the Subdivision shall be null and void and
the subdivider shall conform to the ordinances and
regulations in effect at the time or reapplication for
any subdivision approval.
6. Subdivider warrants that (a) each grantee of a
lot in the Subdivision has not previously been a
grantee in any other family conveyance subdivision; and
(b) Subdivider has owned the parcel of land out of
which the Subdivision is being created since the date
of application for subdivision approval and will con-
tinue to own it until the subdivision is approved.
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7. The Agreement shall (a) run with and bind upon
the parcel of land upon which the Subdivision is being
created and which is the subject of this Agreement; and
(b) inure to the benefit of the parties hereto, their
heirs, personal representatives, legal representatives,
successors and assigns as appropriate.
8. This Agreement shall be governed by Maryland
law and any action brought by or between the parties
shall vest jurisdiction and venue exclusively in the
courts located in Anne Arundel County.
9. This contains the complete and final Agreement
between the parties and no agreement or understanding
shall be binding upon any of them unless set forth in
writing and executed by both parties. [Reproduced
literally.]
All of the lots in petitioners’ subdivision plat, including
lot 12, were unimproved except for lots 3, 4, and 5.
Lot 5 contained a two-story house that was built in 1996.
During September 1997 to December 1999, petitioners rented that
lot to Mr. O’Malley’s brother Kevin R. O’Malley (Kevin O’Malley)
and Kevin O’Malley’s spouse Kelly M. O’Malley (Kelly O’Malley),
who lived in the house on lot 5 while they were renting that lot
from petitioners.
From December 1999 through June 2000, petitioners trans-
ferred by deed to the grantees indicated the following lots,
inter alia, in petitioners’ subdivision plat:5
5
As discussed below, petitioners transferred (1) lot 5 to
Kevin O’Malley and Kelly O’Malley and (2) lot 12 to Mr. O’Mal-
ley’s brother Edward P. O’Malley (Edward O’Malley) and Edward
O’Malley’s spouse Faith M. O’Malley (Faith O’Malley). Petition-
ers did not transfer lot 4 or lot 11 in petitioners’ subdivision
plat. Petitioners’ subdivision plat showed that Mr. O’Malley was
to retain lot 4 and that lot 11 was a “bonus lot”.
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Lot Grantee
1 Patrick O’Malley, Custodian for Megan O’Malley
2 Thomas Galvin
3 Patrick O’Malley and Valerie O’Malley
6 Patrick O’Malley, Custodian for Bradley Galvin
7 Patrick O’Malley, Custodian for Kevin J. O’Malley
8 Patrick O’Malley, Custodian for Hanna Galvin
9 Patrick O’Malley, Custodian for Edward P. O’Malley
10 Patrick O’Malley, Custodian for Tara O’Malley
13 Patrick O’Malley, Custodian for Connor O’Malley
Sometime in the fall of 1999 before December 2, 1999, peti-
tioners concluded that they needed substantial funds to meet
certain financial obligations, including certain obligations with
respect to petitioners’ second loan on the Severn Chapel Road
property. Because of the amount of debt that they had outstand-
ing, petitioners were unable to meet such obligations by borrow-
ing additional funds from one or more financial institutions.
Mr. O’Malley made a proposal to his brothers Kevin O’Malley and
Edward O’Malley (brothers) under which they would accommodate
petitioners’ financial needs. Mr. O’Malley proposed to his
brothers that, as part of petitioners’ respective transfers to
them of lots 5 and 12 pursuant to petitioners’ family subdivision
agreement, his brothers obtain loans secured by their respective
lots and provide the loan proceeds to petitioners.
Mr. O’Malley made inquiries at F&M Bank in order to ascer-
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tain whether his proposal for obtaining funds from his brothers
was feasible as far as that bank was concerned. A mortgage
consultant employed by F&M Bank (F&M Bank mortgage consultant)
informed Mr. O’Malley that, under F&M Bank’s so-called seasoning
requirement, F&M Bank would decline to make any loans to his
brothers that were to be secured by lots 5 and 12, since those
lots did not exist before October 1999, when petitioners’ subdi-
vision plat created them. However, the F&M Bank mortgage consul-
tant advised Mr. O’Malley that if petitioners were to structure
as sales the respective transfers to his brothers of lots 5 and
12 pursuant to petitioners’ family subdivision agreement, F&M
Bank would be willing to make loans to those brothers and secure
any such loans by those respective lots.
In order to enable petitioners to obtain funds that they
needed, on December 2, 1999, petitioners executed a deed (Decem-
ber 2, 1999 deed) under which they transferred lot 5 to Kevin
O’Malley and his spouse Kelly O’Malley.6 That deed provided in
pertinent part:
WITNESSETH, That in consideration of the sum of THREE
HUNDRED EIGHTEEN THOUSAND DOLLARS and 00/100
($318,000.00),[7] which includes the amount of any out-
6
Although Kelly O’Malley was a party to the December 2, 1999
transaction, her role as such is not material to a resolution of
the issues presented. When discussing the December 2, 1999
transaction, we shall for convenience refer only to Kevin O’Mal-
ley, and not to Kelly O’Malley.
7
On Nov. 4, 1999, an appraiser signed an appraisal in which
(continued...)
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standing Mortgage or Deed of Trust, if any, the receipt
whereof is hereby acknowledged, the said GRANTOR [peti-
tioners] does grant and convey to the said Kevin R.
O’Malley and Kelly M. O’Malley, husband and wife, as
tenants by the entirety, their heirs, personal repre-
sentatives and assigns, in fee simple, all that lot of
ground situate in Anne Arundel County, Maryland and
described as follows, that is to say [lot 5] * * *
On December 16, 1999, the December 2, 1999 deed was recorded in
the land records of Anne Arundel County.
On December 2, 1999, Kevin O’Malley borrowed $254,400 from
F&M Bank ($254,400 F&M Bank 1999 loan) and $47,700 from petition-
ers (second loan with respect to lot 5).8 On the same date, Kevin
O’Malley transferred to petitioners all but $3,498 of the
$254,400 F&M Bank 1999 loan proceeds, or $250,902.9
On December 2, 1999, Kevin O’Malley executed a deed of trust
(December 2, 1999 deed of trust) with respect to lot 5 to secure
the $254,400 F&M Bank 1999 loan. The December 2, 1999 deed of
7
(...continued)
the appraiser estimated the fair market value of lot 5 to be
$318,000.
8
The parties stipulated that the second loan with respect to
lot 5 was in the amount of $47,000, and not $47,700. That
stipulation is clearly contrary to the facts that we have found
are established by the record, and we shall disregard it. See
Cal-Maine Foods, Inc. v. Commissioner, 93 T.C. 181, 195 (1989).
The record establishes, and we have found, that the second loan
with respect to lot 5 was in the amount of $47,700.
9
As shown below in the settlement statement prepared with
respect to the events that took place on Dec. 2, 1999, petition-
ers were responsible for settlement charges totaling $3,498, see
infra note 11, which reduced the amount of the $254,400 F&M Bank
1999 loan proceeds that was transferred to petitioners on that
date. As also shown below in that statement, petitioners were
responsible for paying $15,900 of closing costs.
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trust provided in pertinent part:
Borrower [Kevin O’Malley] owes Lender [F&M Bank] the
principal sum of Two Hundred Fifty Four Thousand Four
hundred and no/100 Dollars (U.S. $254,400.00). This
debt is evidenced by Borrower’s note dated the same
date as this Security Instrument (“Note”), which pro-
vides for monthly payments, with the full debt, if not
paid earlier, due and payable on January 1, 2030. This
Security Instrument secures to Lender: (a) the repay-
ment of the debt evidenced by the Note, with interest,
and all renewals, extensions and modifications of the
Note; (b) the payment of all other sums, with interest,
advanced under paragraph 7 to protect the security of
this Security Instrument; and (c) the performance of
Borrower’s covenants and agreements. For this purpose,
Borrower irrevocably grants and conveys to Trustee, in
trust, with power of sale, the following described
property located in Anne Arundel County, Maryland * * *
[Lot 5].
On December 16, 1999, the December 2, 1999 deed of trust was
recorded in the land records of Anne Arundel County.
We shall refer to the above-described events occurring on
December 2, 1999, as the December 2, 1999 transaction.
