132 T.C. No. 6
UNITED STATES TAX COURT
OCMULGEE FIELDS, INC., Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 967-07. Filed March 31, 2009.
P transferred appreciated real property to a qualified intermediary, which sold the property and used the proceeds to purchase from a person related to P like-kind property, which it transferred to P.
Held: P has failed to prove the absence of a principal purpose of Federal income tax avoidance; P’s exchange with the qualified intermediary is part of a transaction structured to avoid the purposes of sec. 1031(f), I.R.C., governing like-kind exchanges between related persons, and, under sec. 1031(f)(4), I.R.C., the nonrecognition provisions of sec. 1031, I.R.C., do not apply to the exchange.
David D. Aughtry and David W. Siegel, for petitioner.
Vicki J. Hyche and Clinton M. Fried, for respondent. - 2 -
HALPERN, Judge: By notice of deficiency (the notice),
respondent determined a deficiency of $2,015,862 in petitioner’s
Federal income tax for its taxable year ended May 31, 2004
(taxable year 2004), and an accuracy-related penalty of $403,172.
Unless otherwise indicated, all section references are to
the Internal Revenue Code of 1986, as amended and in effect for
taxable year 2004, and all Rule references are to the Tax Court
Rules of Practice and Procedure.
The deficiency determination is the result of respondent’s
adjustment requiring that petitioner recognize the gain it
realized on the following transaction: (1) Petitioner
transferred appreciated real property to a “qualified
intermediary” (qualified intermediary), (2) an unrelated third
party purchased the property from the qualified intermediary for
cash, (3) a person related to petitioner sold like-kind property
to the qualified intermediary for cash, (4) the qualified
intermediary transferred the like-kind property to petitioner,
and (5) petitioner realized a gain on the exchange. Petitioner
claims that its exchange is a nontaxable exchange under the so-
called like-kind exchange rules found in section 1031.
Respondent claims that section 1031(f)(4) requires recognition
because petitioner “structured” the transaction “to avoid the
purposes” of the rules for exchanges between related persons.
Respondent concedes that, but for the application of section - 3 -
1031(f)(4), petitioner’s exchange with the qualified intermediary
qualifies for nonrecognition treatment under section 1031.
Because we agree with respondent, we deny petitioner
nonrecognition under section 1031(a)(1). We do not sustain
respondent’s determination of an accuracy-related penalty.
FINDINGS OF FACT
Some facts have been stipulated and are so found. The
stipulation of facts, with attached exhibits, is incorporated
herein by this reference. Petitioner is a corporation organized
in the State of Georgia. At the time it filed the petition, its
principal place of business was in Macon, Georgia (Macon).
Petitioner
Petitioner was organized in 1973 by Charles H. Jones
(Charles Jones). Petitioner develops, owns, and manages real
estate located primarily in middle Georgia, an area including
Macon. During taxable year 2004, petitioner’s principal
shareholders were Charles Jones, his sons Dwight C. and C.
Jefferson (Dwight Jones and Jeff Jones, respectively), and Jones
Family Partnership, which was owned one-third each by Charles
Jones, Dwight Jones, and Jeff Jones. During taxable year 2004,
Dwight Jones was president of petitioner.
During taxable year 2004, Charles Jones, his sons, and their
related entities were among the largest owners of commercial
property, including shopping centers and office buildings, in - 4 -
middle Georgia. At the beginning of taxable year 2004,
petitioner’s real properties included the Wesleyan Station
Shopping Center (Wesleyan Station) and part of the Rivergate
Shopping Center (Rivergate), both in Macon.
The term “Barnes & Noble Corner” is the term petitioner uses
(which we shall adopt) to describe three parcels of real property
in Rivergate. Petitioner had owned the Barnes & Noble Corner
before selling it in 1996 to Treaty Fields, L.L.C. (Treaty
Fields). At the time of that sale, the Barnes & Noble Corner was
undeveloped real property. Petitioner sold it so that the
benefit of developing it would accrue to Treaty Fields.
Treaty Fields
Treaty Fields is a Georgia limited liability company that
Dwight Jones organized in 1996. At all times here pertinent, it
was owned by Dwight Jones and Charles Jones.
The McEachern Agreement
During the spring of 2003, Dwight Jones met Scott Wilson
(Mr. Wilson), a licensed real estate broker. Mr. Wilson told
Dwight Jones that he was looking for income-producing commercial
real estate. He asked him whether petitioner had any for sale.
They discussed Wesleyan Station. Although petitioner had not
listed Wesleyan Station for sale or otherwise marketed it,
petitioner agreed to sell it. On July 17, 2003, petitioner
entered into an agreement (the McEachern agreement) for the sale - 5 -
of Wesleyan Station to two testamentary trusts under the will of
John McEachern and to Mr. Wilson (the son-in-law of John
McEachern). Among other things, the McEachern agreement
provides: (1) The purchase price would be $7,250,000, (2) the
closing would take place on or before October 10, 2003, (3)
petitioner intended to conduct the transaction as part of an
exchange of property qualifying for nonrecognition to petitioner
under section 1031, and (4) in light of (3), petitioner could
assign its interest in the agreement to a qualified intermediary.
