T.C. Memo. 2021-45
UNITED STATES TAX COURT
PLENTYWOOD DRUG, INC., ET AL.,1 Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 17753-16, 17754-16, Filed April 26, 2021. 17755-16.
W. Scott Green, for petitioners.
Timothy M. Peel, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
HOLMES, Judge: Plentywood Drug, Inc., is a Montana corporation that
operates the only pharmacy in Plentywood, Montana. The pharmacy rents space
1 We consolidated two cases with this one: Robert and Marilyn Mann, docket No. 17754-16; and Marvin and Kathryn Eberling, docket No. 17755-16 .
Served 04/26/21 -2-
[*2] in a building that has four owners, who are also its four shareholders. The
Commissioner says that the corporation has been paying its shareholders too high
a rent, which would make some of that rent a nondeductible dividend. The
shareholders disagree.
We must decide what a fair market rent for the building is.
FINDINGS OF FACT
A. Background
Plentywood is a town of 1,700 people in northeast Montana. Local legend
has it that the nearby Plentywood Creek and the town of Plentywood get their
name from a search for firewood. Dutch Henry who, though notorious in Montana
history as a skilled horse thief, was reportedly an otherwise pleasant man and a
talented cowboy, amused himself one day by watching a chuckwagon cook
struggle to start a fire with damp buffalo chips. He finally took pity on the man
and told him to hike two miles up the creek where he could find “plenty wood.”2
The first business was opened in the town in 1900, and a post office followed in
1902. A branch line of the Great Northern arrived a few years later, and
Plentywood incorporated in 1912.
2 See The Outlaw Dutch Henry, The Montana Pioneer (July 2010), https://montanapioneer.com/the-outlaw-dutch-henry/ (last visited Feb. 24, 2021). -3-
[*3] It was the expectation of early settlers in the state that “rain follows the
plow.” Those homesteaders were often disappointed in their hope, but it was
definitely the case in Plentywood that druggists preceded incorporation.
Plentywood Drug opened in 1910 and two years later became Plentywood Drug,
Inc. It is still, more than a century later, a frontier pharmacy.3 It serves people in
four counties that span 7,200 square miles, where there are to this day only about 2
people per square mile. (Washington, D.C., has more than 11,500 people per
square mile.) Plentywood Drug is now owned by Robert Mann, his wife Marilyn
Mann, and the Manns’ daughter and son-in-law Kathryn and Marvin Eberling.
The Eberlings each own 49.42% of the corporation’s stock, while the Manns each
own 0.58%.
Plentywood Drug has a single store on Main Street near the center of town.
Its building has 8,125 square feet of retail space on the main level and 5,250
square feet of support area below. The store is a full-line pharmacy, but is also
stocked as a convenience store for the community--it sells everything from
3 “Frontier pharmacy” is a real term in federal law. It’s a pharmacy in what the Patient Protection and Affordable Care Act defines as a “frontier health professional shortage area,” an area “with a population density less than 6 persons per square mile within the service area * * * and * * * with respect to which the distance or time for the population to access care is excessive.” Patient Protection and Affordable Care Act, Pub. L. No. 111-148, sec. 5002(b)(2), 124 Stat. 119 at 591 (2010). -4-
[*4] groceries to toys. It uses the basement to store both inventory and business
records. Robert Mann bought the building around 1978, and it is now co-owned
in four equal shares by the Manns and the Eberlings.
