Chapman Glen Limited v. Commissioner , 140 T.C. No. 15 ( 2013 )

140 T.C. No. 15UNITED STATES TAX COURT
CHAPMAN GLEN LIMITED, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 29527-07L, 27479-09. Filed May 28, 2013.
In 1998, P was a foreign insurance company that elected under
I.R.C. sec. 953(d) to be treated as a domestic corporation for U.S.
Federal income tax purposes. G signed the election in G’s reported
capacity as P’s secretary. P also applied for and was granted tax-
exempt status as an insurance company effective Jan. 1, 1998. For
2003, P filed a Form 990, Return of Organization Exempt From
Income Tax, that was not signed by one of P’s officers. In 2009, three
years after P consented to R’s revocation of P’s tax-exempt status
effective Jan. 1, 2002, R determined that (1) P’s election was
terminated in 2002 because P was not an insurance company in that
year and (2) P was therefore deemed under I.R.C. secs. 354, 367, and
953(d)(5) to have sold its assets on Jan. 1, 2003, in a taxable
transaction. P’s primary asset on Jan. 1, 2003, was its investment in a
disregarded entity (E) that owned various pieces of real property.
Held: The three-year period of limitations under I.R.C. sec.
6501(a) remains open as to 2003 because P’s Form 990 was not a
valid return in that it was not signed by one of P’s corporate officers.
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Held, further, P properly elected under I.R.C. sec. 953(d) to be
treated as a domestic corporation, and the termination of that election
in 2002 resulted in P’s making a taxable exchange under I.R.C. secs.
354, 367, and 953(d)(5) during a one-day taxable year commencing
and ending on Jan. 1, 2003.
Held, further, E’s real property is included in that taxable
exchange, and the fair market value of the real property is determined.
Held, further, P’s gross income does not include amounts that R
determined were “insurance premiums”, and R may not for the first
time in R’s posttrial opening brief recharacterize the premiums as a
different type of taxable income.
Vicken Abajian and Gary Michael Slavett, for petitioner.
Najah J. Shariff, James C. Hughes, and Michael K. Park, for respondent.
WHERRY, Judge: These cases are consolidated for purposes of trial,
briefing, and opinion. Petitioner petitioned the Court in docket No. 29527-07L to
review the Internal Revenue Service (IRS) Office of Appeals’ determination
sustaining respondent’s proposed levy on petitioner’s property to collect $66,539
in additions to tax for 2004. The additions to tax relate to respondent’s
determination that petitioner failed to timely file Forms 990, Return of
Organization Exempt From Income Tax, and 990-T, Exempt Organization
Business Income Tax Return (and proxy tax under section 6033(e)), for 2004 and
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failed to timely pay the related tax.1 The parties’ only dispute remaining from this
petition is a computational adjustment that turns on the amount of the deficiency
for 2004.
Petitioner petitioned the Court in docket No. 27479-09 to redetermine
respondent’s determination of the following deficiencies and additions to tax under
section 6655:
Addition to tax
Taxable Year Deficiency sec. 6655
2002 $43,719 -0-
Jan. 1 through Jan. 1, 2003 10,130,454 -0-
Jan. 2 through Dec. 31, 2003 113,181 $3,278
2004 111,696 3,191
Respondent alleged in an amendment to answer that the fair market value of real
property underlying the deficiency for the one-day taxable year was $36,589,000
instead of $28,943,229 as determined in the notice of deficiency and that the
deficiency for that year is therefore $12,806,452 instead of $10,130,454.2
Respondent asserts in respondent’s opening brief that recent concessions put the
1
Unless otherwise indicated, section references are to the Internal Revenue
Code of 1986, as amended and in effect for the applicable years (Code), Rule
references are to the Tax Court Rules of Practice and Procedure, and dollar
amounts are rounded to the nearest dollar.
2
Most currently, on the basis of certain concessions that respondent made
after his amendment to answer, respondent alleged in his pretrial memorandum that
the deficiency for the one-day taxable year is $12,693,052.
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applicable value of the real property at $34,607,500. Petitioner argues that the fair
market value of the real property is $13,711,775.
Following concessions (including petitioner’s concessions that it is not an
insurance company and that it does not qualify as a tax-exempt organization under
section 501(c)(15) as of January 1, 2002), we are left to decide the following
issues:
1. whether respondent issued the deficiency notice to petitioner before the
three-year period of limitations of section 6501(a) expired as to 2003;
2. whether petitioner properly elected to be treated as a domestic
corporation under section 953(d);
3. whether the subsequent termination of petitioner’s section 953(d) election
resulted in a taxable exchange under sections 354, 367, and 953(d)(5) during the
one-day taxable year in 2003;
4. whether the real property that Enniss Family Realty I, L.L.C. (EFR),
owned was included in that taxable exchange;
5. whether the fair market value of the real property at the time of the
exchange on January 1, 2003 (valuation date), was $34,607,500 as respondent
asserts; and
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6. whether petitioner’s gross income for the respective taxable years
includes “insurance premiums” of $128,584, $882, $299,178, and $298,000.