Petitioner’s Search for Replacement Property
Raymond Pippin (Mr. Pippin) is a certified public accountant
(C.P.A.) and a member of the Macon accounting firm McNair,
McLemore, Middlebrooks & Co., L.L.P. (McNair). McNair is the
largest accounting firm in the Macon area, and it has as clients
more real estate developers than any other accounting firm in
Macon. Mr. Pippin services more of those clients (including
petitioner) than anyone else at McNair. Even before petitioner
entered into the McEachern agreement, Dwight Jones had asked Mr.
Pippin whether he was aware of any income-producing commercial
real property in the Macon area that could be acquired to replace
Wesleyan Station. Petitioner’s requirements for replacement
property were that it be income-producing commercial real
property in middle Georgia worth more than $7 million. Mr.
Pippin indicated that he was not aware of any such property, and - 6 -
Dwight Jones asked him to keep his eyes open. Dwight Jones also
asked petitioner’s real estate lawyer and two commercial real
estate brokers to help him find suitable replacement property.
In addition, Mr. Wilson (also a broker) offered to help
petitioner find replacement property.
As stated, the deadline for closing the McEachern agreement
was October 10, 2003. Before that date, petitioner had
considered and rejected for various reasons at least six possible
replacement properties presented by brokers. As the date
approached, Dwight Jones considered the possibility of
petitioner’s reacquiring the Barnes & Noble Corner as replacement
property.
On October 9, 2003, petitioner engaged Security Bank of Bibb
County, Macon, Georgia (Security Bank), as a qualified
intermediary. On that date, it assigned its rights to sell
Wesleyan Station to Security Bank. On October 10, 2003, Security
Bank, as a qualified intermediary for petitioner, sold Wesleyan
Station as called for in the McEachern agreement.
Petitioner’s Receipt of the Barnes & Noble Corner
Petitioner settled on the Barnes & Noble Corner as
appropriate replacement property. On October 15, 2003,
petitioner and Treaty Fields entered into a contract of purchase
with respect to that property. Petitioner subsequently
transferred its rights under that contract to Security Bank, and - 7 -
petitioner received the Barnes & Noble Corner on November 4,
2003. Treaty Fields filed a Form 1065, U.S. Return of
Partnership Income, for 2003, reporting the disposition of the
Barnes & Noble Corner as a taxable sale. It reported that the
amount realized on the sale was $6,740,900,1 its adjusted basis
in the property sold was $2,554,901, and it realized a gain of
$4,185,999.
Petitioner’s Taxable Year 2004 Federal Income Tax Return
For taxable year 2004, petitioner filed Form 1120, U.S.
Corporation Income Tax Return (petitioner’s 2004 Form 1120).
Petitioner reported the disposition of Wesleyan Station as a
like-kind exchange on an attached Form 8824, Like-Kind Exchanges.
It reported that the amount realized on the exchange was
$6,838,900, its adjusted basis in the property exchanged and its
expenses related to the exchange were $716,164, and it realized a
gain of $6,122,736. It reported that its basis in the property
received (the Barnes & Noble Corner) was $716,164, and, under the
heading of part II, “Related Party Exchange Information”, it
identified Treaty Fields as the related party. It also reported
on another form installment sale income of $475,396, resulting
from the acceleration of payments due petitioner from Treaty
1 We recognize that $6,740,900 differs from both the purchase price of $7,250,000 stated in the McEachern agreement and the $6,838,900 reported as realized by petitioner on its 2004 Form 1120. See infra. Those discrepancies do not bother the parties and, therefore, do not bother us. - 8 -
Fields on account of petitioner’s previous 1996 sale of the
Barnes & Noble Corner to Treaty Fields.
Mr. Pippin prepared petitioner’s 2004 Form 1120, including
Form 8824. Charles Jones and Dwight Jones had great confidence
in Mr. Pippin. They had relied on him and his firm for tax
advice for many years. They relied on him to prepare properly
petitioner’s 2004 Form 1120.
Respondent’s Determination
Respondent’s determination of a deficiency is principally
based on his adjustment increasing petitioner’s gross income by
$6,122,736 on account of its exchange with Security Bank of
Wesleyan Station for the Barnes & Noble Corner. Respondent
explained his adjustment in an attachment to the notice as
follows: “[Y]ou have not established that you have met all of
the requirements of Section 1031(f) for nonrecognition of that
gain.”
OPINION
I. Introduction
We shall first address the deficiency in tax and then
address the accuracy-related penalty.
II. The Deficiency in Tax
A. Introduction
Petitioner reported on its 2004 Form 1120 that it realized a
gain of $6,122,736 on its exchange of one parcel of real property - 9 -
(Wesleyan Station) for three others (the Barnes & Noble Corner).
The only question we must answer is whether the exchange fails to
qualify for nonrecognition treatment under section 1031(a) on
account of the special rules applicable to exchanges between
related persons found in section 1031(f). We shall describe the
relevant provisions of section 1031 and the accompanying
regulations, set forth the parties’ arguments, settle two
questions with respect to proof, and make our analysis. As
stated, we conclude that petitioner does not qualify for
nonrecognition under section 1031(a).