That brings us to the problem that is central to this case. Plentywood Drug
pays rent to the four owners of the building. The two couples set the terms by oral
agreement at the beginning of each year. They did not, for the years at issue here
or for any other years, put these terms into a formal written lease signed by
themselves once in their capacity as owners of the pharmacy and then again as
owners of the building. But we do know what rent the corporation paid in
2011-13:
Year Amount 2011 $83,584 2012 192,000 2013 192,000
Because the couples each owned half the building, they reported the same amounts
on their returns: -5-
[*5] 2011 2012 2013 Robert and Marilyn Mann $48,584 $96,000 $96,000 Marvin and Kathryn Eberling 35,000 96,000 96,000
Plentywood Drug deducted this rent from its corporate income each year, which
allowed it to avoid double taxation on those amounts.4
B. Audit and Trial
The Commissioner audited Plentywood Drug for tax years 2011-13; he then
lassoed the Manns and the Eberlings into an expanded audit and finally issued
notices of deficiency to both them and their corporation. The parties were able to
resolve all the proposed adjustments except for those related to the rent paid to the
couples as lessors and deducted by Plentywood Drug as lessee. The
Commissioner disallowed large parts of those deductions on the ground that the
rent paid was greater than what a fair market rent would have been for each year in
issue. The Commissioner also recharacterized the allegedly excess rent as
4 Corporations are subject to double taxation because the Code taxes income first when the company receives it and then again when the company distributes it to its shareholders. See Prescott v. Commissioner, 66 T.C. 128, 138 (1976), aff’d, 561 F.2d 1287 (8th Cir. 1977). For a historical account of the development of double taxation, see Steven A. Bank, “Is Double Taxation a Scapegoat for Declining Dividends? Evidence From History,” 56 Tax L. Rev. 463, 479-516 (2003). -6-
[*6] constructive dividends and branded all petitioners with accuracy-related
penalties under section 6662(a).5
Both couples and Plentywood Drug timely filed petitions. We consolidated
the cases and tried them in St. Paul. Both parties presented expert testimony
regarding the fair market rent for the building. The Commissioner did not
introduce any evidence during trial that he’d complied with section 6751(b)(1)
before he determined that Plentywood Drug and its owners owed penalties. See
Graev v. Commissioner, 149 T.C. 485, 493 n.14 (2017) (citing Chai v.
Commissioner, 851 F.3d 190, 221 (2d Cir. 2017), aff’g in part, rev'g in part T.C.
Memo. 2015-42), supplementing and overruling in part 147 T.C. 460 (2016).
At the time the petitions were filed Plentywood Drug’s principal office was
in Plentywood and both the Manns and the Eberlings were Montana residents.6
5 All section references are to the Internal Revenue Code in effect for the years at issue, and all Rule references are to the Tax Court Rules of Practice and Procedure, unless we say otherwise. 6 Presumptive appellate venue would thus lie in the Ninth Circuit. See sec. 7482(b)(1)(A) and (B). -7-
[*7] OPINION
I. Ordinary and Necessary Business Expenses
The rules we apply today are well settled. Section 162(a) allows a taxpayer
to deduct the “ordinary and necessary” expenses he pays in carrying on a trade or
business. The Code specifically lists the rent paid by a business as one of these
deductible expenses. Sec. 162(a)(3). But for an expense like rent to be ordinary
and necessary, it must also be reasonable in amount. United States v. Haskel
Eng’g & Supply Co., 380 F.2d 786, 788 (9th Cir. 1967). Any part of rent that is
unreasonable is not ordinary and necessary and thus not deductible. Velvet Horn,
Inc. v. Commissioner, 41 T.C.M. (CCH) 1445, 1449 (1981).
The Commissioner does not often question the reasonableness of a rent
agreed to by parties at arm’s length. But he does sometimes look closely to the
fairness of rent charged when landlord and tenant might not have an incentive to
drive a hard bargain:
When there is a close relationship between lessor and lessee and in addition there is no arm’s length dealing between them, an inquiry into what constitutes reasonable rental is necessary to determine whether the sum paid is in excess of what the lessee would have been required to pay had he dealt at arm’s length with a stranger. * * *
Place v. Commissioner, 17 T.C. 199, 203 (1951), aff’d, 199 F.2d 373 (6th Cir.
1952); see also Safway Steel Scaffolds Co. of Ga. v. United States, 590 F.2d 1360, -8-
[*8] 1362 (5th Cir. 1979). The Commissioner sometimes suspects that a
corporation might call a payment to its shareholders something like rent, which is
deductible, when the economic reality is that it’s a distribution of profits. If his
suspicion turns out to be true, the seemingly deductible expense is actually a
nondeductible dividend. Tax law calls such a dividend a “constructive” dividend
because the corporation itself doesn’t call it that on its books. See Rosser v.
Commissioner, 99 T.C.M. (CCH) 1035, 1039 (2010); Benson v. Commissioner, 88
T.C.M. (CCH) 520, 534 (2004). Shareholders have to include constructive
dividends in their taxable income under section 61(a)(7).7 These kinds of cases
are disputes about value, and as in any valuation dispute we may use testimony
from experts, see Harmon City, Inc. v. United States, 733 F.2d 1381, 1383-84
(10th Cir. 1984), and may look at all the circumstances of the case and the entire
history of transactions between the parties, Safway Steel Scaffolds, 590 F.2d at
1362.