FINDINGS OF FACT
I. Preliminaries
The parties submitted stipulated facts and exhibits. We incorporate the
stipulated facts and exhibits herein.3 Petitioner’s principal office was in Lakeside,
California, when its petitions were filed.
Petitioner was formed in the British Virgin Islands as a private international
business company on August 29, 1996. It filed Forms 990 for 2002, 2003, and
2004 (as well as for earlier years). Later, in April 2006, petitioner submitted
Forms 1120-F, U.S. Income Tax Return of a Foreign Corporation, for 2002 and
2003 to the IRS. The IRS did not accept those Forms 1120-F.
3
Petitioner objected on grounds of relevancy to the admission into evidence
of Exhibits 45-J, 46-J, and 47-J. The Court reserved ruling on those objections at
trial. We now overrule the objections and admit the exhibits into evidence. See
Fed. R. Evid. 401 (stating that evidence is relevant if it tends to make the existence
of any fact or consequence more or less probable).
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II. Petitioner
A. Background
Petitioner was formed primarily to operate as an insurance (including
captive insurance and reinsurance) company and to own, develop, and deal in real
property, securities, and personal property. On January 8, 1998, its initial director
resolved that all of petitioner’s stock be issued to Caesar Cavaricci and that Adam
Devone and Bruce Molnar be appointed as petitioner’s directors. The initial
director also resolved that its contemporaneously tendered resignation as
petitioner’s initial director was accepted.
B. Section 953(d) Election
On or about November 16, 1998, petitioner delivered to the IRS a “Foreign
Insurance Company Election Under Section 953(d)” (section 953(d) election),
stating that petitioner was electing under section 953(d) to be treated as a domestic
corporation for U.S. tax purposes effective the first day of petitioner’s taxable year
commencing December 27, 1997. Deanna S. Gilpin signed the election on
November 16, 1998, in her reported capacity as petitioner’s secretary and under
penalty of perjury that the statements therein were true and complete to the best of
her knowledge and belief. On or about March 20, 2000, petitioner submitted to the
IRS a Form 2848, Power of Attorney and Declaration of Representative,
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designating Mr. Molnar, Mr. Cavaricci, and David B. Liptz (an associate of Mr.
Molnar’s) as petitioner’s authorized representatives regarding the section 953(d)
election and other stated matters, as each applied to petitioner’s Federal income tax
for 1996 through 2000.
III. Enniss Family
A. Family Members
The Enniss family (as relevant here) has eight members. Arnold Reid
Enniss (Reid Enniss) and his wife (now deceased), Delpha Enniss, are two of the
members. Their children are the other six members. The children’s names are
Chad Enniss, Wade Enniss, Blake Enniss, Carolyn Sandoval, Kelly Kufa, and Eric
Enniss.
B. Enniss Family Business
The Enniss family has owned and operated a sand mine or quarry through
various entities for over five decades. The related business mines or dredges sand,
topsoil, and other dirt products (collectively, sand) mainly (if not solely) from
riverbeds and markets and sells the mined sand. The Enniss family also for many
years has through various entities owned and operated a general engineering and
general building contracting business and a steel fabrication and erection,
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construction trucking, demolition, and grading business. Each member of the
Enniss family is involved in the family businesses.
The Enniss family began operating the sand mine in the early 1970s through
their controlled corporation, Enniss Enterprises, Inc. In 1987, Enniss Enterprises,
Inc., applied for a major use permit (MUP) with respect to the sand mine. The
sand mine was in Lakeside, and a significant portion of the property was on the
San Vicente Creek riverplain. On April 5, 1990, the San Diego County Planning
and Environmental Review Board approved the MUP, allowing Enniss Enterprises,
Inc., for a 15-year period, to conduct a mining operation that excavated and
removed 2.2 million cubic yards of sand and gravel and conducted related
screening.4 Eventually, from January 2002 through 2004, the sand mine business
was owned and operated by Enniss, Inc. (another entity that the Enniss family
controlled as discussed below). The Enniss family, through their various entities,
excavated approximately 1,708,960 tons of sand (approximately 1,139,307 cubic
yards) from the sand mine from 1990 to 2001.5
4
One cubic yard of sand generally weighs 1-1/2 tons.
