T.C. Memo. 1999-9
UNITED STATES TAX COURT
FERYDOUN AHADPOUR, A.K.A. F. AHADPOUR, AND DORIS AHADPOUR, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 4843-96. Filed January 21, 1999.
William K. Norman and Edi Stiles, for petitioners.
Louis Jack and Elizabeth Stetson, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
NAMEROFF, Special Trial Judge: This case was heard pursuant
to the provisions of section 7443A(b)(4) and Rules 180, 181, and
182.1 Respondent determined deficiencies in petitioners’ Federal
income taxes, additions to tax, and penalties as follows:
1 All section references are to the Internal Revenue Code in effect for the years at issue. All Rule references are to the Tax Court Rules of Practice and Procedure. - 2 -
Addition to Tax Penalty Year Deficiency Sec. 6651(a)(1) Sec. 6662(a)
1989 $1,363,638 $340,560 $272,728 1990 303,274 -- 60,655 1991 237,234 60,864 47,447
The issues in this case, Iranian bad debt and domestic
issues, have been bifurcated for separate resolution. This
opinion addresses the domestic issues.
After concessions by the parties,2 the sole issue for
decision is whether certain payments received by petitioners
pursuant to a sale agreement for the sale of real property should
be included in gross income in the year received.
This issue was submitted by the parties fully stipulated.
This reference incorporates herein the stipulation of facts and
attached exhibits. At the time they filed their petition,
petitioners resided in Huntington Beach, California.
FINDINGS OF FACT
Sale Agreement
On November 1, 1989, Doris and Ferydoun Ahadpour as sellers
entered into an “Agreement for Purchase and Sale of Real Property
and Escrow Instructions” (Agreement) with buyer Coultrup
Development Co. (CDC). Pursuant to the Agreement, petitioners
agreed to sell certain improved real property known as
2 The parties filed a Stipulation of Settled Issues with this Court on Apr. 17, 1998, resolving all domestic issues except for the issue before this Court. Furthermore, the parties agree that additions to tax under sec. 6651(a)(1) and accuracy-related penalties under sec. 6662(a) shall not apply to the domestic issues for all years at issue. - 3 -
“Huntington Harbour Bay Club Phase II” (Phase II), with
improvements thereon in the form of parking facilities, tennis
courts, and a clubhouse with restaurant, catering, and bar
facilities. This property is located in the City of Huntington
Beach, in an area called Huntington Harbor near the Pacific
Ocean.
CDC was planning a development project for Phase II. CDC
had previously purchased Phase I, and the Phase I development
project had already been approved for condominium development by
the City of Huntington Beach.
The agreed-upon purchase price for Phase II was $7.5
million. The Agreement set forth a payment schedule. CDC was to
pay $500,000 in cash during escrow: $75,000 as an “Initial
Deposit” to be paid concurrently with the execution of the
Agreement, and $425,000 as an “Additional Deposit” to be paid
within 10 days thereafter. The Agreement provided: “Escrow
Holder is hereby instructed to immediately release the Initial
Deposit to Seller. The Initial Deposit is nonrefundable except
in the case of Seller’s breach of this Agreement, and is
applicable to the Purchase Price.” The Additional Deposit also
was to be released immediately to petitioners and also was
nonrefundable except in case of the sellers’ breach and was
applicable to the purchase price. An additional $5 million in
cash was due at the closing of escrow with the remaining balance
to be paid by a promissory note secured by a First Trust Deed. - 4 -
Furthermore, the Agreement provided that escrow was to close
within 180 days of the time it opened.
The Agreement provided that if CDC needed more time to
obtain government approval for the planned development, then
escrow could be extended for an additional 120 days upon CDC’s
payment of an “Extension Payment” of $200,000. The Extension
Payment was also to be released immediately to petitioners. This
payment was nonrefundable and would be applied to the purchase
price.
Section 6(c)(ii) of the Agreement provided: “If close of
Escrow fails to occur due to Seller’s default hereunder, or for
any reason other than a default by Buyer, Buyer shall be
entitled, in addition to any legal or equitable remedies, to the
immediate refund of the Deposit[3] and Extension Payment, if
applicable.”