7 Plentywood Drug contends that the Commissioner may not recharacterize the rent that it pays as qualified dividends under section 482. But the Commissioner did not rely on section 482 to reclassify the rent. Section 482 caselaw is not relevant here. -9-
[*9] II. Fair Market Rent
A fair market rent is one at which “the property would change hands
between a willing buyer and a willing seller, neither being under any compulsion
to buy or sell and both having reasonable knowledge of relevant facts.”
Sec. 1.170A-1(c)(2), Income Tax Regs. The parties in these cases quickly realized
that finding comparable properties in a town of 1,700 people in frontier Montana
and then using them to come up with a fair market rent would be difficult. One
problem right out of the chute is that Montana is a nondisclosure state. This
means that real-estate data such as sales prices that appraisers can typically find in
other states is legally confidential and simply not available. This issue is
magnified in a town the size of Plentywood, which already has a limited number
of even potentially comparable buildings. We heard entirely credible testimony
that Montanans--perhaps especially Montanans in small communities--don’t
commonly share details of their financial lives very readily with strangers. The
Commissioner’s expert was particularly credible in his statement that when he
tried to find information in Plentywood he did not identify himself as an IRS
agent. - 10 -
[*10] Despite this very significant problem, the parties were able to make as
reasonable a presentation as they could.8 We’ll describe the competing valuations
and then give our own analysis.
A. Petitioners’ Valuation
Petitioners introduced a rent-survey report prepared by Craig McIvor, a
real-estate appraiser certified in Montana and North Dakota, as well as the owner
of a property-management company in Williston, North Dakota. McIvor
conducted his survey by rounding up what data he could from a number of rental
properties, in both Plentywood and in Williston. He also testified--and here we
make a specific finding that he was credible when he did--that he did not know the
rent that Plentywood Drug had paid before he finished his survey.
McIvor also carefully made clear that his analysis was a survey and not an
appraisal. He stated that one doesn’t appraise rent, one estimates rent, and he
viewed his assignment as collecting information about rents in the area and at the
time in question. He got his data from leases on multiple properties both in
Plentywood and Williston. He first looked at a lease for the U.S. post office in
8 We don’t need to decide whether the burden of proof shifted to the Commissioner on this issue because we are able to decide the matter by a preponderance of evidence. See Knudsen v. Commissioner, 131 T.C. 185, 188-89 (2008) (citing Blodgett v. Commissioner, 394 F.3d 1030, 1039 (8th Cir. 2005), aff’g T.C. Memo. 2003-212). - 11 -
[*11] Plentywood. That post office is a federal government facility and the USPS
makes public information about the rent it pays. This data is one of the few public
sources of information about commercial rental properties in Plentywood. It
showed that the USPS had a ten-year lease beginning in 1998 for $18 per square
foot that was renewed in 2008 for $15.90 per square foot. McIvor also looked at
businesses located in Williston, and found information there about rents for an
office building and a pharmacy. McIvor found leases ranging from $15 per square
foot to $30 per square foot in Williston. He also credibly stated that rents in
Williston were increasing during the years at issue because the town found itself in
the middle of the North Dakota oil boom of the late 2000s and early 2010s. He
concluded a fair market rent for Plentywood Drug would be $25 per square foot
for the main floor.
Both Plentywood Drug and McIvor stated that the building’s basement was
necessary for the business, if not for its retail operation. The only comparable
McIvor could find for this space was a finished basement in the drugstore building
in Williston that was renting for $18 per square foot. He thought this was too high
for storage space and concluded that a better number in Plentywood would be
about half that, or $8-$9 per square foot. - 12 -
[*12] B. The Commissioner’s Valuation
The Commissioner’s expert witness was Howard Blanding, a senior
appraiser for the IRS whom we recognized as an expert in real-estate appraisal.
Blanding corralled his data from Plentywood alone. He noted that this was
difficult because of the sparse data available, but that he chose to stick with
comparables in Plentywood instead of looking to those in Williston because
Williston is a much larger city with what he thought was a completely different
economy.