5
The parties stipulated that Exhibit 74-J contains the Mining Operation
Annual Reports for Enniss Enterprises, Inc., Enniss, Inc., and Commercial
Conservancy Number One (another Enniss family controlled entity d.b.a. Enniss
Enterprises) for 1991 through 2001 and 2003 through 2009. Respondent in his
opening brief cited this exhibit and proposed that the Court find that approximately
(continued...)
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IV. Lawsuit
In February 1998, an employee of the Enniss family business was seriously
injured while at work, and he sued some or all of the Enniss family members both
personally and through their business. The Enniss family retained various
attorneys to defend them in the lawsuit and to structure the family’s finances to
protect their assets. The Enniss family asked Earl Husted, an attorney, for advice
on asset protection and estate planning. Mr. Husted recommended that the Enniss
family contact another attorney, Fred Turner, and Mr. Molnar, a certified public
accountant (C.P.A.). Mr. Turner and Mr. Molnar coowned a business in Orange
County, California, named Global Advisors.
V. Petitioner’s Application for Tax Exemption
On June 17, 1999, petitioner filed with the IRS a Form 1024, Application for
Recognition of Exemption Under Section 501(a), seeking tax-exempt status under
5
(...continued)
1,708,960 tons of sand were excavated between 1991 and 2001. Petitioner in its
answering brief admitted this proposed finding. We find in Exhibit 74-J, however,
that the first annual report, while signed in 1991, actually reports sand that was
excavated in 1990 and this sand is included in the 1,708,960 tons. We therefore
find contrary to the stipulation that the sand was excavated between 1990 and
2001. See Gerdau MacSteel, Inc. v. Commissioner, 139 T.C. 67, 144 n.55 (2012)
(stating that, where justice requires, the Court may disregard a stipulation which is
clearly contrary to the record). We also note that the annual report for 1995 lists a
number that appears to be 140,000 but could be 190,000. Respondent in his
proposed finding of fact has reflected that number as 190,000, and we do the same
given petitioner’s agreement with respondent’s proposed finding.
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section 501(c)(15) as a tax-exempt insurance company. The application stated that
petitioner was a licensed property and casualty insurance company which had
entered into reinsurance contracts and anticipated continuing that line of business.
The application stated that petitioner did not insure related parties or reinsure any
related-party insurance. The application listed Mr. Cavaricci as petitioner’s
president and director and Vince Ambrose as petitioner’s secretary and director.
On or about September 15, 1999, petitioner submitted to the IRS a Form 2848
authorizing Mr. Molnar (as a C.P.A.), Mr. Cavaricci (as an officer of petitioner),
and Ms. Gilpin (as a full-time employee of petitioner) to represent petitioner as to
the application and to petitioner’s Forms 990, as each related to petitioner’s
Federal income tax for 1996 through 1999.
On November 24, 1999, the IRS (through the Chief of Exempt Organization
Technical Branch 3) notified petitioner by letter that the IRS had considered the
application and determined solely on the basis of the information furnished
therewith that petitioner was tax exempt as an organization described in section
501(c)(15), effective January 1, 1998. The IRS noted in the letter that petitioner
had filed its section 953(d) election. Petitioner subsequently filed its Forms 990
for 2002, 2003, and 2004 consistent with the status of a domestic tax-exempt entity
for Federal tax purposes.
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VI. Enniss Family’s Asset Protection and Estate Planning Strategies
During or before 2001, Mr. Turner and Mr. Molnar met with the Enniss
family at the family’s office in Lakeside. The attendees discussed the previously
mentioned lawsuit (which was then pending), the Enniss family’s business
operations, and the possible benefits of a captive insurance company.6 Mr. Turner
and Mr. Molnar suggested that the Enniss family consider using a captive
insurance arrangement to protect their assets. Later that year, the Enniss family
decided to avail themselves of the proffered benefits of a captive insurance
company. Global Advisors recommended that the Enniss family purchase
petitioner, an already-existing captive insurance company that the then owner
wanted to sell, in order to avoid the costs of forming a new entity and to save
money on the venture. Petitioner’s stock was then wholly owned by Mr. Cavaricci.
6
As the Court explained in Hosp. Corp. of Am. v. Commissioner,
T.C. Memo. 1997-482:
The insurance laws of some States provide for a category of
limited purpose insurance companies, popularly called captive
insurance companies or captive insurers. Captive insurance company
statutes generally apply to companies that insure on a direct basis only
the risks of companies related by ownership to the insurer. Because
pure captive insurance companies typically are formed for the purpose
of insuring the risks of related companies, the function of risk
selection, in essence, is attained at the onset.