Pursuant to section 6(f)(ii) of the Agreement, petitioners
were required to deposit into escrow, no later than the business
day immediately before the close of escrow, the deed conveying
title to Phase II to CDC in fee simple.
The Agreement further provided that taxes, utility charges,
and other expenses were to be prorated between the parties on a
per diem basis as of the close of escrow.
3 Deposit refers to both the Initial Deposit and the Additional Deposit. - 5 -
Escrow Deposits
On November 2, 1989, pursuant to the Agreement, petitioners
opened escrow No. 607137-JH with Chicago Title Insurance Co. as
“Escrow Holder”. The closing date for escrow was May 1, 1990.
Also on November 2, CDC deposited a $75,000 cashier’s check as
the Initial Deposit referred to in the Agreement with Escrow
Holder. On that same day, Escrow Holder released the $75,000
cashier’s check to petitioners.
On November 7, 1989, petitioners purchased a certificate of
deposit in the amount of $100,000. The funds used to purchase
the certificate of deposit consisted of the $75,000 petitioners
received from Escrow Holder and $25,000 from petitioners’
personal checking account.
Pursuant to the Agreement, on November 17, 1989, CDC
deposited the $425,000 Additional Deposit with Escrow Holder. On
that same day, the $425,000 was released to petitioners by wire
transfer to petitioners’ personal account. Before the wire
transfer of the Additional Deposit, the balance in the account
was $118,420.13. On November 21, 1989, petitioners disbursed
$500,000 from their account and used this money to pay down the
mortgage on their residence in Huntington Beach.
On May 2, 1990, CDC exercised their right to extend escrow
and delivered the $200,000 Extension Payment to Escrow Holder.
The closing date was extended until September 1, 1990. Escrow
Holder released the $200,000 Extension Payment to petitioners by
delivering a check to petitioners’ attorney Mr. Jay Steinman (Mr. - 6 -
Steinman). Also on May 2, 1990, petitioners deposited the
$200,000 into an account at Wells Fargo Bank held in the name
“Huntington Harbour Bay and Racquet Club Marina Acct”. The
balance in this account immediately before the deposit was
$35,214.02. On the same day, petitioners wrote a check from this
account for $200,000 to purchase a certificate of deposit.4
Petitioners did not report the $500,000 received in 1989 and
the $200,000 received in 1990 from Escrow Holder as income on
their 1989 or 1990 tax return or on any subsequent returns.
Public Trust Land Problem
In April 1990, local Huntington Beach residents sued CDC and
the City of Huntington Beach with respect to CDC’s planned
condominium development at the Huntington Harbour Bay Club Phase
I. The lawsuit challenged, inter alia, the legality of “land use
approvals” made by the City of Huntington Beach under the
“General Plan” with respect to a zoning variance for Phase I of
the project. The residents also contended that height
restrictions were violated and that the project did not promote
the general welfare of the neighborhood.
In a letter dated May 11, 1990, the attorney representing
the residents wrote a letter to the deputy city attorney for
Huntington Beach and the executive director of the California
4 The record contains substantial additional evidence tracing petitioners’ use of the funds received from the Escrow Holder. We believe that material is irrelevant to the issue. Suffice it to say that petitioners exercised dominion and control over these funds without restriction. - 7 -
Coastal Commission to inform the parties that the condominium
development project was in violation of the State of California’s
(State) public easement over patented tidelands.5 Soon after,
the State declared that the Phase I and II properties were
located on tidelands and were subject to a public trust easement
in favor of commerce, navigation, and fishing.
Because of the State’s claim regarding the public easement,
the closing of escrow was delayed. CDC requested that
petitioners further extend escrow past the September 1, 1990,
closing date. On September 5, 1990, Mr. Steinman referred the
State’s easement claim to First American Title Insurance Co.
(First American) for resolution under petitioners’ title
insurance policy, which had been issued April 2, 1979.
Around October 1990, petitioners and CDC began negotiating a
“Third Amendment to Agreement for Purchase and Sale of Real
Property and Escrow Instructions” (Third Amendment) in order to
establish terms for a further extension of the Phase II escrow.