That left Blanding with four properties as his comparables--two
government-subsidized multifamily residential buildings, the post office, and a
625-square-foot commercial retail property. For each of these, Blanding adjusted
the rent actually charged for positive and negative differences between them and
Plentywood Drug’s building. Here is what he concluded:
Subject Rental 1 Rental 2 Rental 3 Rental 4 Rent N/A $74,760 $78,300 $6,000 $86,400 amount ($6.14/sf) ($15.26/sf) ($9.60/sf) ($6.55/sf) Lease 2011-13 2011-13 1998-2018 2013 2017 year Age/Con- Remodel/ 1976/ Avg. 1997/ Good Older/ Remodel/ dition Avg. + Avg.- Avg.- - 13 -
[*13] Category Retail Multi- Post office Retail Multi- type family family Size 8,125 12,168 5,130 625 13,200 (sq. ft.) Utilities No No No No Yes (Assum.) Storage Partial None None Full None basement basement Net N/A 0% -45% -16% -7% adjust. % Adjusted N/A $6.14 $8.39 $8.06 $6.09 $/sf
He made both general and specific adjustments. His general adjustment was
for the lease year of his comparables. He reasoned that older leases became
submarket as time went on, and so he assumed that fair market rents would, all
other things being equal, rise each year by the average Consumer Price Index
(CPI) increase of 1.4% per year. He also made specific adjustments for each of his
comparable properties. He noted the age and condition from his own
observations. He adjusted for different types of property to reflect their different
costs--he noted that retail properties generally have lower construction costs than
apartments or offices because of their large open areas. - 14 -
[*14] He adjusted for the different square footage of his comparables. He even
adjusted the square footage of the post office. The lease information for the post
office, publicly available, lists the size of the property and the rent paid by the
government each year. The size of the post office is 4,276 square feet and the rent
paid by the USPS is $68,000 per year, or $15.90 per square foot. In his report,
however, Blanding stated the size of the post office was 5,130 square feet, which
led to a lower rent per square foot. His justification was that the square footage on
the website was a measure of its interior space. He said he needed to adjust this
number to square footage calculated from the outside to be consistent with the
other comparables used in his report. He also reported the rent as $78,300, which
is what the USPS paid under its original lease in 1998. When the USPS renewed
its lease in 2008, the rent fell to $68,000. Blanding didn’t explain why he used
$78,300 instead of the more recent rent of $68,000.
He adjusted the square footage of Plentywood Drug’s building by entirely
leaving out the 5,250 square feet of basement space. He did this, he said, because
the basement was hard to access, had a low ceiling, and contained large items that
could not be removed. He instead made the presence or absence of storage
another item in his growing herd of adjustments for the comparable properties. - 15 -
[*15] All this led him to find an average rent per square foot of $7.17. He
rounded this to $7.20 for 2012. With 8,125 square feet as the size of the drugstore
building (remember that he omitted the more than 5,000 square feet of basement
space), he concluded that a fair rent would have been $58,500 for 2012. He then
used his CPI deflater to decrease this number to $57,681 for 2011, and increase it
to $59,319 for 2013.
C. Analysis
Each party had some reasonable criticisms of the other party’s expert. The
Commissioner argued that McIvor should have followed the Uniform Standards of
Professional Appraisal Practice (USPAP) and, even if he didn’t, that he should at
least have made adjustments for his comparable properties from Williston to
reflect the differences between that area and Plentywood. McIvor claimed that he
did not need to follow USPAP because he prepared a rent survey and not an
appraisal, but the Commissioner is correct that opinions on market rent for
commercial properties are considered appraisals subject to USPAP standards. See
USPAP 2016-2017 ed., Frequently Asked Questions 285, Question 161 “Market
Rent Opinion.” McIvor’s report would not qualify under those standards as an
“appraisal”. It is simple in form and lacks the usual thickeners of an appraisal--
pages about the economy in the subject area, a USPAP certification, and a - 16 -
[*16] definition of market value, for example. But it does have relevant data, and
that too is helpful to a factfinder.
The Commissioner’s criticism of McIvor’s use of comparable properties in
Williston also has some merit. Williston is only about a one-hour drive from
Plentywood,9 but it has a population more than eight times as large. It also has a
stronger economy and a stronger rental market because of its larger population.