B. Section 1031
Section 1031(a)(1) provides that no gain or loss shall be
recognized on the exchange of property held for productive use in
a trade or business or for investment if the property is
exchanged solely for property of a like kind that is to be held
either for productive use in a trade or business or for
investment. Under section 1031(d), the basis of property
acquired in a section 1031 exchange is the same as the basis of
the property exchanged, decreased by any money the taxpayer
receives and increased by any gain the taxpayer recognizes.
Section 1031 and the regulations thereunder allow for
deferred exchanges of property. Under section 1031(a)(3) and
section 1.1031(k)-1(b), Income Tax Regs., however, the property a
taxpayer receives in the exchange (replacement property) must be - 10 -
(1) identified within 45 days of the transfer of the property
relinquished in the exchange (relinquished property) and (2)
received by the earlier of 180 days after the transfer of the
relinquished property or the due date (including extensions) of
the transferor’s tax return for the taxable year in which the
relinquished property is transferred.
Section 1.1031(k)-1(g)(4), Income Tax Regs., allows a
taxpayer to use a qualified intermediary to facilitate a
like-kind exchange. The qualified intermediary is not considered
the agent of the taxpayer for purposes of section 1031(a). Sec.
1.1031(k)-1(g)(4)(i), Income Tax Regs. In the case of a transfer
of relinquished property involving a qualified intermediary, the
taxpayer’s transfer of relinquished property to a qualified
intermediary and subsequent receipt of like-kind replacement
property from the qualified intermediary is treated as an
exchange with the qualified intermediary. Id.
Section 1031(f) provides special rules for property
exchanged between related persons. In pertinent part, it
provides as follows:
SEC. 1031(f). Special Rules for Exchanges Between Related Persons.--
(1) In general.--If–
(A) a taxpayer exchanges property with a related person,
(B) there is nonrecognition of gain or loss to the taxpayer under this - 11 -
section with respect to the exchange of such property (determined without regard to this subsection), and
(C) before the date 2 years after the date of the last transfer which was part of such exchange--
(i) the related person disposes of such property, or
(ii) the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer,
there shall be no nonrecognition of gain or loss under this section to the taxpayer with respect to such exchange * * *.
(2) Certain dispositions not taken into account.-- For purposes of paragraph (1)(C), there shall not be taken into account any disposition–-
* * * * * * *
(C) with respect to which it is established to the satisfaction of the Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax.
(4) Treatment of certain transactions.-- This section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection. - 12 -
C. Arguments of the Parties
1. Petitioner’s Arguments
Petitioner’s argument with respect to section 1031(f) is
straightforward. On or before the date it entered into the
McEachern agreement, petitioner formed a plan to replace Wesleyan
Station with property from an unrelated person. Only when its
search for appropriate property owned by an unrelated person
proved unfruitful and the deadline to close under the McEachern
agreement approached did petitioner consider replacing Wesleyan
Station with the Barnes & Noble Corner. It chose to do so for
business reasons (to reunite its ownership of the Barnes & Noble
Corner with its ownership of the rest of Rivergate) and in the
face of advice from its accountant and tax adviser (Mr. Pippin)
that the decision would result in higher taxes. Therefore,
concludes petitioner, it lacked intent to avoid the provisions of
section 1031(f). Petitioner also argues that respondent bears
the burden of proof.
2. Respondent’s Arguments
Respondent’s argument with respect to section 1031(f) is
equally straightforward. The facts in this case are similar to
those in Teruya Bros., Ltd. & Subs. v. Commissioner, 124 T.C. 45
(2005), a case involving the section 1031 rules applicable to
exchanges between related persons. In that case, we found that a
qualified intermediary was interposed in an attempt to circumvent - 13 -
the limitation in section 1031(f)(1) that would have applied to
an exchange directly between related persons, and the taxpayer
failed to show that tax avoidance was not one of the principal
purposes of the transactions. We concluded that the transactions
were structured to avoid the purposes of section 1031(f) and,
consequently, pursuant to section 1031(f)(4), the taxpayer was
not entitled to nonrecognition under section 1031(a)(1).
Respondent argues for the same result here.
Respondent denies that he bears the burden of proof.
D. Questions Relating to Proof
1. Burden of Proof
The parties argue over who bears the burden of proof,
particularly with respect to petitioner’s eligibility for the
non-tax-avoidance exception found in section 1031(f)(2)(C).
Petitioner argues that respondent bears the burden for three
reasons.
First, petitioner argues that respondent bears the burden of
proof because his explanation of his adjustment increasing
petitioner’s gross income (viz, “you have not established that
you have met all of the requirements of Section 1031(f) for
nonrecognition”) is inadequate because it “contains no
affirmative factual determination that could be presumptively
correct.” Petitioner’s argument is misguided. There is no
requirement that a notice of deficiency that adequately informs - 14 -
the taxpayer of the basis for the deficiency contain a factual
determination. Often, particularly with respect to deductions,
we have said: “[A] taxpayer bears the burden of proof, and
respondent’s determinations are entitled to a presumption of
correctness.” E.g., Shafrir v. Commissioner, T.C. Memo. 2008-280
(emphasis added). That does not require that the Commissioner
lay out the factual predicate for his determination. The
determination referred to is the Commissioner’s deficiency
determination, not any underlying factual determination. See
sec. 6212(a) (“If the Secretary determines that there is a
deficiency”.). Section 7522(a) requires that the notice
“describe the basis for, and identify the amounts (if any) of,
the tax due, interest, additional amounts, additions to the tax,
and assessable penalties included in such notice.” The final
sentence of section 7522(a) provides: “An inadequate description
under the preceding [quoted] sentence shall not invalidate such
notice.” Respondent’s explanation of his deficiency
determination informed petitioner that it was required to
recognize gain because it had not established that it had
satisfied the section 1031(f) special rules applicable to like-
kind exchanges between related parties. In that respect, Shea v.