During these negotiations, CDC was aware of the State’s easement
claim but wanted to ultimately close the Phase II escrow if the
claim could be satisfactorily resolved. Also during this time,
petitioners took the position that CDC had an unconditional
obligation to purchase Phase II and the fact that the City of
5 This letter also informed the parties that the development project violated the Alquist-Priolo Special Studies Act since the planned location of one of the buildings was directly over the trace of an active earthquake fault. Such a location is prohibited. This matter was resolved by CDC. - 8 -
Huntington Beach refused to process CDC’s application for Phase
II development due to the State’s claim was CDC’s problem.
Many drafts of the Third Amendment went back and forth
between the parties. Mr. Steinman prepared a final version of
the Third Amendment dated June 11, 1991, which petitioners
signed, but which was never signed or agreed to by CDC.
By letter dated July 22, 1991, Mr. Michael McCaffrey (Mr.
McCaffrey), who was working with Mr. Steinman as petitioners’
attorney, requested that First American provide petitioners with
a $2 million interest-free loan because escrow for Phase II had
not closed yet and petitioners were unable to make a required
loan payment for certain real estate not relevant here. Mr.
McCaffrey stated that First American had an obligation to
indemnify petitioners for the title problem. On August 14, 1991,
petitioners and First American entered into an agreement entitled
“Limited Agreement” pursuant to which First American would lend
petitioners $600,000 interest free. The loan was secured by the
Phase II property and was to be repaid out of the proceeds of its
eventual sale.
By letter dated December 4, 1991, Mr. Steinman requested,
inter alia, that First American advance up to $700,000 to
petitioners. This amount would then be offered to CDC in order
to terminate the Agreement and discharge CDC’s claims under the
Agreement. The loan was to be interest free and would be repaid
with the proceeds from the eventual sale of Phase II. CDC was
not aware of this request. On December 10, 1991, CDC notified - 9 -
Escrow Holder by letter that the parties wished to continue with
the escrow and that they considered it still open.
Cancellation of Agreement
On January 31, 1992, after several weeks of negotiations
between petitioners and First American, those parties executed an
“Amendment to Limited Agreement” incorporating the matters
discussed in Mr. Steinman’s December 4, 1991, letter. Pursuant
to the “Amendment to Limited Agreement”, First American issued a
cashier’s check in the amount of $750,000 to petitioners so that
they could pay CDC. This amount was added to petitioners’
accumulated indebtedness to First American.
Since petitioners were unable to deliver title in fee simple
to Phase II free of the cloud of the State’s public easement
claim, petitioners and CDC decided to cancel escrow. CDC agreed
to accept $650,000 to terminate its rights under the Agreement.
By letter dated February 4, 1992, Mr. Steinman informed Escrow
Holder that petitioners and CDC agreed to cancel the Phase II
escrow. On February 14, 1992, petitioners and CDC signed a
“Mutual Release” in which they agreed to terminate the sale of
Phase II and to release each other from any causes of action
relating to the Agreement.
Pursuant to the terms of the Mutual Release, the parties
agreed that CDC would receive up to $650,000 from petitioners “as
consideration” for executing the Mutual Release: $600,000 to be
paid at the signing of the Mutual Release and an “Additional
Amount” of $50,000 to be paid upon, inter alia, the return of - 10 -
CDC’s work product on the Phase II project. On May 28, 1992,
petitioners paid to CDC $42,500 of the Additional Amount.
Petitioners retained $7,500 of the Additional Amount, which they
considered to be an offset of CDC’s share of the legal fees that
petitioners had incurred as a result of the State’s tidelands
easement claim.6
On their 1992 tax return, petitioners did not claim a
deduction for the $642,500 paid to CDC in 1992. Petitioners also
did not report as gross income on any tax return the $57,500
difference between the $700,000 they received from CDC under the
Agreement during 1989 and 1990 and the $642,500 they paid to CDC
pursuant to the Mutual Release in 1992.7
During this entire period, petitioners remained in
possession of Phase II and retained all benefits and burdens of
ownership including liability for payment of taxes and insurance.
It does not appear from the record that CDC ever took possession
of Phase II.
6 The record contains a considerable amount of information pertaining to events that occurred between petitioners and the State, and petitioners and First American, after the years at issue. We do not consider this information to be of any relevance to the years before the Court. 7 We do not have jurisdiction with regard to 1992. We make this finding of fact as to 1992 for completeness, but we draw no conclusions with respect to petitioners’ tax liability for 1992 resulting from this transaction. - 11 -
OPINION
Respondent contends that petitioners received the payments
from Escrow Holder under a claim of right, without any
restrictions on their use, and, therefore, the payments are
included in income in the years of receipt.