Plentywood Drug had some pointed criticisms of its own about Blanding’s
work. When a town is so small that an appraiser looking for comparables for retail
space ends up looking at apartment buildings, perhaps it might be wiser to go to
the next town over. In this case, that town is Williston--and Plentywood Drug
says Blanding could have found comparables there. It denies that there are
material differences in the economies of the two towns.
Plentywood Drug also takes issue with the adjustments that Blanding made.
Two in particular that it thought unjustifiable were a downward adjustment of 45%
for the Plentywood post office and Blanding’s decision not to compute a dollar
amount per square foot for the drug store’s basement.
9 Testimony about this minor point was unchallenged, but we note that it does imply Montanans drive upwards of 75 m.p.h. on their roads. - 17 -
[*17] We are of course not bound by the opinion of any expert witness and may
accept or reject expert testimony in the exercise of our sound judgment. Helvering
v. Nat’l Grocery Co., 304 U.S. 282, 295 (1938); Williams v. Commissioner (In re
Williams Estate), 256 F.2d 217, 219 (9th Cir. 1958), aff’g T.C. Memo. 1956-239.
We may also choose which part of an expert’s opinion, if any, we will accept.
Parker v. Commissioner, 86 T.C. 547, 562 (1986).
We start by looking at the Commissioner’s criticism of McIvor. He argues
that McIvor’s failure to adhere to USPAP makes his report unreliable and entitled
to no weight. It is true, as the Commissioner points outs, that Montana and North
Dakota require licensed appraisers to follow USPAP, see Mont. Code Ann. sec.
37-54-403 (2017); N.D. Cent. Code sec. 43-23.3-18 (2017), but state laws are not
federal rules of evidence. Our Court has itself found that an expert’s valuation
opinion that does not comport with USPAP is still admissible, although it may or
may not be helpful. See Epco, Inc. v. Commissioner, 77 T.C.M. (CCH) 1731,
1735 (1999). We have “decline[d] to adopt USPAP as the sole standard for
reliability of an expert appraiser under Rule 702 of the Federal Rules of
Evidence.” Whitehouse Hotel Ltd. P’ship v. Commissioner, 131 T.C. 112, 128
(2008), rev’d on other grounds, 615 F.3d 321 (5th Cir. 2010). That McIvor’s
report was not an appraisal under USPAP may affect the weight we give his - 18 -
[*18] testimony but does not by itself make it so unreliable as to be inadmissible.
See id.
We take more seriously the problem of using comparables from Williston.
Although the properties McIvor found are very similar to Plentywood Drug’s retail
space, we also find that the difference in market areas is very great. Williston has
a larger population than Plentywood and rents there have been much affected by
the oil boom. It’s possible that the boom also affected Plentywood, but neither
party put in any solid proof of that--for example, evidence of a surge in population
or business formation--into the record of these cases. We therefore do not accept
the Williston properties as being reasonable comparables.
But we also question the comparability of the properties that the
Commissioner used. His expert used two residential properties in his analysis.
Government-subsidized multifamily residential housing is like a retail drugstore in
that both are rented. But not in much else. Blanding tried to deal with this by
making adjustments, but we do not believe this is a reliable way to overcome the
differences between the properties. He also used a small donut shop as a
comparable in his analysis. Using a retail space is an improvement on using
residential housing, but this particular shop is only 625 square feet, a small - 19 -
[*19] fraction of the size of Plentywood Drug, and we therefore find that it is not a
reasonable comparable either.
Blanding also shrank the fair market rent for the drugstore by not taking into
account the 5,250 square feet of its used and useful basement space. We therefore
do not accept his conclusions on what a fair market rent for the drugstore would
be.
We think that under these unusual circumstances we can use the one
property that both parties agree is comparable--the Plentywood post-office
building--to begin to figure out a fair market rent for the Plentywood Drug
building. We find it more likely than not that it’s the property that would most
accurately represent the fair market value of large retail space in Plentywood
during the years at issue. Yet even though both parties agree that the post office is
comparable, they disagree about the number of square feet it has. Blanding stated
that the size of the post office was 5,130 square feet because he measured its area
from the exterior. McIvor looked at the USPS website and copied down the 4,276
square feet that he found. We’re not going to tinker with the website’s number.