Page 1 of a U.S. Department of Housing and Urban Development
(HUD) settlement statement (December 2, 1999 settlement state-
ment) prepared with respect to the December 2, 1999 transaction
showed the following entries:
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D. NAME OF BORROWER: Kevin R. O’Malley and Kelly M. O’Malley
* * * * * * *
E. NAME OF SELLER: Patrick G. O’Malley and Valerie V. O’Malley
Dorothy O’Malley Galvin
* * * * * * *
F. NAME OF LENDER: Farmers & Mechanics National Bank
ADDRESS: 9337 Liberty Road, Randallstown, MD 21133
G. PROPERTY ADDRESS: 1104 Abbington Farm Road, Crownsville, MD 21032
H. SETTLEMENT AGENT: Mid-Maryland Title Company, Inc.
PLACE OF SETTLEMENT: 900 Bestgate Road, Suite 104, Annapolis, MD 21401
I. SETTLEMENT DATE: 12/02/99
J. SUMMARY OF BORROWER’S TRANSACTION: K. SUMMARY OF SELLER’S TRANSACTION:
100. GROSS AMOUNT DUE FROM BORROWER 400. GROSS AMOUNT DUE TO SELLER:
101. Contract sales price 318,000.00 401. Contract sales price 318,000.00
* * * * * * *
103. Settlement charges to borrower (line 1400)[10] * * *
11,665.26
* * * * * * *
120. GROSS AMOUNT DUE FROM BORROWER 329,665.26 420. GROSS AMOUNT DUE TO SELLER: 318,000.00
200. AMOUNTS PAID BY OR ON BEHALF OF BORROWER 500. REDUCTIONS IN AMOUNT DUE TO SELLER
* * * * * * *
202. Principal Amount of new loans 254,400.00 502. Settlement charges to seller (line
1400)[11] 3,498.00
* * * * * * *
206. Second Mortgage from Seller 47,700.00 506. Second Mortgage from Seller 47,700.00
207. Closing Costs paid by Seller 15,900.00 507. Closing Costs paid by Seller 15,900.00
* * * * * * *
220. TOTAL PAID BY/FOR BORROWER 318,000.00 520. TOTAL REDUCTION AMOUNT DUE SELLER
67,098.00
300. CASH AT SETTLEMENT FROM OR TO BORROWER 600. CASH AT SETTLEMENT TO OR FROM SELLER
301. Gross amount due from borrower (line 120) 601. Gross amount due to seller (line 420)
329,665.26 318,000.00
302. Less amounts paid by/for borrower(line 220) 602. Less reduction amount due seller (line
318,000.00 520) 67,098.00
303. CASH FROM BORROWER 11,665.26 603. CASH TO SELLER 250,902.00
Page 1 of the December 2, 1999 settlement statement also
stated:
10
Line 1400 on page 2 of the December 2, 1999 settlement statement showed settlement
charges to borrower of $11,665.26 consisting of $3,459.75 of fees and $1,437.53 of prepaid
interest with respect to the $254,400 F&M Bank 1999 loan, $2,385.04 of county property taxes,
$1,605 of title charges, $2,778 of government recording and transfer charges, and a downward
adjustment of six cents for an aggregate analysis adjustment to F&M Bank.
11
Line 1400 on page 2 of the December 2, 1999 settlement statement showed settlement
charges to seller of $3,498 consisting of $1,113 of State recordation tax, $795 of State transfer
tax, and $1,590 of county transfer tax.
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WARNING: It is a crime to knowingly make false state-
ments to the United States on this or any other similar
form. Penalties upon conviction can include a fine and
imprisonment. For details see: Title 18 U.S. Code
Section 1001 and Section 1010.
* * * * * * *
SUBSTITUTE FORM 1099 SELLER STATEMENT: The information
contained herein is important tax information and is
being furnished to the Internal Revenue Service. If
you are required to file a return, a negligence penalty
or other sanction will be imposed on you if this item
is required to be reported and the IRS determines that
it has not been reported. The Contract Sales Price
described on line 401 above constitutes the Gross Pro-
ceeds of this transaction.
SELLER INSTRUCTIONS: If this real estate was your
principal residence, file Form 2119, Sale or Exchange
of Principal Residence, for any gain, with your income
tax return; for other transactions, complete the appli-
cable parts of Form 4797. Form 6252 and/or Schedule D
(Form 1040).
Attached to the December 2, 1999 settlement statement was a
document entitled “ACKNOWLEDGEMENT AND RECEIPT OF SETTLEMENT
STATEMENT”, which petitioners and Kevin O’Malley signed. That
document provided in pertinent part:
We, the undersigned SELLER(S), BUYER(S) and CLOSING
AGENT do hereby acknowledge and agree that:
1. BUYER(S) acknowledge receipt and disbursement on
his behalf of the loan proceeds in full and SELLER(S)
acknowledge payment in full of the proceeds due
SELLER(S) from the settlement, as shown on Line 603.
* * * * * * *
SELLER(S) further acknowledge that receipt of a
copy hereof shall constitute a receipt at closing of
IRS Form 1099-S [Proceeds From Real Estate Transac-
tions].
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I have carefully reviewed the HUD-1 Settlement State-
ment and to the best of my knowledge and belief, it is
a true and accurate statement of all receipts and dis-
bursements made on my account or by me in this transac-
tion. I further certify that I have received a copy of
the HUD-1 Settlement Statement.
A settlement agent for the December 2, 1999 transaction
issued Form 1099-S, Proceeds From Real Estate Transactions (Form
1099-S), which reported that transaction as a sale at a gross
sales price of $318,000.
At all relevant times after the December 2, 1999 transac-
tion, (1) Kevin O’Malley (a) continued to live in the house
located on lot 5, (b) ceased paying rent to petitioners with
respect to that lot, and (c) made payments to F&M Bank with
respect to the $254,400 F&M Bank 1999 loan; and (2) petitioners
did not make any payments to F&M Bank with respect to that loan.
During February 2000 to November 2001, petitioners issued
the following checks totaling $7,407.40 to Kevin O’Malley:
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Date of Check Check Number Amount
1
2/17/00 2459 $357.37
2
2/17/00 2460 357.37
3
4/12/00 2495 357.37
3
4/20/00 2498 357.37
3
6/23/00 2531 714.74
10/23/00 2098 1,429.48
12/2/00 2626 357.37
12/10/00 2055 70.00
1/22/01 2674 322.37
3/9/01 2709 939.74
6/8/01 2792 357.37
8/23/01 2845 1,072.11
11/02/01 2950 714.74
1
The notation “Feb 00" appeared at the bottom of check No. 2459.
2
The notation “March 00" appeared at the bottom of check No. 2460.
3
The notation “April 00" appeared at the bottom of each of check Nos.
2495, 2498, and 2531.
Petitioners issued a $54,400 check dated June 3, 2003, to
Kevin O’Malley. A notation at the bottom of that check stated:
“Loan Repayment”.
Sometime between December 2, 1999, and September 14, 2004,
petitioners forgave the second loan with respect to lot 5.
Although the funds that petitioners received from Kevin
O’Malley as a result of the December 2, 1999 transaction enabled
them to satisfy certain of their financial obligations, they
needed additional funds in order to meet certain other obliga-
tions. Mr. O’Malley asked his brother Edward O’Malley whether he
would be willing to accommodate petitioners and enable them to
obtain such additional funds. Edward O’Malley agreed to do so.
To that end, Edward O’Malley and Mr. O’Malley entered into an
oral agreement (agreement between Edward O’Malley and Mr. O’Mal-
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ley) under which: (1) Petitioners’ transfer of lot 12 to Edward
O’Malley pursuant to petitioners’ family subdivision agreement
was to be structured in the form of a sale;12 (2) Edward O’Malley
was to borrow from F&M Bank $180,000 ($180,000 loan), or 80
percent of the estimated $225,000 fair market value of lot 12,13
and was to secure that loan with that lot; (3) Edward O’Malley
was to transfer proceeds of the $180,000 loan to petitioners;
(4) petitioners were to make all the payments to F&M Bank re-
quired by the terms of the $180,000 loan; (5) the balance of the
estimated $225,000 fair market value of lot 12 (i.e., $45,000)
was to be reflected as a loan from petitioners to Edward O’Malley
on which Edward O’Malley was not required to make any payments;
(6) petitioners were to pay all the expenses relating to lot 12,
including all real property taxes; and (7) Edward O’Malley was to
retransfer lot 12 to petitioners after a five-year period.