Commissioner, 112 T.C. 183, 192 (1999), is distinguishable. The
notice was adequate in all respects, and there is nothing about - 15 -
respondent’s explanation of his adjustment that bears on who
bears the burden of proof.
Second, petitioner argues that respondent bears the burden
of proof because “the ‘failure-to-establish’ non-assertion is
arbitrary and capricious”, purportedly because respondent failed
to consider intent. We believe that petitioner’s second argument
is directed to the section 1031(f)(2)(C) requirement that the
taxpayer establish the absence of a principal purpose of tax
avoidance. We do so because, in its reply brief, under the
heading “Burden of Proof”, petitioner incorporates a portion of
its pretrial memorandum in which it states: “In particular,
nowhere does the Notice contain the Section 1031(f)(2)(C)
statutorily-mandated determination as to the presence or absence
of a principal purpose of tax avoidance.” As established in the
immediately preceding paragraph, the notice is sufficient.
Moreover, as discussed infra in section II.E.2.b. of this report,
the evidence establishes that, because of a deemed exchange,
basis shift, and sale of Wesleyan Station by Treaty Fields,
petitioner and Treaty Fields avoided approximately $1.8 million
of gain recognition. Respondent makes clear in his pretrial
memorandum his assumption that the deemed exchange and sale had
as a principal purpose Federal income tax avoidance. We find
that assumption neither arbitrary nor capricious. Petitioner has
failed to convince us with its second argument that respondent - 16 -
bears the burden of proving that petitioner had a principal
purpose of tax avoidance.
Finally, petitioner argues that respondent bears the burden
of proof under section 7491(a)(1). In pertinent part, Rule
142(a)(1) provides, as a general rule: “The burden of proof
shall be upon the petitioner”. In certain circumstances,
however, if the taxpayer introduces credible evidence with
respect to any factual issue relevant to ascertaining the proper
tax liability, section 7491 places the burden of proof on the
Commissioner. See sec. 7491(a)(1); Rule 142(a)(2). Credible
evidence is evidence that, after critical analysis, a court would
find constituted a sufficient basis for a decision on the issue
in favor of the taxpayer if no contrary evidence were submitted.
Baker v. Commissioner, 122 T.C. 143, 168 (2004); Bernardo v.
Commissioner, T.C. Memo. 2004-199 n.6. Petitioner’s argument
fails because, for the reasons discussed infra in section
II.E.2.b. of this report, petitioner has not introduced credible
evidence of the absence of a principal purpose of tax avoidance.2
It follows that petitioner retains the burden of proving the
absence of that prohibited purpose, a burden that, because of the
absence of credible evidence on that issue, petitioner cannot
sustain. See Bernardo v. Commissioner, supra n.7; see also
2 See the discussion infra in sec. II.D.2. of this report as to what would constitute credible evidence in this case. - 17 -
Rendall v. Commissioner, 535 F.3d 1221, 1225 (10th Cir. 2008)
(citing Bernardo), affg. T.C. Memo. 2006-174. Therefore, our
discussion of that issue may be viewed as setting forth the basis
for our determination that petitioner has failed to (1) introduce
credible evidence and (2) carry its burden of proof. See
Bernardo v. Commissioner, supra; see also Rendall v.
Commissioner, supra at 1225.
2. Measure of Persuasion
To satisfy the non-tax-avoidance exception found in section
1031(f)(2)(C), the Secretary must be satisfied as to the absence
of a principal purpose of Federal income tax avoidance.
Respondent “acknowledges that the Secretary’s discretion is not
limitless.” He argues that, nevertheless, the measure of
persuasion that petitioner must satisfy to show that the
Secretary abused his discretion is great, and to satisfy that
measure petitioner must show by “substantial evidence” the
absence of the prohibited purpose. Petitioner argues for a
“strong proof” measure. In Teruya Bros., Ltd. & Subs. v.
Commissioner, 124 T.C. at 54 n.12, we stated that, although we
have applied a “strong proof” measure in other contexts involving
language similar to the “satisfaction of the Secretary” language
in section 1031(f)(2)(C), because the measure made no difference
to the outcome of the case, we would not apply a more than usual
measure of persuasion. Here, the measure of persuasion also - 18 -
makes no difference. Petitioner cannot satisfy the usual measure
of persuasion required to prove a fact in this court; viz, a
preponderance of the evidence. See Merkel v. Commissioner, 109
T.C. 463, 476 (1997), affd. 192 F.3d 844 (9th Cir. 1999).