When measurements were made and accepted by parties operating at arm’s length,
we may rely on those figures in computing a proper price per square foot. See - 20 -
[*20] Learner v. Commissioner, T.C. Memo. 1983-122, 45 T.C.M. (CCH) 922,
928 (1983). We will use 4,276 square feet.
The parties also disagree about just how comparable the two buildings are.
Blanding incorporated a number of factors to adjust the post office’s rent per
square foot downward, and we will take each in turn. He first asserts that the age
and condition of the post office, which was built in 1997 and remains in good
condition, make it 20% more expensive than Plentywood Drug. While the drug
store is quite old, it was fully remodeled in 2004, so we do not find a 20%
adjustment is appropriate. Next is “Category Type.” Blanding’s appraisal states
that “retail construction cost tends to be lower due to its large open areas as
opposed to apartment or office which have a higher level of interior finish.” He
therefore gave Plentywood Drug a 25% discount as compared to the post office.
McIvor disagrees, noting that the post office is a “shell” where they “move all
their boxes and everything.” We again find Blanding’s discount for this factor
excessive. The third factor is size, which accounts for “certain standard fixed
costs in new construction, regardless of building size,” which make smaller
buildings more expensive per square foot. Plentywood Drug is nearly twice as
large as the post office, not including its basement, which we think makes
Blanding’s 5% adjustment for size reasonable. But Blanding didn’t consider one - 21 -
[*21] factor relevant to rent costs: the certainty that the landlord will be paid. As
McIvor--who is himself the owner of a property-management company--credibly
testified, typical commercial property leases to private parties last two to five
years; much shorter than the ten-year lease held by the post office in Plentywood.
The government as a tenant is also far more likely than a private tenant to pay its
rent in full and on time. This would likely lead a landlord to accept a lower rent
for a property. On these facts, we find that these reasonable adjustments offset
each other. We will use the $15.90 per square foot rent paid by the USPS, without
any discount or premium, as the fair market rent for the main level of Plentywood
Drug. Multiplied by 8,125 square feet, that means $129,187.50.
This leaves the 5,250 square feet of basement storage area. The
Commissioner’s expert did not include this 5,250 square feet when computing his
rental value; he said instead that it increased the rental value of the main floor by
5% per square foot as compared to similar properties with no storage space. That
equates to about $1.23 extra rent per square foot of basement. Plentywood Drug’s
expert estimated that it would have a value of $8 to $9 per square foot. He
calculated this value at somewhat less than half the value of a comparable finished
basement in Williston, which rented for $18 per square foot. We do find it much
more likely than not that some value should be attached to this 5,250 square feet of - 22 -
[*22] storage space, as it was used by Plentywood Drug for housing both
inventory and its records. See, e.g., Duplicating Supply Co. v. Commissioner, 66
T.C.M. (CCH) 853, 855 (1993) (finding value of storage space separate from retail
space). We also find that a fair rent for this space is lower than the retail space
above it. See id. (“Clearly, the retail and office space has more rental value than
the storage space.”) While again acknowledging how thin the evidence is, we do
find the rental value for the basement storage area estimated by Plentywood
Drug’s expert to be reasonable. At $8 per square foot, a fair rent for the basement
would be $42,000.
This puts the total fair market rent for the Plentywood Drug property at
$171,187.50. We will not adjust this figure year by year to reflect changes in the
CPI. We know that the Postal Service won a reduction in rent in 2008, and this
suggests to us that the market fluctuations specific to real estate in Plentywood
would overwhelm the effect of the low but steady inflation in prices of consumer
goods and services throughout the entire national economy.
III. Penalties
That leaves only the issue of penalties. The Commissioner asserted that
Plentywood Drug, the Manns, and the Eberlings owe accuracy-related penalties
under section 6662(a), which imposes a 20% penalty on the portion of an - 23 -
[*23] underpayment of tax that is attributable to any of the various causes listed in
section 6662(b). The Commissioner alleges that the first cause on this list--
negligence or disregard of rules or regulations, sec. 6662(b)(1)--applies to
Plentywood Drug, the Manns, and the Eberlings, but only Plentywood Drug’s
underpayment is also due to a substantial understatement of its income tax due,
sec. 6662(b)(2). An understatement of a corporation’s income tax is substantial if
it exceeds the lesser of $10 million or “10 percent of the tax required to be shown
on the return * * * (or, if greater, $10,000).” Sec. 6662(d)(1)(B).