Petitioners, on the other hand, contend that since escrow
never closed and the sale was never consummated, the deposits
made by CDC are not taxable to them. In the alternative,
petitioners request that if it is determined that the amounts
received are included in income (as if the sale had closed), then
the amounts received should be reduced by all or part of the
adjusted basis of the property and reported for Federal tax
purposes under the installment method of reporting.
Gross income means all income from whatever source derived
including gains derived from dealings in property. Sec.
61(a)(3). Gain from the sale of property had been held to be
gross income in the year when the sale is consummated, and not in
the year when the contract was executed. Veenstra & DeHaan Coal
Co. v. Commissioner, 11 T.C. 964, 967 (1948). Under section
1001(a), gain from the sale or other disposition of property is
the excess of the amount realized over the taxpayer’s adjusted
basis in the property.
For purposes of Federal income taxation, a sale occurs upon
the transfer of benefits and burdens of ownership, rather than
upon the satisfaction of the technical requirements for the
passage of title under State law. Derr v. Commissioner, 77 T.C. - 12 -
708, 723-724 (1981); Yelencsics v. Commissioner, 74 T.C. 1513,
1527 (1980). The question of when a sale is complete for Federal
income tax purposes is essentially one of fact. Baird v.
Commissioner, 68 T.C. 115, 124 (1977). The applicable test is a
practical one that considers all of the facts and circumstances,
with no single fact controlling the outcome. Derr v.
Commissioner, supra at 724; Baird v. Commissioner, supra at 124;
Deyoe v. Commissioner, 66 T.C. 904, 910 (1976). Generally, a
sale of real property is complete upon the earlier of the
transfer of legal title or the practical assumption of the
benefits and burdens of ownership. Derr v. Commissioner, supra
at 724; Baird v. Commissioner, supra at 124; Deyoe v.
Commissioner, supra at 910.
CDC did not receive the benefits and burdens of ownership of
Phase II upon execution of the Agreement. There is no evidence
that CDC ever had possession of Phase II. Furthermore, as stated
in the Agreement, petitioners were still liable for the payment
of taxes and insurance on Phase II until the closing of escrow.
CDC did not have full legal title at the time the Agreement was
executed. Under California law, delivery and acceptance of a
deed passes full legal title. Cal. Civ. Code sec. 1056 (West
1982). According to the Agreement, petitioners were to retain
the deed until no later than the business day preceding the close
of escrow, at which time they were to deposit into escrow the
deed conveying title to CDC in fee simple. - 13 -
An earnest money deposit, received on the execution of a
sales contract, is not income until the taxpayer acquires an
unconditional right to retain the deposit. Bourne v.
Commissioner, 62 F.2d 648, 649 (4th Cir. 1933), affg. 23 B.T.A.
1287 (1931). If the sale is consummated, it fixes the seller’s
right to retain the deposit, and the earnest money is included as
part of the sales proceeds. Kang v. Commissioner, T.C. Memo.
1993-601; Kellstedt v. Commissioner, T.C. Memo. 1986-435. If the
sale is not consummated, the sales contract fixes the seller’s
right to retain the deposit, and the deposit is included in
income at the time that the contract fixes the seller’s right to
retain the deposit. Baird v. United States, 65 F.2d 911, 912
(5th Cir. 1933). Because earnest money is in the nature of a
payment for an option, it is included in the seller’s ordinary
income when forfeited to him. Sec. 1234; Elrod v. Commissioner,
87 T.C. 1046, 1068-1069 (1986); see Kang v. Commissioner, supra
(taxpayers’ rights to earnest money were not fixed before they
refunded a portion of it; amount they kept was included in
ordinary income in year they made refund, not year they received
earnest money).
At the time the parties entered into the Agreement in 1989,
they anticipated that the sale of Phase II would be consummated
in 1990. At the time petitioners received the Initial Deposit
and the Additional Deposit, they did not have an unconditional
right to retain these deposits. The unconditional right to
retain the deposits was to be fixed only after CDC paid the - 14 -
remainder of the purchase price and when petitioners delivered
the executed deed conveying title to Phase II in fee simple to
CDC. If the sale was not consummated, section 6(c)(ii) of the
Agreement fixed petitioners’ right to retain the deposits only if
CDC breached.