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VII. Enniss Family Purchases Petitioner Through BC Investments, L.L.C.
From August through December 2001, the Enniss family caused a series of
transactions to be consummated to effect the family’s purchase of all petitioner
stock from Mr. Cavaricci. Through the transactions, petitioner first relinquished
all of its assets and liabilities and then Mr. Cavaricci sold his petitioner stock to BC
Investments, L.L.C., for $10,000.7 At that time, each member of the Enniss family
owned a 12.5% interest in BC Investments, L.L.C., and the IRS had issued the
Enniss family a Federal identification number for the company.
BC Investments, L.L.C., continued to be petitioner’s sole owner through
2004. BC Investments, L.L.C., did not file a Form 1065, U.S. Return of
Partnership Income, or a Form 1120, U.S. Corporation Income Tax Return, for any
of the years 2001 through 2004.
7
The parties have stipulated that Exhibit 21-J is a stock purchase agreement
between Mr. Cavaricci and BC Investments, L.L.C., dated December 11, 2001, and
that Exhibit 23-J is a copy of the Form 990 that petitioner filed for 2002. The
former exhibit states that BC Investments, L.L.C., is a Nevis limited liability
company, and the latter exhibit states that BC Investments, L.L.C., is a California
general partnership. The parties also have stipulated that petitioner has not
stipulated that BC Investments, L.L.C., is either a Nevis limited liability company
or a California general partnership. The record fails to indicate whether BC
Investments, L.L.C., is a Nevis limited liability company, a California general
partnership, or something else, and we need not and do not make a finding as to
that matter.
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VIII. Enniss, Inc., and EFR
A. Overview
Mr. Turner and Mr. Molnar wanted to establish an entity (eventually, Enniss,
Inc.) to operate the Enniss family’s general engineering and general building
contracting business and another entity (eventually, EFR) to hold the Enniss
family’s real property. Mr. Turner and Mr. Molnar wanted petitioner to provide
insurance coverage for Enniss, Inc., and for EFR.
B. EFR
1. Background
Effective December 31, 2001, the Enniss family formed EFR as a California
limited liability company to hold and to manage their real property. Incident to
this formation, each Enniss family member contributed $125 to EFR in exchange
for a 12.5% interest in EFR. Each Enniss family member later transferred his or
her real property to EFR. From 2002 through 2004, EFR owned various pieces of
real property and operated primarily as a real property management company.
Reid Enniss was EFR’s general manager, and members of the Enniss family
performed in the United States activities related to the management of EFR’s real
properties. EFR did not file a Form 1065 (or a Form 1120) for any of the years
2001 through 2004.
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2. Transfers
On or about January 1, 2002, the Enniss family contributed their
membership interests in EFR to BC Investments, L.L.C.8 BC Investments, L.L.C.,
then contributed those interests to petitioner. As of January 1, 2002, petitioner
owned EFR as a “Disregarded Entity” for Federal tax purposes.9 Petitioner has
treated EFR as its wholly owned disregarded entity since January 1, 2002.
3. Specific Real Property Holdings
During 2002 and 2003, EFR owned the following nine groups of property,
as identified by Eichel, Inc., real estate analysis and appraisers, with the following
corresponding parcels:10
8
While Ms. Sandoval testified that she never transferred her membership
interest in EFR to BC Investments, L.L.C., that testimony is disproved by the
credible evidence in the record.
9
See secs. 301.7701-1(a)(4) (providing that “certain organizations that have
a single owner can choose to be recognized or disregarded as entities separate from
their owners”), 301.7701-3(b)(1) (providing that a domestic entity is “Disregarded
as an entity separate from its owner if it has a single owner” and does not elect
otherwise), Proced. & Admin. Regs.
10
For part of this time, EFR also owned lot 8, parcel No. 375-190-08-00, in
addition to the listed parcels. That 1.08-acre parcel was sold on October 8, 2002,
for $635,000.