On June 14, 2000, pursuant to the agreement between Edward
O’Malley and Mr. O’Malley, petitioners executed a deed (June 14,
2000 deed) under which they transferred lot 12 to Edward O’Malley
12
Edward O’Malley and Mr. O’Malley agreed to structure the
transfer of lot 12 as a sale because F&M Bank required such a
structure before it was willing to make a loan to Edward O’Malley
that was to be secured by that lot.
13
An appraiser for F&M Bank estimated the value of lot 12 to
be $225,000.
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and his wife Faith O’Malley.14 That deed provided in pertinent
part:
WITNESSETH, That in consideration of the sum of TWO
HUNDRED TWENTY FIVE THOUSAND DOLLARS and 00/100
($225,000.00), which includes the amount of any out-
standing Mortgage or Deed of Trust, if any, the receipt
whereof is hereby acknowledged, the said GRANTOR [peti-
tioners] does grant and convey to the said Edward P.
O’Malley and Faith M. O’Malley, husband and wife, as
tenants by the entirety their heirs, personal represen-
tatives and assigns, in fee simple, all that lot of
ground situate in Anne Arundel County, Maryland and
described as follows, that is to say [lot 12] * * *
On June 30, 2000, the June 14, 2000 deed was recorded in the land
records of Anne Arundel County.
On June 14, 2000, pursuant to the agreement between Edward
O’Malley and Mr. O’Malley, Edward O’Malley borrowed $180,000 from
F&M Bank ($180,000 F&M Bank 2000 loan). On the same date, Edward
O’Malley transferred to petitioners all but $8,475 of the
$180,000 F&M Bank 2000 loan, or $171,525.15
On June 14, 2000, pursuant to the agreement between Edward
O’Malley and Mr. O’Malley, Edward O’Malley executed a deed of
14
Although Faith O’Malley was a party to the various agree-
ments into which Edward O’Malley entered relating to lot 12, her
role as such is not material to our resolution of the issues
presented. When discussing the June 14, 2000 transaction, we
shall for convenience refer only to Edward O’Malley, and not to
Faith O’Malley.
15
As shown below in the settlement statement prepared with
respect to the events that took place on June 14, 2000, petition-
ers were responsible for settlement charges of $2,475 and costs
of $6,000, the total of which charges and costs reduced the
amount of the $180,000 F&M Bank 2000 loan proceeds that was
transferred to petitioners on that date.
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trust (June 14, 2000 deed of trust) with respect to lot 12 to
secure the $180,000 F&M Bank 2000 loan. The June 14, 2000 deed
of trust provided in pertinent part:
Borrower [Edward O’Malley] owes Lender [F&M Bank] the
principal sum of One Hundred Eighty Thousand and no/100
Dollars * * *. This debt is evidenced by Borrower’s
note dated the same date as this Security Instrument
(“Note”), which provides for monthly payments, with the
full debt, if not paid earlier, due and payable on
July 1, 2003. This Security Instrument secures to
Lender: (a) the repayment of the debt evidenced by the
Note, with interest, and all renewals, extensions and
modifications of the Note; (b) the payment of all other
sums, with interest, advanced under paragraph 7 to
protect the security of this Security Instrument; and
(c) the performance of Borrower’s covenants and agree-
ments. For this purpose, Borrower irrevocably grants
and conveys to Trustee, in trust, with power of sale,
the following described property [lot number twelve]
* * *.
On a date not disclosed by the record, the June 14, 2000 deed of
trust was recorded in the land records of Anne Arundel County.
We shall refer to the above-described events occurring on
June 14, 2000, as the June 14, 2000 transaction.
Page 1 of a HUD settlement statement (June 14, 2000 settle-
ment statement) prepared with respect to the June 14, 2000 trans-
action showed the following entries:
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D. NAME OF BORROWER: Edward P. O’Malley and Faith M. O’Malley
ADDRESS: 1105 Abbington Farm Road, Crownsville, MD 21032
E. NAME OF SELLER: Patrick G. O’Malley and Valerie V. O’Malley
Dorothy Galvin
* * * * * * *
F. NAME OF LENDER: Farmers & Mechanics National Bank
ADDRESS: 110 Thomas Johnson Drive, Frederick, MD 21705
G. PROPERTY ADDRESS: 1105 Abbington Farm Road, Crownsville, MD 21032
H. SETTLEMENT AGENT: Mid-Maryland Title Company, Inc.
PLACE OF SETTLEMENT: 900 Bestgate Road, Suite 104, Annapolis, MD 21401
I. SETTLEMENT DATE: 06/14/2000
J. SUMMARY OF BORROWER’S TRANSACTION: K. SUMMARY OF SELLER’S TRANSACTION:
100. GROSS AMOUNT DUE FROM BORROWER 400. GROSS AMOUNT DUE TO SELLER:
101. Contract sales price 225,000.00 401. Contract sales price 225,000.00
* * * * * * *
103. Settlement charges to borrower (line 1400)[16] * * *
7,327.71
* * * * * * *
120. GROSS AMOUNT DUE FROM BORROWER 232,327.71 420. GROSS AMOUNT DUE TO SELLER: 225,000.00
200. AMOUNTS PAID BY OR ON BEHALF OF BORROWER 500. REDUCTIONS IN AMOUNT DUE TO SELLER
* * * * * * *
202. Principal amount of new loan(s) 180,000.00 502. Settlement charges to seller (line
1400)[17] 2,475.00
* * * * * * *
206. Seller Financing 45,000.00 506. Seller Financing 45,000.00
207. Costs paid by seller 6,000.00 507. Costs paid by seller 6,000.00
* * * * * * *
220. TOTAL PAID BY/FOR BORROWER 231,000.00 520. TOTAL REDUCTION AMOUNT DUE SELLER
53,475.00
300. CASH AT SETTLEMENT FROM OR TO BORROWER 600. CASH AT SETTLEMENT TO OR FROM SELLER
301. Gross amount due from borrower (line 120) 601. Gross amount due to seller (line 420)
232,327.71 225,000.00
302. Less amounts paid by/for borrower (line 602. Less reduction amount due seller (line
220) 231,000.00 520) 53,475.00
303. CASH FROM BORROWER 1,327.71 603. CASH TO SELLER 171,525.00
Page 1 of the June 14, 2000 settlement statement also
stated:
WARNING: It is a crime to knowingly make false state-
ments to the United States on this or any other similar
form. Penalties upon conviction can include a fine and
16
Line 1400 on page 2 of the June 14, 2000 settlement statement showed settlement charges
to borrower of $7,327.71 consisting of $2,350 of fees and $607.81 of prepaid interest with
respect to the $180,000 F&M Bank 2000 loan, $1,501 of title charges, $2,550 of government
recording and transfer charges, and $318.90 of additional settlement charges.
17
Line 1400 on page 2 of the June 14, 2000 settlement statement showed settlement charges
to seller of $2,475 consisting of $787.50 of State recordation tax, $562.50 of State transfer
tax, and $1,125 of county transfer tax.
- 20 -
imprisonment. For details see: Title 18 U.S. Code
Section 1001 and Section 1010.
* * * * * * *
SUBSTITUTE FORM 1099 SELLER STATEMENT: The information
contained herein is important tax information and is
being furnished to the Internal Revenue Service. If
you are required to file a return, a negligence penalty
or other sanction will be imposed on you if this item
is required to be reported and the IRS determines that
it has not been reported. The Contract Sales Price
described on line 401 above constitutes the Gross Pro-
ceeds of this transaction.
SELLER INSTRUCTIONS: If this real estate was your
principal residence, file Form 2119, Sale or Exchange
of Principal Residence, for any gain, with your income
tax return; for other transactions, complete the appli-
cable parts of Form 4797, Form 6252 and/or Schedule D
(Form 1040).
A settlement agent for the June 14, 2000 transaction issued
Form 1099-S, which reported that transaction as a sale at a gross
sales price of $225,000.