E. Analysis
1. Avoiding the Purposes of the Rules Governing Exchanges Between Related Parties
Petitioner is denied nonrecognition treatment on its
exchange of Wesleyan Station with Security Bank for the Barnes &
Noble Corner if the exchange was part of a transaction or series
of transactions structured to avoid the purposes of the rules
found in section 1031(f) governing exchanges between related
persons. See sec. 1031(f)(4). We begin by considering the
history of those rules and our interpretation of them in Teruya
Bros.
Replacement property acquired in a like-kind exchange
generally takes the basis of the property relinquished. See sec.
1031(d). In effect, the basis of the relinquished property
shifts to the replacement property. In the absence of the
general rule of section 1031(f)(1), a taxpayer anticipating the
sale of low basis property might be tempted to exchange the low
basis property for high basis property owned by a related person,
with the related person then selling the property received in the
exchange at a reduced gain (or possibly a loss) because of the
shift to that property of his high basis in the property he - 19 -
relinquished.3 See Teruya Bros., Ltd. & Subs. v. Commissioner,
supra at 51-53. In Teruya Bros., we said this about the history
of section 1031(f): “Congress concluded that if a related party
exchange is followed shortly thereafter by a disposition of the
property, the related parties have, in effect, ‘cashed out’ of
the investment, and the original exchange should not be accorded
nonrecognition treatment.” Id. at 52 (certain quotation marks
and citation omitted). We explained section 1031(f)(4) as
reflecting Congress’s concern that related persons not be able to
circumvent the purposes of section 1031(f)(1) by interposing an
exchange with an unrelated third party. Id.
The essential facts of Teruya Bros. are as follows. The
taxpayer negotiated the sale of relatively low basis real
property to an unrelated person. In anticipation of the sale,
the taxpayer arranged to purchase relatively high basis
replacement property from a related person. To carry out the
transaction, the taxpayer arranged for a qualified intermediary
to acquire the property the taxpayer had agreed to sell and to
sell it to the unrelated person, to use the proceeds to purchase
the replacement property from the related person, and then to
transfer that replacement property to the taxpayer.
3 Or if the property he receives is received in an exchange not qualifying for nonrecognition treatment, at his tax cost for that property. See sec. 1012; Phila. Park Amusement Co. v. United States, 130 Ct. Cl. 166, 126 F. Supp. 184, 189 (1954). - 20 -
In Teruya Bros., Ltd. & Subs. v. Commissioner, supra at 53,
we concluded that the described transaction was economically
equivalent to a direct exchange of properties between the
taxpayer and the related person, followed by the related person’s
sale of the property it received to an unrelated third party. We
stated that the interposition of a qualified intermediary in the
transactions could not obscure the end result. Id. Because the
deemed exchange and sale was described in section 1031(f)(1), we
then looked to see whether avoidance of Federal income tax was
one of the principal purposes of the deemed exchange. Id. at 54.
We did so because we had concluded that the non-tax-avoidance
exception of section 1031(f)(2)(C) “is subsumed within the
purposes of section 1031(f), [and] any inquiry into whether a
transaction is structured to avoid the purposes of section
1031(f) should * * * take this exception into consideration.”
Id. at 53. We rejected the taxpayer’s argument that it met the
requirements of the exception. We restated our observation:
“The economic substance of the transactions remains that the
investments in * * * [the relinquished properties] were cashed
out immediately and * * * [the related person] ended up with the
cash proceeds.” Id. at 55. We detailed the tax savings to the
taxpayer and the related person resulting from the redirection of
the proceeds from the sale of the relinquished property to the
related person. Id. We concluded that (1) the taxpayer had - 21 -
failed to prove that tax avoidance was not one of the principal
purposes of the two transactions and (2) the taxpayer had
interposed the qualified intermediary to avoid the tax
consequences of an economically equivalent direct exchange with
the related person. Id. at 54-55.
2. Non-Tax-Avoidance Exception
The transaction at bar is similar to the transaction in
Teruya Bros. Petitioner exchanged Wesleyan Station with a third
party, Security Bank, a qualified intermediary, for replacement
property, the Barnes & Noble Corner, formerly owned by a related
person, Treaty Fields. Between the two legs of that exchange,
Security Bank sold Wesleyan Station to an unrelated third party
and used the proceeds to acquire the replacement property from
Treaty Fields. Petitioner does not dispute that, within the
meaning of section 1031(f)(3), Treaty Fields is a related person.
To determine whether petitioner’s exchange with Security
Bank was part of a transaction or series of transactions
structured to avoid the purposes of section 1031(f), we must
disregard that exchange and consider how petitioner would have
fared had it instead exchanged Wesleyan Station with Treaty
Fields for the Barnes & Noble Corner and had Treaty Fields then
sold Wesleyan Station. We must determine whether, assuming those - 22 -
hypothetical facts, petitioner has shown the absence of a
principal purpose of Federal income tax avoidance.
b. Application of Section 1031(f)(2)(C) to the Deemed Exchange
Petitioner must establish that neither its deemed exchange
of Wesleyan Station with Treaty Fields nor Treaty Fields’s deemed
sale of that property had avoidance of Federal income tax as one
of its principal purposes. See sec. 1031(f)(2)(C).
H. Conf. Rept. 101-386 (1989) is the report of the committee
of conference (the conference report) that accompanied H.R. 3299,
101st Cong., 1st Sess. (1989), which, as enacted, became the
Omnibus Budget Reconciliation Act of 1989 (OBRA), Pub. L.