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Approximate
Property group Parcel Parcel number acreage Zoning
1--Sand mine
A: Lot 210 375-040-01-00 18.38 A70
B: Lot 209 375-040-18-00 14.50 A70
C: Lot 206 375-040-15-00 9.90 A70
D: Lot 203 375-040-14-00 10.15 A70
E: Lot 215 375-040-33-00 17.70 M58
70.63
2--Rock quarry
F: Highway 67 326-050-11-00 7.53 M58
3--Vacant industrial
land
G: Lot 212 375-041-41-00 2.86 M58
H: 375-041-44-00 4.70 M58
I: Lot 1 375-190-01-00 0.88 M58
8.44
4--Vacant industrial
land
J: Lot 2 375-190-02-00 1.05 M58/A70
K: Lot 4 375-190-04-00 2.37 M58/A70
L: Lot 10 375-190-10-00 1.14 M58
M: Lot 11 375-190-11-00 1.29 M58
N: Lot 12 375-190-12-00 3.93 M58
9.78
5--Vacant multifamily
site
O: Graves 384-120-63-00 22.23 HL
P: 378-120-62-00 6.25 HL
Q: 378-120-31-00 2.99 HL
31.47
6--Single-family
dwelling
R: Lot 17 379-060-21-00 2.76 A70
7--Single-family
dwelling
S: Via Viejas 404-300-03-00 2.5 A70
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8--Vacant single-family
lots
T: Utah 27-02-426-002 0.13 R
U: Utah 27-02-426-005 0.16 R
0.29
9--Vacant residential
site
V: Ramona 287-031-26-00 39.24 A72
A70 zoning allows limited agricultural and commercial uses related to
agricultural or civic uses. M58 zoning reflects high-impact industrial use (e.g.,
steel fabrication and contractors’ yards), and vacant land with M58 zoning
provides an additional advantage to certain businesses in that it allows for
unenclosed commercial and industrial uses having potential nuisance
characteristics. HL zoning allows for limited residential development.
4. Description of Properties
a. Property Group 1
Property group 1 is the Enniss family’s sand mine plant at the corner of
Vigilante Road and Moreno Avenue. As of the valuation date, parcels A through
D were used to mine sand and topsoil, and parcel E, which had a few small
buildings on it, was used primarily as the sand mine’s business office and for
storage. The highest and best use of property group 1 as of the valuation date was
continued mining of the property’s mineral resources. The highest and best use for
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the property after the mineral resources are depleted is industrial development or
outdoor storage.
b. Property Group 2
Property group 2 is vacant land north of Vigilante Road, on State Highway
67. This property’s use is limited to source material for a rock quarry operation.
The parties agree that the fair market value of property group 2 as of the valuation
date was $500,000.
c. Property Groups 3 and 4
Property groups 3 and 4 (which the parties refer to as the Vigilante Industrial
Lots) are vacant industrial lots across the street from each other on Vigilante Road
between property group 1 and State Highway 67. The eight underlying parcels are
irregular in shape, they are accessible by way of Vigilante Road, and they have
available water, sewer, and electricity service.
As of the valuation date, property groups 3 and 4 were used for open surface
and minor office buildings. The highest and best use for these property groups was
industrial usage, open storage, or outdoor manufacturing.
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d. Property Group 5
Property group 5 (which the parties refer to as the Graves Avenue
Properties) is undeveloped Rattlesnake Mountain hillside land in Santee,
California, approximately five miles south of property groups 3 and 4. Property
group 5 is located at the terminus of Graves Avenue.
The Enniss family bought property group 5 for $300,000 in 1998. The
previous owner had mined granite on the property, leaving a decomposed granite
pit with several hundred thousand tons of large boulders weighing from 1 to 30
tons each. The Enniss family purchased property group 5 to resell the boulders for
rip rap along the coast of California. Rip rap is the rock revetment that goes along
the beach to dissipate the energy from the ocean so that it does not erode the cliffs.
The Enniss family started marketing the boulders as rip rap during the
spring of 1999, but a local sheriff ordered them in 2001 to stop their activities on
property group 5. The property remained idle until 2002, when a lawyer for a
developer, Joel Faucetta, approached the Enniss family to buy the property as part
of Mr. Faucetta’s efforts to redevelop a surrounding area to the west. Graves
Avenue was the proposed development’s only access road, and Mr. Faucetta
wanted property group 5 to access his proposed development. Santee was backing
and spearheading a development of the surrounding area for residential use.
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On August 12, 2002, EFR, as optionor, and Faucetta Development Co.
(FDC), as optionee, entered into an option agreement that provided FDC, for a
term of up to 24 months (or, if earlier, five days after the recordation of the first
final subdivision map for the development), with the right to purchase property
group 5 for $5 million.11 FDC paid EFR $1 for the option. If FDC failed
11
The option agreement provided in part:
A. Optionor has offered to grant Optionee an option to
purchase its fee title interest in approximately 30 acres (plus or minus)
of real property located in the City of Santee, County of San Diego,
California * * * on the terms and conditions hereinafter set forth.
B. Optionee desires to acquire an option to purchase the
Property under the terms and conditions hereinafter set forth.
C. Optionee understands and agrees that the Property will
be processed for development entitlements with other adjacent
property consisting of approximately 275 acres under a joint
application for one Master Project.