As reflected in the terms of the $180,000 F&M Bank 2000 loan
and the June 14, 2000 deed of trust, the $180,000 F&M Bank 2000
loan was due and payable in full on July 1, 2003. In order to
repay that loan, Edward O’Malley and Mr. O’Malley agreed that
Edward O’Malley was to refinance it, which he did around July 1,
2003 (refinanced F&M Bank 2000 loan). The refinanced F&M Bank
2000 loan was secured by lot 12, was due and payable in full on a
date not disclosed by the record in August 2006, and bore an
interest rate that was lower than the interest rate on the
$180,000 F&M Bank 2000 loan. Because the refinanced F&M Bank
- 21 -
2000 loan was not payable in full until August 2006, Edward
O’Malley and Mr. O’Malley agreed that Edward O’Malley was not to
retransfer lot 12 to petitioners in June 2005, as contemplated by
the agreement between Edward O’Malley and Mr. O’Malley. Instead,
they agreed that Edward O’Malley was to retransfer that lot to
petitioners when the refinanced F&M Bank 2000 loan was paid in
full.
Pursuant to the agreement between Edward O’Malley and Mr.
O’Malley, as modified by them when Edward O’Malley agreed to
refinance the $180,000 F&M Bank 2000 loan, petitioners made from
July 2000 through December 2005 the following payments totaling
$69,538.49 to F&M Bank on the $180,000 F&M Bank 2000 loan or the
refinanced F&M Bank 2000 loan:18
18
Petitioners maintained at least two checking accounts with
Bank of America (petitioners’ Bank of America checking accounts)
from which petitioners made payments to F&M Bank on the $180,000
F&M Bank 2000 loan or the refinanced F&M Bank 2000 loan.
- 22 -
Date1 Check Number Amount2
7/21/00 2540 1,227.92
8/29/00 2573 1,227.92
9/22/00 2596 1,227.92
11/6/00 2612 1,227.92
12/8/00 2633 1,227.92
1/5/01 2660 1,227.92
2/9/01 2680 1,227.92
3/22/01 2726 1,289.31
3/22/01 2727 1,227.92
4/30/01 2764 1,227.92
6/8/01 2789 1,227.92
7/2/01 2826 1,289.31
8/12/01 3437 1,227.92
9/1/01 2915 1,227.92
10/12/01 3470 1,227.92
12/11/01 2987 1,227.92
1/4/02 3533 1,227.92
2/5/02 5018 1,227.92
2/28/02 5082 1,228.92
3/29/02 - 1,289.31
5/09/02 8006 1,289.31
3
6/21/02 1097 1,232.92
7/5/02 8057 1,227.92
8/9/02 3576 1,227.92
9/16/02 8070 1,232.92
10/10/02 3591 1,227.92
11/1/02 3616 1,227.92
12/20/02 3643 1,294.31
1/10/03 3662 1,227.92
2/6/03 3678 1,227.92
3/4/03 3711 1,227.92
3/25/03 3728 1,227.92
5/15/03 3593 1,232.92
6/13/03 3758 1,232.92
7/3/03 3784 1,227.92
7/29/03 3796 1,227.92
10/10/03 3837 966.32
11/10/03 3847 920.31
3
12/15/03 3866 1,845.65
3
2/17/04 3887 1,891.63
4/10/04 3933 920.31
5/12/04 3948 920.31
5/18/04 3956 925.31
7/10/04 3970 920.31
8/6/04 3991 920.31
- 23 -
9/16/04 5140 925.31
10/12/04 1540 1,855.62
12/17/04 5145 1,845.62
2/1/05 6015 920.31
3/11/05 1000 925.31
3/26/05 6028 920.31
5/13/05 6034 925.31
6/4/05 6045 920.31
7/18/05 1001 1,845.62
9/13/05 - 925.31
10/8/05 6119 920.31
11/4/05 6133 920.31
12/2/05 6145 920.31
1
In the case of payments evidenced by petitioners’ checks, the dates
indicated are the dates of the respective checks. In the case of payments
evidenced by petitioners’ bank statements, the dates indicated are the dates
reflected on such respective statements.
2
Except for the reduced payments attributable to the refinanced F&M Bank
2000 loan, the record is not altogether clear why the amounts of the payments
that petitioners made to F&M Bank varied at times. However, it appears that
certain payments that petitioners made to F&M Bank were increased to reflect
additional interest and/or late charges with respect to the $180,000 F&M Bank
2000 loan or the refinanced F&M Bank 2000 loan that F&M Bank imposed because
of late payments by petitioners. It also appears that petitioners intended
that certain payments that they made on the refinanced F&M Bank 2000 loan,
which were in amounts that are approximately twice as much as the amounts of
the other payments that they generally made, were to be applied as payments on
that loan for the month of the date of the check and the following month.
3
Check Nos. 1097, 3866, and 3887 were issued by a process known as “Pay
by check over the phone Western Union phone pay”. Edward O’Malley’s name
appeared both in the upper left hand corner and the signature line of each of
those checks. However, the payment on each of those checks was drawn from one
of petitioners’ Bank of America checking accounts.
Pursuant to the agreement between Edward O’Malley and Mr.
O’Malley, as modified by them when Edward O’Malley agreed to
refinance the $180,000 F&M Bank 2000 loan: (1) From June 14,
2000, until at least the time of the trial in this case in early
2006, Edward O’Malley did not (a) make any payments to F&M Bank
on the $180,000 F&M Bank 2000 loan or the refinanced F&M Bank
2000 loan, (b) make any payments on the second loan with respect
- 24 -
to lot 12, or (c) live on lot 12;19 (2) petitioners paid all the
expenses relating to lot 12, including all real property taxes;
and (3) sometime after June 14, 2000, and before September 15,
2004, petitioners forgave the second loan with respect to lot 12.
Petitioners timely filed Form 1040, U.S. Individual Income
Tax Return, for each of their taxable years 1999 and 2000, which
their return preparer prepared. Prior to filing their 1999
return, petitioners did not consult a professional with respect
to the tax treatment of the December 2, 1999 transaction. Nor
did they consult a professional with respect to the tax treatment
of the June 14, 2000 transaction before they filed their 2000
return. Petitioners did not report the December 2, 1999 transac-
tion in their 1999 return. Nor did they report the June 14, 2000
transaction in their 2000 return.
Respondent issued to petitioners a notice of deficiency
(notice) with respect to their taxable years 1999 and 2000. In
that notice, respondent determined, inter alia, that the December
2, 1999 transaction and the June 14, 2000 transaction constitute
sales by petitioners of lots 5 and 12, respectively. Conse-
quently, respondent determined in the notice to increase peti-
tioners’ taxable income for each of their taxable years 1999 and
19
As discussed above, at the time petitioners’ subdivision
plat was recorded in the land records of Anne Arundel County, lot
12 was unimproved. Although not altogether clear from the
record, it appears that lot 12 remained unimproved at all rele-
vant times.
- 25 -
2000. The notice contained the following computations of such
increases:
1999 Sale of Lot 5
Contract price 318,000
Reduction (47,700) §108(e)(5)[20]
Selling costs (19,398)
Selling price 250,902
Basis (119,425)
Gain $ 131,477.00[21]
2000 Sale of Lot 12
Contract price 225,000
Reduction (45,000) §108(e)(5)[22]
Selling costs (8,475)
Selling price 171,525
Basis (54,361)
Gain $ 117,164.36[23]
[Reproduced literally.]
Respondent further determined in the notice that petitioners are
liable for each of their taxable years 1999 and 2000 for the
20
Respondent made the $47,700 adjustment under sec.
108(e)(5) to reflect that petitioners forgave the second loan
with respect to lot 5.
21
The parties agree that if the Court were to sustain re-
spondent’s determination that the December 2, 1999 transaction
constitutes a sale of lot 5 by petitioners, the gain resulting
from that sale must be calculated by using the correct amount of
petitioners’ adjusted basis in that lot, i.e., $168,494.
22
Respondent made the $45,000 adjustment under sec.
108(e)(5) to reflect that petitioners forgave the second loan
with respect to lot 12.
23
The parties agree that if the Court were to sustain re-
spondent’s determination that the June 14, 2000 transaction
constitutes a sale of lot 12 by petitioners, the gain resulting
from that sale must be calculated by using the correct amount of
petitioners’ adjusted basis in that lot, i.e., $52,466.
- 26 -
accuracy-related penalty under section 6662(a).24
OPINION
Petitioners bear the burden of proving that respondent erred
in making the determinations in the notice that remain for our
consideration.25 Rule 142(a); Welch v. Helvering, 290 U.S. 111,
115 (1933). We address below the standard of proof required of
petitioners in order to satisfy that burden with respect to the
December 2, 1999 transaction and the June 14, 2000 transaction.