101-239, 103 Stat. 2106. OBRA section 7601(a), 103 Stat. 2370,
added section 1031(f). With respect to that addition, the
conference report states:
The Senate amendment is the same as the House bill, except that the * * * [Committee on Finance] report provides that the non-tax avoidance exception generally will apply to (1) transactions involving certain exchanges of undivided interests, (2) dispositions in nonrecognition transactions, and (3) transactions that do not involved [sic] the shifting of basis between properties. [H. Conf. Rept. 101-386, supra at 614].
The conference report further states that (with respect to the
addition of section 1031(f)) the conference agreement follows the
Senate amendment. Id.
If Treaty Fields had received Wesleyan Station from
petitioner in exchange for the Barnes & Noble Corner, Treaty - 23 -
Fields’s adjusted basis of $2,554,901 in the Barnes & Noble
Corner would have shifted to Wesleyan Station (which, in
petitioner’s hands, had a basis of only around $716,164).
Because of that step-up in basis, Treaty Fields would have
realized a gain on the sale of Wesleyan Station approximately
$1.8 million less than petitioner would have realized had it
forgone an exchange with Treaty Fields and sold Wesleyan Station
itself. While the conference report identifies transactions not
involving basis shifting as transactions generally lacking
Federal income tax avoidance as a principal purpose, a fair
inference to be drawn from the report is that Federal income tax
avoidance generally is a principal purpose of transactions
involving basis shifting. Indeed, petitioner appears to concede
the point: “[I]f all other factors were equal * * *, a basis
differential may supply the principal purpose of tax avoidance.”
Petitioner adds: “It is equally true, however, that the tax
impact of a basis differential may be overridden and reversed by
more important tax considerations such as rate differentials,
lost elections, and the like–-not to mention non-tax
considerations.” Petitioner lists five “monumental” tax factors
that, it argues, override the basis differential that it concedes
existed here:
(i) the immediate tax on Treaty Fields’ sale of the Barnes & Noble Corner, (ii) the immediate tax to * * * [petitioner] on the outstanding installment note from Treaty Fields from the earlier sale of the Barnes & - 24 -
Noble Corner to Treaty Fields, (iii) the decrease in depreciation on the Barnes & Noble Corner, (iv) the 34% tax on * * * [petitioner] rather than the 15% tax rate Treaty Fields’ partners would have had on the future sale of the Barnes & Noble Corner, and (v) the sacrifice of the Section 754 election for Charles Jones [upon his death] which would entirely eliminate 70 percent of the gain from the future sale of the Barnes & Noble Corner to a third party if Treaty Fields had retained ownership.
Although there may be situations in which a taxpayer can
overcome the negative inference to be drawn from basis shifting
and a “cash out”, this is not one of them. Our reaction to
petitioner’s five “monumental” tax factors is as follows. First,
indeed there was an immediate tax on Treaty Fields’s sale of the
Barnes & Noble Corner, but that tax was approximately equal to
the tax it would have paid had it first exchanged the Barnes &
Noble Corner for Wesleyan Station and then sold Wesleyan Station.
Second, while Treaty Fields’s sale of the Barnes & Noble Corner
resulted in the acceleration of $475,396 in installment income to
petitioner, the result was not the addition of some new tax
burden but merely the acceleration of a deferred tax burden,
equivalent in consequence to the early call of a loan.
Petitioner has failed to quantify the associated cost, which
surely was much less than $475,396. Third, petitioner’s adjusted
basis in Wesleyan Station shifted to the Barnes & Noble Corner
and, therefore, it gave up no depreciable basis. Treaty Fields’s
adjusted basis in the Barnes & Noble Corner offset the amount it
realized on the sale of that property to Security Bank. The - 25 -
proceeds of the sale, perhaps reduced by a distribution to Treaty
Fields’s members to pay tax, were available for reinvestment in
new depreciable property. Fourth, petitioner focuses on the tax
rate differential between gain taxable to petitioner (34 percent)
and gain taxable to Treaty Fields’s members (15 percent, Treaty
Fields being a pass-through entity whose members (individuals)
are taxed on capital gains at rates not available to corporate
taxpayers, like petitioner). Petitioner ignores that, if its
exchange with Security Bank is recast as an exchange with Treaty
Fields followed by Treaty Fields’s sale of Wesleyan Station, the
deemed exchange not only shifted Treaty Fields’s basis in the
Barnes & Noble Corner to Wesleyan Station, reducing the amount of
gain deemed recognized by Treaty Fields, but also subjected that
gain to the 15-percent tax rate on gain taxable to Treaty
Fields’s members rather than the 34-percent tax rate that
petitioner would have incurred had it sold the property itself.
Moreover, petitioner’s supposition as to what tax petitioner
might pay in the future on a supposed taxable sale of the Barnes
& Noble Corner is too speculative for us to take into account, as
is petitioner’s fifth argument concerning a section 754 election
made following Charles Jones’s death.