NOW THEREFORE, in consideration of the payment of $1.00
and the mutual promises contained herein, the parties agree as
follows:
1. Grant of Option. Optionor hereby grants to Optionee, or
its Assignee, the exclusive right and option to purchase the Property
upon the terms and conditions and for the purchase price hereinafter
set forth.
* * * * * * *
(continued...)
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to exercise the option, EFR had to sell FDC two easements over property group 5
at a total cost of $2 million and FDC had to make certain improvements to the
property. When the option agreement was entered into, Reid Enniss knew that Mr.
Faucetta was trying to acquire several surrounding parcels for a larger
development. On the valuation date, property group 5 was zoned Hillside Limited,
which allowed residential development of approximately seven to nine homes.
On August 8, 2004, FDC notified EFR that FDC was exercising the option
to purchase property group 5 on or before September 12, 2004. FDC and EFR
11
(...continued)
6. Exercise of Option. In the event that Optionee, or its
Assignee, exercises this Option, such exercise shall be effected by
Optionee, or its Assignee, sending written notice to Optionor of the
intent to exercise the option. Thereafter, Optionee shall within three
(3) business days of the date of the written notice open an escrow to
purchase the Property in accordance with the terms provided herein.
In the event that Optionee does not exercise the Option
provided for herein, Optionor shall sell to Optionee an easement for
ingress and egress over the road across the Property shown on the
approved tentative map for the Master Project. In addition, Optionor
shall grant Optionee an easement over the land at the entrance of the
Master Project, not to exceed one-half acre, in order to erect
appropriate entry monumentation for the Master Project. In exchange
for the purchase of the easement for the road and the easement for
entry monumentation of the Master Project, Optionee shall improve
the access road, the entry monumentation area and provide stubbed
underground utilities, including sewer, water, electricity and cable to
all the approved lots on the Property and pay the sum of Two Million
and No/Dollars ($2,000,000) within five (5) business days after the
approval of the first final subdivision map for the Master Project.
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eventually agreed on September 20, 2004, to extend the close of the sale and the
escrow until April 15, 2005, in exchange for FDC’s agreeing to pay EFR an
additional $500,000. The option was ultimately assigned to Lennar Homes, a
national home builder, which purchased property group 5 on April 15, 2005, for its
Sky Ranch development project.
e. Property Group 6
Property group 6 is an older single family dwelling in Lakeside. The parties
agree that the fair market value of property group 6 was $367,500 as of the
valuation date.
f. Property Group 7
Property group 7 is a high-end single-family dwelling in Alpine, California.
The parties agree that the fair market value of property group 7 was $918,000 as of
the valuation date.
g. Property Group 8
Property group 8 is two adjacent single family lots in Sandy, Utah. The
parties agree that the fair market value of property group 8 was $126,000 as of the
valuation date.
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h. Property Group 9
Property Group 9 is vacant land in a remote rural area of northeast San
Diego County. The parties agree that the fair market value of property group 9 was
$145,000 as of the valuation date.
5. Leases
From 2002 through 2004, EFR entered into leasing agreements with various
third parties for rental of its properties. On January 1, 2002, EFR leased parcels A
through D of property group 1 to Enniss, Inc., in exchange for a royalty payment of
$2 per ton of material processed and sold from those parcels.
C. Enniss, Inc.
Mr. Husted incorporated Enniss, Inc., in the State of California on or about
December 19, 2001. Enniss, Inc., is involved in general engineering, general
building contracting, steel fabrication and erection, construction trucking,
demolition, and grading and operates the Enniss family’s sand mine. Enniss, Inc.,
is controlled by the Enniss family.
Since January 1, 2002 (including on the valuation date), Enniss, Inc., has
operated the sand mine on parcels A through D pursuant to its lease agreement
with EFR. The agreement provided that Enniss, Inc., could use the property as its
sand mining operation, materials division office, and maintenance facilities. The
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parties to that lease also entered into a second lease agreement on the same date
under which Enniss, Inc., used one acre and 4,800 feet of office space on parcel E.
As of the valuation date, Enniss, Inc., used parcel E as the site for its offices and
storage and maintenance sheds, as well as a yard area for the stacking and
processing of materials.12
IX. Reclamation Plan
A. Background
The Surface Mining and Reclamation Act of 1975 (SMARA), Cal. Pub. Res.
secs. 2710 through 2796 (West 2001 & Supp. 2013), required that the sand mine
have an approved reclamation plan that details how the mine would be reclaimed
to a usable condition in a manner that prevented or minimized adverse
environmental impacts and eliminated residual hazard to the public health and
safety. The reclamation plan for property group 1, as in effect on the valuation
date, generally required that the operator of the sand mine reclaim the sand mine
after the mining was complete. Specifically, as of that time, fill had to be
transported to the pits on the property to construct various stable and compacted
pads. The reclamation plan also required that a drainage channel be constructed
12
Minimal mining also occurred on parcel E.