Respondent argues that the claim of right doctrine applies
and the deposits received by petitioners should be included in
their gross income in the year received. The Supreme Court case
North Am. Oil Consol. v. Burnet, 286 U.S. 417 (1932), established
the elements of the claim of right doctrine. The three basic
elements are: (1) The taxpayer receives money or property, (2)
under a claim of right, and (3) the taxpayer has control over the
use or disposition of the money or property. Id. at 424.
Amounts received under a claim of right, without restriction as
to their disposition, are taxable when received even though the
taxpayer may have a contingent obligation to restore the funds at
some future point. Id.
It is clear that petitioners received the deposits to which
they were entitled under the Agreement, and that they exercised
control over the use and disposition of those deposits. However,
we conclude that the claim of right doctrine does not apply to
the instant case. Petitioners received the amounts pursuant to
the Agreement for the sale of real property. Therefore, cases
pertaining to deposits taxpayers received before the consummation
of a sale for real property are applicable to the case at hand
rather than those involving the claim of right doctrine. - 15 -
Respondent contends that, since the money was directly
released to petitioners for their use, the amounts should be
included in gross income when received. However, in Kang v.
Commissioner, supra, the earnest money was deposited into the
taxpayers’ personal checking account.
Additionally, respondent contends that petitioners were
under a contingent liability to repay the funds to CDC, and that
to avoid application of the claim of right doctrine, the
recipient must recognize in the year of receipt an existing and
fixed obligation to repay the amount received and must make
provisions for repayment. Hope v. Commissioner, 55 T.C. 1020,
1030 (1971), affd. 471 F.2d 738 (3d Cir. 1973). A restriction on
the disposition or the use of the funds may also prevent the
application of the claim of right doctrine. Commissioner v.
Indianapolis Power & Light Co., 493 U.S. 203, 209 (1990).
We do not find that petitioners were merely under a
contingent obligation to repay the deposits to CDC as respondent
contends. There was an existing and fixed obligation for
petitioners to repay the deposits in the event that they breached
or “for any other reason other than a default by Buyer”. Indeed,
petitioners did repay an amount close to the amount CDC deposited
upon execution of the Mutual Release. Petitioners did not have
an unconditional right to retain the deposits. Bourne v.
Commissioner, supra at 649.
The cases that respondent relies on pertain to items that
would normally be included in income upon receipt even though it - 16 -
may be determined at a future date that they are not to be
retained. E.g., Healy v. Commissioner, 345 U.S. 278 (1953)
(salary); United States v. Lewis, 340 U.S. 590 (1951) (bonus from
employer); Hirsch Improvement Co. v. Commissioner, 143 F.2d 912
(2d Cir. 1944) (advance payments of rent); Nordberg v.
Commissioner, 79 T.C. 655 (1982) (corporate distribution), affd.
without published opinion 720 F.2d 658 (1st Cir. 1983); Hope v.
Commissioner, 55 T.C. 1020 (1971) (sale of stock), affd. 471 F.2d
738 (3d Cir. 1973); Angelus Funeral Home v. Commissioner, 47 T.C.
391 (1967) (prepaid services), affd. 407 F.2d 210 (9th Cir.
1969); Goldberg v. Commissioner, T.C. Memo. 1997-74 (advance
payment for sale of goods); Alexander Shokai, Inc. v.
Commissioner, T.C. Memo. 1992-41 (commissions), affd. 34 F.3d
1480 (9th Cir. 1994); Rosenberg v. Commissioner, T.C. Memo. 1956-
68 (legal fees).
Accordingly, we hold that the claim of right doctrine does
not apply to the case at hand. Therefore, the deposits that
petitioners received are not included in income in the year
received, but in the year the right to retain them is fixed.
Since the determination of petitioners’ rights to the deposits
did not occur in 1989, 1990, or 1991, the years before this
Court, the amounts are not included in petitioners’ gross income
for those years. - 17 -
Because of our holding above, there is no need to consider
petitioners’ alternative argument.
An appropriate order
will be issued.