Before considering the December 2, 1999 transaction and the
June 14, 2000 transaction, we shall (1) summarize certain princi-
ples applicable in determining whether those transactions consti-
tute sales for tax purposes by petitioners of lots 5 and 12 and
(2) evaluate certain evidence in the record on which petitioners
rely.
Certain Applicable Principles
The determination of whether a purported sale is a sale for
tax purposes is a factual determination, Derr v. Commissioner, 77
24
Respondent made certain additional determinations in the
notice with respect to petitioners’ taxable year 1999 that
petitioners do not dispute. Certain of those determinations were
favorable to petitioners, and certain others were unfavorable.
In addition, respondent made certain additional determinations in
the notice with respect to petitioners’ taxable years 1999 and
2000, the resolution of which flows automatically from the
resolution of certain other determinations in the notice.
25
Petitioners do not claim that the burden of proof shifts
to respondent under sec. 7491(a). We conclude that the burden of
proof does not shift to respondent under that section.
- 27 -
T.C. 708, 724 (1981), that must be made as of the date of the
purported sale, see id. at 723-724.26 In Grodt & McKay Realty,
Inc. v. Commissioner, 77 T.C. 1221, 1237-1238 (1981), we held:
The key to deciding whether petitioners’ transactions
* * * are sales is to determine whether the benefits
and burdens of ownership have passed * * *. This is a
question of fact which must be ascertained from the
intention of the parties as evidenced by the written
agreements read in light of the attending facts and
circumstances. Some of the factors which have been
considered by courts in making this determination are:
(1) Whether legal title passes; (2) how the parties
treat the transaction; (3) whether an equity was ac-
quired in the property; (4) whether the contract cre-
ates a present obligation on the seller to execute and
deliver a deed and a present obligation on the pur-
chaser to make payments; (5) whether the right of pos-
session is vested in the purchaser; (6) which party
pays the property taxes; (7) which party bears the risk
of loss or damage to the property; and (8) which party
receives the profits from the operation and sale of the
property. * * * [Fn. refs. and citations omitted.]
The Court applies the so-called strong proof rule where a
taxpayer asserts, as petitioners do here, that a transaction that
is in form a sale of property is not a sale for tax purposes.
See Ill. Power Co. v. Commissioner, 87 T.C. 1417, 1434 (1986);
Coleman v. Commissioner, 87 T.C. 178, 204 (1986), affd. without
published opinion 833 F.2d 303 (3d Cir. 1987). Under the strong
proof rule, a taxpayer must present strong proof, i.e., more than
a preponderance of the evidence, for the Court to disregard the
form in which the taxpayer cast a transaction. See Ill. Power
26
See also Siegel v. Commissioner, T.C. Memo. 1985-441;
Hunter v. Commissioner, T.C. Memo. 1982-126.
- 28 -
Co. v. Commissioner, supra; Coleman v. Commissioner, supra. The
United States Court of Appeals for the Fourth Circuit to which an
appeal in this case would normally lie requires application of
the strong proof rule where a taxpayer attempts to disregard the
form of a transaction as not reflective of its substance. In an
unpublished opinion, Estate of Hoffman v. Commissioner, 8 Fed.
Appx. 262, 266 n.2 (4th Cir. 2001), that Court of Appeals ob-
served: “Taxpayers who seek to elevate substance over form must
present ‘strong proof,’ a burden which is greater than a prepon-
derance of the evidence.”
Applying the foregoing principles to the instant case,
petitioners must show by strong proof that the benefits and
burdens of ownership of lots 5 and 12 did not pass to Kevin
O’Malley and Edward O’Malley, respectively, in order to sustain
their position that the December 2, 1999 transaction and the June
14, 2000 transaction do not constitute sales for tax purposes.
Evaluation of Certain Evidence on Which Petitioners Rely
Petitioners rely on certain testimonial and documentary
evidence in order to satisfy their burden of proof. The testimo-
nial evidence on which petitioners rely is the testimony of Mr.
O’Malley and Edward O’Malley. We found both Mr. O’Malley and
Edward O’Malley to be credible. As discussed below, we also
found certain of Mr. O’Malley’s testimony regarding the December
2, 1999 transaction to be general, vague, conclusory, and/or
- 29 -
incomplete. The documentary evidence on which petitioners rely
includes certain checks payable to F&M Bank and certain F&M Bank
statements. We found that evidence to be credible.
December 2, 1999 Transaction
It was petitioners’ position at the time they filed their
1999 return that the December 2, 1999 transaction did not consti-
tute a sale of lot 5 when it occurred. Consequently, they did
not report that transaction as a sale in that return. Petition-
ers maintained at trial, and continue to maintain on brief, the
same position that they took in their 1999 return. However,
petitioners argued at trial, and continue to argue on brief,
that, because of events occurring in years after the December 2,
1999 transaction, that transaction became a sale of lot 5 in
1999, but for $200,000 and not for $318,000 as reflected in the
December 2, 1999 settlement statement.
We address first petitioners’ position that the December 2,
1999 transaction did not constitute a sale of lot 5 when it
occurred. According to petitioners, the record establishes that
that transaction was some type of venture with respect to lot 5
between Mr. O’Malley and Kevin O’Malley (alleged venture).
Petitioners contend that, pursuant to that alleged venture,
(1) at the time of the December 2, 1999 transaction, Kevin O’Mal-
ley was to (a) borrow $254,400 from F&M Bank and secure that loan
with lot 5, (b) contribute $200,000 of the proceeds of the
- 30 -
$254,400 F&M Bank 1999 loan to the alleged venture (alleged
$200,000 contribution), and (c) lend $54,400 of the $254,400 F&M
Bank 1999 loan to petitioners (purported $54,400 loan); and
(2) sometime after the December 2, 1999 transaction, (a) Kevin
O’Malley was to contribute an additional $100,000 to the alleged
venture (additional $100,000 contribution),27 and Mr. O’Malley was
to contribute the same amount to the alleged venture. Petition-
ers also contend that on June 3, 2003, they repaid Kevin O’Malley
the purported $54,400 loan.
In support of petitioners’ contentions with respect to the
alleged venture, including the purported $54,400 loan, petition-
ers rely on the testimony of Mr. O’Malley and certain checks that
petitioners issued to Kevin O’Malley about which Mr. O’Malley
testified. We found that testimony of Mr. O’Malley to be gen-
eral, vague, conclusory, and/or incomplete, and we shall not rely
on that testimony to establish petitioners’ contentions as to
that alleged venture. To illustrate, Mr. O’Malley’s testimony
was general, vague, conclusory, and incomplete regarding Kevin
O’Malley’s alleged $200,000 contribution to the alleged venture.
The December 2, 1999 settlement statement showed $250,902 of the
proceeds of the $254,400 F&M Bank 1999 loan as “CASH TO SELLER
27
According to petitioners, petitioners were to repay the
purported $54,400 loan to Kevin O’Malley at the time Kevin
O’Malley was to make his additional $100,000 contribution to the
alleged venture, and Kevin O’Malley was to use such funds, as
well as additional funds, to make that contribution.
- 31 -
[petitioners]”. Mr. O’Malley’s testimony does not explain why
and how petitioners received those loan proceeds if, as petition-
ers contend, Kevin O’Malley was to, and did, contribute $200,000
of such proceeds to the alleged venture.28 By way of further
illustration, Mr. O’Malley’s testimony was general, vague,
conclusory, and incomplete with respect to the terms of the
purported $54,400 loan from Kevin O’Malley to petitioners. His
testimony does not establish with respect to that loan, inter
alia, (1) the interest rate, (2) the term, (3) the schedule for
payments, or (4) whether it was secured. As a final illustration
of why we shall not rely on Mr. O’Malley’s testimony regarding
the alleged venture, including the purported $54,400 loan, Mr.
O’Malley testified that during February 2000 to November 2001
petitioners issued to Kevin O’Malley checks totaling $7,407.40.
Petitioners claim that such checks were payments with respect to
the purported $54,400 loan from Kevin O’Malley to petitioners.
Mr. O’Malley did not explain why petitioners made no additional
payments with respect to that purported loan until June 3, 2003,
the date on which petitioners contend they repaid the purported
$54,400 loan.
On the record before us, we find that petitioners have
28
Petitioners do not claim, and the record does not show,
that at the time of the December 2, 1999 transaction the alleged
venture lent petitioners $200,000 or otherwise distributed such
amount to them.