We are not prepared to say that, as a matter of law, a
finding of basis shifting precludes the absence of a principal
purpose of tax avoidance, but, in this case, the immediate tax - 26 -
consequences resulting from petitioner’s deemed exchange with
Treaty Fields included an approximately $1.8 million reduction in
taxable gain and the substitution of a 15-percent tax rate for a
34-percent tax rate. The tax savings are plain, and petitioner’s
counterfactors are unconvincing or speculative. Petitioner has
failed to convince us that tax avoidance was not a principal
purpose of the deemed exchange.
Petitioner offers as a business reason for exchanging
Wesleyan Station for the Barnes & Noble Corner that the exchange
allowed petitioner to reunite ownership of the Barnes & Noble
Corner with the rest of Rivergate and yielded operating
efficiencies and increased the overall value of the reunited
property. Yet, beyond self-serving testimony, petitioner offers
no evidence to support that claim. We need not, and do not,
accept that testimony. See Mendes v. Commissioner, 121 T.C. 308,
320 (2003) (“This Court is not bound to accept a taxpayer's
self-serving, unverified, and undocumented testimony.”).
Moreover, even had petitioner shown a legitimate business purpose
for the acquisition of the Barnes & Noble Corner, that would not
necessarily preclude a finding that either the deemed exchange of
Wesleyan Station for the Barnes & Noble Corner or Treaty Fields’s
deemed sale of Wesleyan Station had as a principal purpose the
avoidance of Federal income tax. See sec. 1031(f)(2)(C). - 27 -
c. Teruya Bros. Distinguished
Petitioner argues that there is a critical difference
between the transaction at bar and the transaction in Teruya
Bros., Ltd. & Subs. v. Commissioner, 124 T.C. 45 (2005):
“[Petitioner] did NOT structure the Wesleyan Station exchange
with the intention of avoiding the purposes of subsection
1031(f)”. Petitioner argues that there was no “prearranged plan”
for Security Bank to acquire the Barnes & Noble Corner and to
exchange it with petitioner: “[Petitioner] affirmatively planned
all along to swap Wesleyan Station through a Qualified
Intermediary for new replacement property owned by a completely
unrelated third party.”
Apparently, petitioner seeks to rely on a negative inference
to be drawn from an example in the legislative history of section
1031(f). H. Rept. 101-247 (1989) is the report of the Committee
on the Budget4 that accompanied H.R. 3299, 101st Cong., 1st Sess.
(1989), which, as enacted, became OBRA. As stated, OBRA section
7601(a) added section 1031(f). With respect to that addition,
the report provides the following example of a transaction that
would violate section 1031(f)(4):
[I]f a taxpayer, pursuant to a prearranged plan, transfers property to an unrelated party who then exchanges the property with a party related to the taxpayer within 2 years
4 Including as tit. XI of the report, from the Committee on Ways and Means, an explanation of the revenue provisions of the accompanying bill, which, among other things, added sec. 1031(f). - 28 -
of the previous transfer in a transaction otherwise qualifying under section 1031, the related party will not be entitled to nonrecognition treatment under section 1031. [H. Rept. 101-247, supra at 1341.]
Petitioner seems to believe that the presence or absence of a
“prearranged plan” is dispositive of a violation of section
1031(f)(4). Petitioner insists that it, unlike the taxpayer in
Teruya Bros., had no prearranged plan to use property from a
related person to complete a like-kind exchange. Although we set
forth the above example in Teruya Bros., and although the
taxpayer in that case did have a prearranged plan, we did not
make much of that fact. Indeed, outside of the example, we did
not even use the phrase. See Teruya Bros., Ltd. & Subs. v.
Commissioner, supra. The example, therefore, is just that: one
of many transactions that will fall afoul of section 1031(f)(4).5
As stated supra in section II.E.2.b. of this report, in
considering whether petitioner’s actual exchange with Security
determine whether, with respect to a hypothetical direct exchange
of properties between petitioner and Treaty Fields followed by a
hypothetical sale by Treaty Fields of the property received,
5 In Teruya Bros., Ltd. & Subs. v. Commissioner, 124 T.C. 45, 53 (2005), we described the example as “highly elliptical”. A commentator has said of it: “Because of the way this example is drafted, it appears not to make the point for which it is offered.” Mandarino, “Reconciling Rulings on Related Party Like- Kind Exchanges”, 30 Real Estate Taxn. 174, 175 (2003). - 29 -
petitioner has shown the absence of a principal purpose of
Federal income tax avoidance. Even if petitioner convinced us
that the actual exchange was not prearranged (which it has not6),
we would still need to determine the application to the
hypothetical facts of the non-tax-avoidance exception of section
1031(f)(2)(C).
d. Conclusion
Petitioner has failed to prove that neither its deemed
exchange of Wesleyan Station with Treaty Fields for the Barnes &
Noble Corner nor Treaty Fields’s deemed sale of Wesleyan Station
thereafter had as one of its principal purposes the avoidance of
Federal income tax.