- 24 -
through the two southern parcels of the site to carry water from the lake to the
existing San Vicente Creek south of the site.
The SMARA also required a financial assurance mechanism (e.g., a bond or
a letter of credit) to guarantee that the costs associated with reclaiming the land in
accordance with the approved reclamation plan would be paid if the mine operator
became financially insolvent. Regardless of the mine operator’s financial
condition, the land owner is ultimately responsible for the cost of reclamation. As
of the valuation date, no financial assurance was in place to guarantee that
reclamation of property group 1 would occur. Property group 1, once in the 1990s,
had a $40,000 bond but the bond expired before the valuation date.
B. Fill
The primary reclamation activity is obtaining fill to refill the mined pits.13
Sand mine owners and operators in San Diego County sometimes purchase fill,
especially when the fill is of a specialized material. Other times, the owners and
operators receive free fill from construction debris and other off-site sources, or
charge a $2 to $6 per ton tipping fee to allow companies desiring to dispose of
their fill to dump the fill in the mined pits at the sand mines.
13
Other reclamation activities included removing equipment and structures,
revegetation, and certain indirect items. The costs of these other activities were
relatively minimal in relation to the cost of the fill.
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As of the valuation date, multiple mining enterprises in the San Diego area
used fill for reclamation purposes. Many of these enterprises charged tipping fees
for accepting the fill. Development projects in downtown San Diego provided a
major source of the fill in San Diego County, and other sites outside of the
downtown area did as well. Additional fill sources in the Lakeside area at or
around that time included concrete rubble, asphalt rubble, construction overburden,
and sand and gravel that was not suitable for processing. During 2002 and 2003,
the amount of fill that these areas around the sand mine were capable of generating
was projected over five years to comprise between 475,000 and 2 million cubic
yards.
Enniss, Inc.’s nearby neighbor, Hanson Materials (Hanson), had about 2
million cubic yards of fill dirt at that time sitting in a large pile on the property.
The Hanson site was near property group 1 but, inter alia, a 5,700-foot conveyor
system would have had to be constructed to transport the fill to property group 1.
Baxter owned a parcel of real property between property group 1 and the Hanson
site. The owner of property group 1 would need Baxter’s consent to build the
conveyor on or over Baxter’s property. Baxter was a blasting contractor and stored
explosives on its land. Other parcels of land also were between the Hanson site
and property group 1, and the owner of property group 1 also needed the consent
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of those property owners to build the conveyor on or over their properties. The
Enniss family had no permission from Baxter or from any of the other property
owners to run a conveyor over their properties. The Enniss family, however, may
have then owned the other properties.14
Beginning in 2002, Enniss, Inc., charged companies tipping fees to dump
their fill at its sand mine. The relevant data underlying the tipping fees that Enniss,
Inc., received in 2002 and 2003 is as follows:
Fill received Tipping fees Average tipping
Year (tons) collected fee per ton
2002 2,769.52 $84,128 $30.38
2003 10,483.37 144,450 13.78
C. Lakes
Property group 1 included a northerly lake. As of the valuation date, no
sand remained for permissible excavation in that lake. The approved mining depth
was generally 35 feet, and the northerly lake had been overexcavated to a depth of
at least 40 feet and perhaps as deep as 75 feet. The approved reclamation plan and
the MUP called for the area to remain a lake.
14
Although the record is ambiguous, Chad Enniss testified that to construct
and to operate the proposed conveyor system Enniss Inc., would have needed
“permission [i.e., an easement or license] from Hanson, Baxter, [and] possibly a
couple of the others there on Vigilante Road, but at that time, I think that we
owned all of those” other parcels of property.
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Property group 1 also included a southerly lake. As of the valuation date,
no sand remained for permissible excavation in the southerly lake. The southerly
lake had to be filled as part of the reclamation of property group 1.
D. Condition of Mine on the Valuation Date
On the valuation date, property group 1 was in the worst condition it had
been in since the Enniss family started mining the property. Few if any conditions
of the MUP had been met; little reclamation had taken place; and the property had
been mined out of phase, over depth, and too close to the road. In addition, no
financial assurance was in place; existing roads were not widened; new roads were
not built; and the mines were approximately 60 to 80 feet deep from the surface
elevation.