- 32 -
failed to carry their burden of showing, let alone by strong
proof, that the December 2, 1999 transaction was some type of
venture with respect to lot 5 between Mr. O’Malley and Kevin
O’Malley and that, as part of that alleged venture, Kevin O’Mal-
ley lent petitioners $54,400 of the $254,400 F&M Bank 1999 loan.
We have found on the record presented that, at all relevant
times after the December 2, 1999 transaction, (1) Kevin O’Malley
(a) continued to live in the house located on lot 5, (b) ceased
paying rent to petitioners with respect to that lot, and (c) made
payments to F&M Bank with respect to the $254,400 F&M Bank 1999
loan; and (2) petitioners did not make any payments to F&M Bank
with respect to that loan. Moreover, petitioners have failed to
carry their burden of showing, let alone by strong proof, that,
after the December 2, 1999 transaction, petitioners, and not
Kevin O’Malley, (1) were vested with the right of possession with
respect to lot 5 or (2) paid the expenses (e.g., real property
taxes) with respect to that lot.
On the record before us, we find that petitioners have
failed to carry their burden of showing, let alone by strong
proof, that, after the December 2, 1999 transaction, they re-
tained the benefits and burdens of ownership with respect to lot
5.
Based upon our examination of the entire record before us,
we find that petitioners have failed to carry their burden of
- 33 -
establishing, let alone by strong proof, that, at the time of the
December 2, 1999 transaction, that transaction was not a sale for
tax purposes.
We address next petitioners’ argument that, because of
events occurring in years after the December 2, 1999 transaction,
that transaction became a sale of lot 5 in 1999, but for $200,000
and not for $318,000 as reflected in the December 2, 1999 settle-
ment statement. As discussed above, the determination of whether
a purported sale is a sale for tax purposes must be made as of
the date of the purported sale.29 See Derr v. Commissioner, 77
T.C. at 723-724. Any events occurring in years after the Decem-
ber 2, 1999 transaction could not have resulted in a sale in 1999
of lot 5 by petitioners.30 See id. We reject petitioners’ argu-
ment that, because of events occurring in years after the Decem-
ber 2, 1999 transaction, that transaction became a sale of lot 5
in 1999, but for $200,000 and not for $318,000 as reflected in
the December 2, 1999 settlement statement.
Based upon our examination of the entire record before us,
we sustain respondent’s determination in the notice that the
December 2, 1999 transaction constitutes a sale of lot 5 by
petitioners for $318,000.
In the event the Court were to sustain, as the Court has,
29
See supra note 26.
30
See supra note 26.
- 34 -
respondent’s determination that the December 2, 1999 transaction
constitutes a sale of lot 5 by petitioners for $318,000, peti-
tioners maintain an alternative position under section 108(e)(5)
with respect to that transaction. According to petitioners, the
$54,400 check dated June 3, 2003, that petitioners issued to
Kevin O’Malley qualifies petitioners for a purchase price reduc-
tion (purchase price reduction) under section 108(e)(5) with
respect to the December 2, 1999 transaction. In support of that
position, petitioners argue that the legislative history of
section 108(e)(5) indicates that Congress did not intend for
section 108(e)(5) to apply only when the debt of a purchaser to
the seller of property is reduced.
Section 108(e)(5) provides:
SEC. 108. INCOME FROM DISCHARGE OF INDEBTEDNESS.
* * * * * * *
(e) General Rules for Discharge of Indebted-
ness (Including Discharges Not in Title 11 Cases
or Insolvency).--For purposes of this title--
* * * * * * *
(5) Purchase-money debt reduction for solvent
debtor treated as price reduction.--If--
(A) the debt of a purchaser of property
to the seller of such property which arose
out of the purchase of such property is re-
duced,
(B) such reduction does not occur--
(i) in a title 11 case, or
- 35 -
(ii) when the purchaser is insol-
vent, and
(C) but for this paragraph, such reduc-
tion would be treated as income to the pur-
chaser from the discharge of indebtedness,
then such reduction shall be treated as a
purchase price adjustment.
The language of section 108(e)(5) is plain and unambiguous.
By its terms, section 108(e)(5) applies only when “the debt of a
purchaser of property to the seller of such property which arose
out of the purchase of such property is reduced”. Sec.
108(e)(5)(A). We may not resort to the legislative history of
section 108(e)(5), as petitioners urge.31 See Burlington N. R.R.
Co. v. Okla. Tax Commn., 481 U.S. 454, 461 (1987); Fernandez v.
Commissioner, 114 T.C. 324, 329-330 (2000).
The $54,400 check dated June 3, 2003, that petitioners
issued to Kevin O’Malley did not reduce any debt of Kevin O’Mal-
ley to petitioners. Indeed, petitioners maintain that it was
petitioners who owed $54,400 to Kevin O’Malley as a result of the
December 2, 1999 transaction, not Kevin O’Malley who owed peti-
31
Nor are there any exceptional circumstances warranting our
turning for guidance to the legislative history of sec.
108(e)(5). See Burlington N. R.R. Co. v. Okla. Tax Commn., 481
U.S. 454, 461 (1987); Fernandez v. Commissioner, 114 T.C. 324,
329-330 (2000). Nonetheless, it is noteworthy that, consistent
with its plain language, the legislative history of sec.
108(e)(5) provides that that section applies only when the debt
of a purchaser of property to the seller of such property, which
arose out of the purchase of such property, is reduced. See S.
Rept. 96-1035 at 16 (1980), 1980-2 C.B. 620, 628.
- 36 -
tioners that amount.
On the record before us, we find that the check dated June
3, 2003, that petitioners issued to Kevin O’Malley for $54,400
does not qualify under section 108(e)(5) as a purchase price
reduction of the $318,000 price for the sale of lot 5.32
June 14, 2000 Transaction
Petitioners acknowledge that they cast the form of the June
14, 2000 transaction as a sale by petitioners of lot 12 to Edward
O’Malley for $225,000. However, it is petitioners’ position that
that transaction does not constitute a sale for tax purposes. In
support of their position, petitioners argue:
There is no debate in this case as to what tran-
spired. Shortly after acquiring their home in 1997
Petitioners endeavored to investigate the subdivision
and development of the property into lots for resale
separate from what they desired to retain for their
residence. When it was determined that the property
could be subdivided under the Anne Arundel County fam-
ily conveyance subdivision provisions, Petitioners
elicited agreements and understandings with * * * Ed-
ward O’Malley, to accept * * * Lot [12] and as regards
to Lot No. 12 an agreement and understanding with Ed-
ward O’Malley to reconvey Lot No. 12 to Petitioners at
the expiration of the five (5) year holding period.
Edward O’Malley would not benefit financially from the
development of Lot No. 12, nor would he assume any of
the benefits of, or incur any obligations associated
with, ownership of Lot No. 12. Although Edward O’Mal-
ley was legally responsible to the Bank to comply with
the terms and conditions of its first mortgage loan,
the evidence clearly establishes that Petitioners have
paid all of the debt service on the mortgage loan in
accordance with their agreement and understanding that
Edward O’Malley was only to be an accommodation party
32
See supra note 21.
- 37 -
in the subdivision of Lot No. 12 and the financing
derived from said Lot. Under no circumstances would
the seller of property in a bona fide sale pay the
purchaser’s debt service on the financing obtained by
purchaser used to pay the purchase price to seller.
We have found the following facts with respect to the June
14, 2000 transaction. Although the funds that petitioners re-
ceived from Kevin O’Malley as a result of the December 2, 1999
transaction enabled them to satisfy certain of their financial
obligations, they needed additional funds in order to meet cer-
tain other obligations. Mr. O’Malley asked his brother Edward
O’Malley whether he would be willing to accommodate petitioners
and enable them to obtain such additional funds. Edward O’Malley
agreed to do so. To that end, Edward O’Malley and Mr. O’Malley
entered into an oral agreement under which: (1) Petitioners’
transfer of lot 12 to Edward O’Malley pursuant to petitioners’
family subdivision agreement was to be structured in the form of
a sale;33 (2) Edward O’Malley was to borrow from F&M Bank
$180,000, or 80 percent of the estimated $225,000 fair market
value of lot 12, and was to secure that loan with that lot;
(3) Edward O’Malley was to transfer proceeds of the $180,000 loan
to petitioners; (4) petitioners were to make all the payments to
F&M Bank required by the terms of the $180,000 loan; (5) the
33
Edward O’Malley and Mr. O’Malley agreed to structure the
transfer of lot 12 as a sale because F&M Bank required such a
structure before it was willing to make a loan to Edward O’Malley
that was to be secured by that lot.