6 While the uncontradicted testimony of petitioner’s witnesses is that, at least initially, petitioner planned to swap Wesleyan Station for property from an unrelated person, petitioner had turned its attention exclusively to the Barnes & Noble Corner by Oct. 9, 2003, the day it engaged Security Bank as qualified intermediary and 1 day before Security Bank sold Wesleyan Station on petitioner’s behalf. Indeed, petitioner’s president, Dwight Jones, testified that the sec. 1031(a)(3)(A) deadline of 45 days after the transfer of relinquished property to identify replacement property is so short a period to negotiate price and to do due diligence that to identify and designate replacement property within that period is “just about impossible”. Moreover, on Oct. 15, 2003, 6 days after petitioner relinquished Wesleyan Station, it agreed to purchase the Barnes & Noble Corner from Treaty Fields. Taking into account Dwight Jones’s testimony about the time constraints imposed by sec. 1031(a)(3)(A), that indicates to us that petitioner had sometime before that date identified the Barnes & Noble Corner as the replacement property for Wesleyan Station. We believe that, on Oct. 10, 2003, the day Security Bank sold Wesleyan Station for petitioner, petitioner had a “prearranged plan” for the Barnes & Noble Corner to be received in exchange, and we so find. - 30 -
3. Conclusion
The end result of petitioner’s exchange of Wesleyan Station
with Security Bank for the Barnes & Noble Corner is the same as
if petitioner had made an exchange of Wesleyan Station with
Treaty Fields followed by Treaty Fields’s sale of Wesleyan
Station. Petitioner has failed to show that the deemed
transaction lacked as a principal purpose the avoidance of
Federal income tax. Therefore, the actual exchange is part of a
transaction structured to avoid the purposes of section 1031(f)
and, under section 1031(f)(4), the nonrecognition provisions of
section 1031 do not apply to that exchange.
F. Conclusion
We sustain the deficiency in tax respondent determined.
III. Section 6662 Accuracy-Related Penalty
A. Applicable Law
Section 6662(a) provides for an accuracy-related penalty
equal to 20 percent of the portion of any underpayment of tax
attributable to, among other things, negligence or intentional
disregard of rules or regulations (without distinction,
negligence), any substantial understatement of income tax, or any
substantial valuation misstatement. See sec. 6662(b)(1)-(3).
Although the notice states that respondent bases his imposition
of a penalty of $403,172 on “one or more” of those three grounds, - 31 -
on brief he relies on only the first two of those grounds:
negligence and substantial understatement of income tax.
Negligence has been defined as lack of due care or failure
to do what a reasonably prudent person would do under like
circumstances. See, e.g., Hofstetter v. Commissioner, 98 T.C.
695, 704 (1992). It also “includes any failure to make a
reasonable attempt to comply with the provisions of the internal
revenue laws or to exercise ordinary and reasonable care in the
preparation of a tax return.” Sec. 1.6662-3(b)(1), Income Tax
Regs.
For corporations such as petitioner, a substantial
understatement of income tax exists if the amount of the
understatement for the taxable year exceeds the greater of (1) 10
percent of the tax required to be shown on the return for the
taxable year, or (2) $10,000. Sec. 6662(d)(1)(B).
Section 6664(c)(1) provides that the accuracy-related
penalty shall not be imposed with respect to any portion of an
underpayment if it is shown that there was reasonable cause for
that portion and the taxpayer acted in good faith with respect to
that portion. Further:
The determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances. * * * Reliance on * * * professional advice * * * constitutes reasonable cause and good faith if, under all the circumstances, such reliance was reasonable and the taxpayer acted in good faith. * * * - 32 -
Sec. 1.6664-4(b)(1), Income Tax Regs.; see also sec. 1.6664-4(c),
Income Tax Regs. (“Reliance on opinion or advice”).
B. Analysis
There was a substantial understatement of petitioner’s
taxable year 2004 income tax within the meaning of section
6662(d)(1).
the attached Form 8824, which reported the exchange of Wesleyan
Station for the Barnes & Noble Corner as a like-kind exchange.
Mr. Pippin is a C.P.A. and a member of the largest accounting
firm in the Macon area, and he and his firm have more experience
representing real estate developers than anyone else in Macon.
Dwight Jones (petitioner’s president) had relied on Mr. Pippin
and his firm for tax advice for many years. Dwight Jones had
great confidence in him and relied on him to prepare properly
petitioner’s tax returns. Mr. Pippin was aware of all facts
relevant to the exchange of Wesleyan Station for the Barnes &
Noble Corner. He was required to interpret section 1031(f)(4) in
preparing petitioner’s 2004 return. As our exposition of that
section in Teruya Bros., Ltd. & Subs. v. Commissioner, 124 T.C.
45 (2005), and this report show, that provision is not without
its interpretative difficulties. When petitioner filed its 2004
Form 1120, we had not yet decided Teruya Bros. Granted,
respondent had issued a revenue ruling, Rev. Rul. 2002-83, 2002-2 - 33 -
C.B. 927, presaging the result in that case, but we do not think
that the ruling left the result free from doubt or that, given
the facts before him, Mr. Pippin made unreasonable legal
assumptions. We conclude that, with respect to petitioner’s
underpayment in tax attributable to its failure to report the
gain it recognized on the exchange of Wesleyan Station for the
Barnes & Noble Corner, petitioner, in relying on Mr. Pippin to
prepare properly its return, had reasonable cause for the
underpayment and acted in good faith, and we so find.
C. Conclusion
Petitioner is not liable for the section 6662(a) penalty
respondent determined.
An appropriate decision will
be entered for respondent.