We must also consider whether the Commissioner complied with section
6751. That section states that no penalty is allowed unless the “initial
determination of such assessment is personally approved (in writing) by the
immediate supervisor of the individual making such determination.” Sec.
6751(b)(1). This written approval must be obtained no later than the date the
notice of deficiency is issued or the date the Commissioner files an answer or
amended answer in which he asserts the penalty. Chai, 851 F.3d at 221; see also
Graev, 149 T.C. at 493. There is an exception to the approval requirement for
penalties “automatically calculated through electronic means.” Sec.
6751(b)(2)(B). - 24 -
[*24] No party produced any evidence that the Commissioner either did or didn’t
comply with the approval requirements of section 6751. Section 7491(c) places
the burden of production on the Commissioner with respect to liability for any
individual for any penalty. This means the Commissioner bears the burden of
production with respect to the Manns’ and the Eberlings’ cases. The absence of
any evidence means the Manns and the Eberlings have thrown off the penalties
asserted against them, but what about Plentywood Drug? It’s a corporation, so it
bears the burden of production for its own case. NT, Inc. v. Commissioner, 126
T.C. 191, 195 (2006). When the burden lies on the Commissioner, we have held
that he must introduce evidence that he complied with section 6751. See, e.g.,
Dynamo Holdings Ltd. P’ship v. Commissioner, 150 T.C. 224, 227 (2018); Higbee
v. Commissioner, 116 T.C. 438, 446 (2001). When the burden lies on an estate or
corporation or some other nonindividual, it must show that the Commissioner did
not get supervisory approval. This is a somewhat unusual burden--the burden of
producing evidence that no evidence exists of the Commissioner’s compliance
with his obligation to show supervisory approval of penalties. It can be met, for
example, by asking for the penalty-approval form through a FOIA request or an
informal discovery request and then showing that there wasn’t one. Plentywood - 25 -
[*25] Drug didn’t do that here, so it cannot take shelter from the penalties under
section 6751.10
That also leaves Plentywood Drug to argue its way out of a penalty on the
merits, which it can do in a couple ways. The first begins with our finding that the
fair rent for all three years was $171,187.50. Plentywood Drug paid only $83,584
in 2011, meaning there was no excessive rent that led to an underpayment of tax
that year. No penalty applies. In 2012 and 2013 Plentywood Drug did overpay its
rent by about $20,000 and wrongfully claimed deductions on that overpayment.
But the consequent underpayment of tax due is almost certainly less than $10,000,
even with the several much smaller adjustments that Plentywood conceded.
Only the penalty for negligence remains. Taxpayers, both corporate and
individual, can buck against the Commissioner’s effort to saddle them with both
negligence and substantial-understatement penalties if they can show their
underpayments were due to reasonable cause and they acted in good faith. Sec.
6664(c)(1). We start out by noting just how difficult it was for the parties’
professional appraisers to calculate a fair rent themselves. And while the methods
10 The Commissioner argues that the penalty for substantial understatement of tax at section 6662(b)(2) falls within the automatic-computation exception to section 6751. Because Plentywood Drug is the only party alleged to have under- stated its income tax and failed to carry its burden of production for the section 6751 issue, the Commissioner’s argument is moot and we will not address it. - 26 -
[*26] the Eberlings and the Manns used to estimate what the rent should be were
informal--they called up some shops in Plentywood and Williston and looked
online for what little information was available there--they weren’t all that
different from what the appraisers used to collect their data. The rent they settled
on wasn’t far from what we’ve found is fair, either. We therefore find that they
acted on behalf of their corporation in a reasonable way and reached a reasonable
result in good faith. See Estate of Thompson v. Commissioner, 88 T.C.M. (CCH)
48, 64-65 (2004) (stock valuation in good faith where no comparable companies
and “difficult judgment calls” led taxpayer to valuation closer to Court’s than
Commissioner’s), vacated and remanded, 499 F.3d 129 (2d Cir. 2007).
No penalties apply, and
Decisions will be entered under
Rule 155.