- 38 -
balance of the estimated $225,000 fair market value of lot 12
(i.e., $45,000) was to be reflected as a loan from petitioners to
Edward O’Malley on which Edward O’Malley was not required to make
any payments; (6) petitioners were to pay all the expenses relat-
ing to lot 12, including all real property taxes; and (7) Edward
O’Malley was to retransfer lot 12 to petitioners after a five-
year period.
On June 14, 2000, pursuant to the agreement between Edward
O’Malley and Mr. O’Malley, (1) petitioners entered into a trans-
action with Edward O’Malley with respect to lot 12 that was
structured in the form of a sale of lot 12 by petitioners to
Edward O’Malley; (2) Edward O’Malley borrowed $180,000 from F&M
Bank and secured that loan with lot 12; and (3) Edward O’Malley
transferred to petitioners all but $8,475 of the $180,000 F&M
Bank 2000 loan, or $171,535.34
Pursuant to the agreement between Edward O’Malley and Mr.
O’Malley, as modified by them when Edward O’Malley agreed to
refinance the $180,000 F&M Bank 2000 loan, petitioners made from
July 2000 through December 2005 payments totaling $69,538.49 to
F&M Bank on the $180,000 F&M Bank 2000 loan or the refinanced F&M
Bank 2000 loan. Pursuant to the agreement between Edward O’Mal-
ley and Mr. O’Malley, as modified by them when Edward O’Malley
agreed to refinance the $180,000 F&M Bank 2000 loan: (1) From
34
See supra note 15.
- 39 -
June 14, 2000, until at least the time of the trial in this case
in early 2006, Edward O’Malley did not (a) make any payments to
F&M Bank on the $180,000 F&M Bank 2000 loan or the refinanced F&M
Bank 2000 loan, (b) make any payments on the second loan with
respect to lot 12, or (c) live on lot 12; (2) petitioners paid
all the expenses relating to lot 12, including all real property
taxes; and (3) sometime after June 14, 2000, and before September
15, 2004, petitioners forgave the second loan with respect to lot
12.
On the record before us, we find that petitioners have
carried their burden of showing by strong proof that the form of
the June 14, 2000 transaction does not reflect the substance of
that transaction. On that record, we further find that petition-
ers have carried their burden of showing by strong proof that,
after the June 14, 2000 transaction, petitioners retained the
benefits and burdens of ownership with respect to lot 12.
Based upon our examination of the entire record before us,
we find that petitioners have carried their burden of establish-
ing by strong proof that the June 14, 2000 transaction does not
constitute a sale for tax purposes. Accordingly, we reject
respondent’s determination that the June 14, 2000 transaction was
a sale of lot 12 for $225,000.
- 40 -
Accuracy-Related Penalty
Respondent determined that petitioners are liable for each
of their taxable years 1999 and 2000 for the accuracy-related
penalty under section 6662(a) because of: (1) Negligence or
disregard of rules or regulations under section 6662(b)(1) or
(2) a substantial understatement of tax under section 6662(b)(2).
Section 6662(a) imposes an accuracy-related penalty equal to
20 percent of the underpayment to which section 6662 applies.
Section 6662 applies to the portion of any underpayment which is
attributable to, inter alia, (1) negligence or disregard of rules
or regulations, sec. 6662(b)(1), or (2) a substantial understate-
ment of tax, sec. 6662(b)(2).
The term “negligence” in section 6662(b)(1) includes any
failure to make a reasonable attempt to comply with the Code.
See sec. 6662(c). Negligence has also been defined as a failure
to do what a reasonable person would do under the circumstances.
See Leuhsler v. Commissioner, 963 F.2d 907, 910 (6th Cir. 1992),
affg. T.C. Memo. 1991-179; Antonides v. Commissioner, 91 T.C.
686, 699 (1988), affd. 893 F.2d 656 (4th Cir. 1990). The term
“disregard” includes any careless, reckless, or intentional
disregard. Sec. 6662(c).
For purposes of section 6662(b)(2), an understatement is
equal to the excess of the amount of tax required to be shown in
the tax return over the amount of tax shown in such return. See
- 41 -
sec. 6662(d)(2)(A). An understatement is substantial in the case
of an individual if the amount of the understatement for the
taxable year exceeds the greater of 10 percent of the tax re-
quired to be shown in the tax return for that year or $5,000.
Sec. 6662(d)(1)(A).
The amount of the understatement is to be reduced to the
extent that it is attributable to, inter alia, the tax treatment
of an item for which there is or was substantial authority. Sec.
6662(d)(2)(B)(i). The substantial authority standard is an
objective standard involving an analysis of the law and the
application of the law to the relevant facts. Sec. 1.6662-
4(d)(2), Income Tax Regs. In order to satisfy the substantial
authority standard of section 6662(d)(2)(B)(i), a taxpayer must
show that the weight of the authorities supporting the tax return
treatment of an item is substantial in relation to the weight of
authorities supporting contrary treatment. See Antonides v.
Commissioner, supra at 702; sec. 1.6662-4(d)(3)(i), Income Tax
Regs. The substantial authority standard is not so stringent
that a taxpayer’s treatment must be one that is ultimately upheld
in litigation or that has a greater than 50-percent likelihood of
being sustained in litigation. See sec. 1.6662-4(d)(2), Income
Tax Regs. A taxpayer may have substantial authority for a posi-
tion even where it is supported only by a well-reasoned construc-
tion of the pertinent statutory provision as applied to the
- 42 -
relevant facts. See sec. 1.6662-4(d)(3)(ii), Income Tax Regs.
There may be substantial authority for more than one position
with respect to the same item. See sec. 1.6662-4(d)(3)(i),
Income Tax Regs.
The accuracy-related penalty under section 6662(a) does not
apply to any portion of an underpayment if it is shown that there
was reasonable cause for, and that the taxpayer acted in good
faith with respect to, such portion. Sec. 6664(c)(1). The
determination of whether the taxpayer acted with reasonable cause
and in good faith depends on the pertinent facts and circum-
stances, including the taxpayer’s effort to assess such tax-
payer’s proper tax liability, the knowledge and experience of the
taxpayer, and the reliance on the advice of a professional, such
as an accountant. Sec. 1.6664-4(b)(1), Income Tax Regs.
Respondent has the burden of production under section
7491(c) with respect to the accuracy-related penalty under sec-
tion 6662. To meet that burden, respondent must come forward
with sufficient evidence showing that it is appropriate to impose
the accuracy-related penalty. Higbee v. Commissioner, 116 T.C.
438, 446 (2001). Although respondent bears the burden of produc-
tion with respect to the accuracy-related penalty that respondent
determined for each of petitioners’ taxable years 1999 and 2000,
respondent “need not introduce evidence regarding reasonable
cause, substantial authority, or similar provisions. * * * the
- 43 -
taxpayer bears the burden of proof with regard to those issues.”
Id.
It is petitioners’ position that they are not liable for
1999 for the portion of the accuracy-related penalty that is
attributable to their not reporting the December 2, 1999 transac-
tion as a sale in their 1999 return.35 In support of their posi-
tion, petitioners argue that there is or was substantial author-
ity for that return position. Consequently, according to peti-
tioners, if the Court were to sustain respondent’s determination
in the notice with respect to the December 2, 1999 transaction,
as the Court has, the understatement of tax attributable to
petitioners’ failure to report that transaction as a sale in
their 1999 return should be reduced pursuant to section
6662(d)(2)(B)(i). In that event, petitioners maintain, there
would be no substantial understatement of tax in their 1999
return within the meaning of section 6662(d)(1)(A). (We shall
refer to petitioners’ argument under section 6662(d) as petition-
ers’ substantial authority argument.)
As we understand petitioners’ substantial authority argu-
35
Petitioners do not maintain that they are not liable for
1999 for the portion of the accuracy-related penalty under sec.
6662(a) that is attributable to the following determinations that
respondent made for that year and that they do not dispute:
(1) $5,200 increase in petitioners’ Schedule C gross receipts and
(2) $1,715 decrease in their claimed Schedule C interest expense.
- 44 -
ment, the application of certain well-established principles36 to
the facts and circumstances surrounding the December 2, 1999
transaction supports the conclusion that that transaction was not
a sale of lot 5 when it occurred. Therefore, according to peti-
tioners, they had substantial authority when they filed their
1999 return for not reporting the December 2, 1999 transaction as
a sale in that return.37
We reject petitioners’ substantial authority argument. The
problem with that argument is that petitioners have failed to
carry their burden of establishing, let alone by strong proof,
the facts and circumstances that they contend surrounded the
36
The well-established principles on which petitioners rely
are the principles that we concluded are applicable in determin-
ing whether the December 2, 1999 transaction and the June 14,
2000 transaction constitute sales for tax purposes. Those
principles are: (1) The key in determining whether a transaction
is a sale for tax purposes is whether the benefits and burdens of
ownership have passed, Grodt & McKay Realty, Inc. v. Commis-
sioner, 77 T.C. 1221, 1237 (1981); and (2) a taxpayer may attempt
to disregard the form of a transaction as not reflective of its
substance, but must present strong proof to do so, see Ill. Power
Co. v. Commissioner, 87 T.C. 1417, 1434 (1986).
37
On brief, petitioners appear to suggest at times that they
had substantial authority only to support their position with
respect to “that part of the [December 2,] 1999 transaction in
excess of the $200,000.00 first mortgage loan amount.” Thus,
petitioners seem to take inconsistent positions on brief with
respect to the accuracy-related penalty that respondent deter-
mined for 1999. Regardless whether petitioners intend petition-
ers’ substantial authority argument to pertain to the entire
December 2, 1999 transaction or to be limited to “that part of
the 1999 transaction in excess of the $200,000.00 first mortgage
loan amount”, for the reasons set forth below, we reject that
argument.
- 45 -
December 2, 1999 transaction. We have found on the record pre-
sented that petitioners have failed to carry their burden of
showing, let alone by strong proof, that the December 2, 1999
transaction was some type of venture with respect to lot 5 be-
tween Mr. O’Malley and Kevin O’Malley pursuant to which petition-
ers claim, inter alia, that Kevin O’Malley lent petitioners
$54,400 of the $254,400 F&M Bank 1999 loan. We have further
found on that record that, at all relevant times after the Decem-
ber 2, 1999 transaction, (1) Kevin O’Malley (a) continued to live
in the house located on lot 5, (b) ceased paying rent to peti-
tioners with respect to that lot, and (c) made payments to F&M
Bank with respect to the $254,400 F&M Bank 1999 loan; and
(2) petitioners did not make any payments to F&M Bank with re-
spect to that loan. We have also found on the record presented
that petitioners have failed to carry their burden of showing,
let alone by strong proof, that, after the December 2, 1999
transaction, petitioners, and not Kevin O’Malley, (1) were vested
with the right of possession with respect to lot 5 or (2) paid
the expenses (e.g., real property taxes) with respect to that
lot. Finally, we have found on the record presented that peti-
tioners have failed to carry their burden of showing, let alone
by strong proof, that, after the December 2, 1999 transaction,
they retained the benefits and burdens of ownership with respect
to lot 5. The record simply does not support petitioners’ asser-
- 46 -
tion with respect to the December 2, 1999 transaction that “The
only rational explanation supported by the record is that the
Petitioners were engaged in obtaining financing” with respect to
lot 5.
Petitioners do not dispute that if the Court were to reject,
as the Court has, petitioners’ substantial authority argument,
there would be a substantial understatement of tax within the
meaning of section 6662(d)(1)(A) for their 1999 taxable year. We
conclude that the burden of production under section 7491(c)
imposed on respondent with respect to the accuracy-related pen-
alty is satisfied.
Petitioners not only advance petitioners’ substantial au-
thority argument in support of their position that they are not
liable for 1999 for the portion of the accuracy-related penalty
that is attributable to their tax treatment of the December 2,
1999 transaction, they also maintain that they are not liable for
such portion of the penalty because they had reasonable cause
for, and acted in good faith in, not reporting that transaction
as a sale in their 1999 return.
In determining whether a taxpayer acted with reasonable
cause and in good faith, generally the most important factor to
consider “is the extent of the taxpayer’s effort to assess the
taxpayer’s proper tax liability.” Sec. 1.6664-4(b)(1), Income
Tax Regs. Petitioners made no effort to ascertain the proper tax
- 47 -
treatment of the December 2, 1999 transaction by, for example,
consulting a tax professional. Petitioners suggest that they
made no effort to do so because Mr. O’Malley’s education and
business background gave him “the necessary knowledge to under-
stand that the borrowing of money is not a taxable event”.38
According to petitioners, even if they had consulted a tax pro-
fessional with respect to the December 2, 1999 transaction, the
professional would have advised them, “after thorough research
* * * that substance trumps form and in substance Petitioners
engaged merely in financing transactions.”
The problem with petitioners’ argument under section 6664(c)
is the same as the problem with petitioners’ substantial author-
ity argument under section 6662(d). That is to say, petitioners
have failed to carry their burden of establishing, let alone by
strong proof, the facts and circumstances that they contend
surrounded the December 2, 1999 transaction. We have found on
the record presented that petitioners have failed to carry their
burden of establishing, let alone by strong proof, the facts and
38
In this connection, Mr. O’Malley testified:
It never occurred to me to even have a discussion with
him [petitioners’ 1999 and 2000 tax return preparer]
about them [the December 2, 1999 transaction and the
June 14, 2000 transaction] being sales because it was
the furthest thing from my mind that not only would I
be paying all the interest on the loan, but to also
have to pay a tax on the transaction it never struck me
as remotely possible or required.
- 48 -
circumstances that would support petitioners’ position that the
December 2, 1999 transaction was not a sale of lot 5 but was a
financing transaction in which petitioners engaged.39
On the record before us, we find that petitioners have
failed to carry their burden of establishing that there was
reasonable cause for, and that they acted in good faith with
respect to, the portion of the underpayment for 1999 that is
attributable to their failure to report the December 2, 1999
39
Petitioners also contend that they did not receive Form
1099-S that the settlement agent for the December 2, 1999 trans-
action issued with respect to that transaction and that therefore
they were not “on notice” that that transaction was shown in that
form and reported to respondent as a sale. Even if, as petition-
ers claim, they did not receive Form 1099-S with respect to the
December 2, 1999 transaction, they received warnings that that
transaction was to be shown in Form 1099-S and reported to
respondent as a sale. The December 2, 1999 settlement statement
stated in pertinent part:
SUBSTITUTE FORM 1099 SELLER STATEMENT: The information
contained herein is important tax information and is
being furnished to the Internal Revenue Service. If
you are required to file a return, a negligence penalty
or other sanction will be imposed on you if this item
is required to be reported and the IRS determines that
it has not been reported. The Contract Sales Price
described on line 401 above constitutes the Gross
Proceeds of this transaction.
Moreover, petitioners signed a document that was attached to the
December 2, 1999 settlement statement. That document, entitled
“ACKNOWLEDGEMENT AND RECEIPT OF SETTLEMENT STATEMENT”, provided
in pertinent part:
SELLER(S) further acknowledge that receipt of a
copy hereof shall constitute a receipt at closing of
IRS Form 1099-S [Proceeds From Real Estate Transac-
tions].
- 49 -
transaction as a sale in their 1999 return.
Based upon our examination of the entire record before us,
we find that petitioners have failed to carry their burden of
establishing that they are not liable for 1999 for the accuracy-
related penalty under section 6662(a) because of a substantial
understatement of tax under section 6662(b)(2).40
We now address respondent’s determination in the notice that
petitioners are liable for 2000 for the accuracy-related penalty
under section 6662(a). We have found that petitioners have
sustained their burden of establishing by strong proof that
respondent erred in determining that the June 14, 2000 transac-
tion constitutes a sale of lot 12 for $225,000. Consequently,
there is no underpayment of tax for 2000 on which the accuracy-
related penalty under section 6662(a) may be imposed. On the
record before us, we find that petitioners are not liable for
2000 for the accuracy-related penalty.
We have considered all of the contentions and arguments of
the parties that are not discussed herein, and we find them to be
without merit, irrelevant, and/or moot.
40
In light of our finding under sec. 6662(a) and (b)(2), we
need not address respondent’s argument that petitioners are
liable for 1999 for the accuracy-related penalty under sec.
6662(a) because of negligence or disregard of rules or regula-
tions under sec. 6662(b)(1).
- 50 -
To reflect the foregoing,
Decision will be entered under
Rule 155.