X. Ms. Sandoval
Ms. Sandoval was petitioner’s secretary during the subject years. She was in
charge of filing and signing petitioner’s tax returns.
XI. Petitioner’s Forms 990 and 990-T
A. Form 990 for 2002
Petitioner filed its Form 990 for 2002 on or about January 15, 2004. The
return lists Chad Enniss as petitioner’s president and Ms. Sandoval as petitioner’s
secretary. The return is signed and dated by Ms. Sandoval, and she also printed her
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name and title (“Secretary”) next to her signature on the line for those items. The
return was prepared and also signed by a representative of Molnar and Associates
on behalf of that entity in his or her capacity as the return’s preparer. The
representative’s signature is illegible.
The Form 990 for 2002 reports that EFR is a limited liability company that
petitioner wholly owned. The return also reports that EFR is a disregarded entity.
In addition, the return reports that petitioner received tax-exempt insurance
premium revenue of $128,584 during 2002.
B. Form 990 for 2003
Petitioner filed its Form 990 for 2003 on or about November 19, 2004. The
return lists Chad Enniss as petitioner’s president and Ms. Sandoval as petitioner’s
secretary. The return was prepared and signed by a representative of Molnar and
Associates on behalf of that entity in his or her capacity as the return’s preparer.
The representative’s signature is illegible, but it appears to be that of the same
individual who signed the Form 990 for 2002 as its preparer.15 The return was not
signed by anyone other than the preparer.
The Form 990 for 2003 reports that EFR is a limited liability company that
petitioner wholly owns. The return also reports that EFR is a disregarded entity.
15
While petitioner asks the Court to find that the signature is that of Mr.
Molnar, the signature is most likely that of Mr. Liptz.
- 29 -
The return also reports that petitioner received tax-exempt insurance premiums
revenue of $300,000 during 2003.
C. Form 990 for 2004
Petitioner filed its Form 990 for 2004 on or about November 21, 2005. The
return lists Chad Enniss as petitioner’s president and Ms. Sandoval as petitioner’s
secretary. The return was prepared by J. Douglass Jennings, Jr., on behalf of his
professional corporation, and was signed by him in that capacity. The return also
was signed and dated by Ms. Sandoval in her capacity as petitioner’s secretary, and
she also printed her name and title (“Secretary”) under her signature on the line for
those items.
The Form 990 for 2004 reports that petitioner received tax-exempt insurance
premiums revenue of $298,000 during 2004.
D. Form 990-T for 2004
Petitioner filed its Form 990-T for 2004 on or about November 15, 2005.
XII. Respondent’s Examination
A. Tax-Exempt Status
During or about June 2005, the IRS (through its Tax-Exempt and
Government Entities Division) began an examination for petitioner’s 2002 and
2003 taxable years and most specifically petitioner’s tax-exempt status under
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section 501(c)(15). The IRS ultimately determined that petitioner was not an
insurance company and did not qualify as a tax-exempt organization described in
section 501(c)(15) as of January 1, 2002. Petitioner eventually agreed with this
determination. On April 12, 2006, Ms. Sandoval, as petitioner’s secretary and
treasurer, signed Form 6018-A, Consent to Proposed Action, consenting to the
IRS’s revocation of petitioner’s tax exemption as of January 1, 2002.
B. Income Tax
During or around November 2005, the IRS (through its Large and Mid-Size
Business Division) began an examination for petitioner’s income tax liabilities for
2002 and 2003. The examination was later expanded to include 2004.
Respondent used substitute for return procedures to determine petitioner’s
income tax liability for each subject year. Respondent determined that the
termination of petitioner’s section 953(d) election caused petitioner to be a taxable
corporation which sold its assets to a controlled foreign corporation on January 1,
2003 (which, respondent determined, was a one-day taxable year in and of itself).
Respondent bifurcated petitioner’s 2003 taxable year into the one-day taxable year
beginning and ended on January 1, 2003, and a second taxable year consisting of
the remainder of 2003. For the one-day taxable year, respondent determined
petitioner’s income tax liability in part on the basis of the deemed sale.
- 31 -
XIII. Notice of Deficiency
On August 5, 2009, respondent issued petitioner the notice of deficiency
underlying these cases.
OPINION
I. Burden of Proof
With one exception, petitioner bears the burden of proving that respondent’s
determination of the deficiencies set forth in the deficiency notice is incorrect. See
Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115 (1933); Baxter v.
Commissioner, 816 F.2d 493, 495 (9th Cir. 1987), aff’g in part, rev’g in part on
issue not relevant here T.C. Memo. 1985-378. Section 7491(a) sometimes shifts to
the Commissioner part or all of the burden of proof where the taxpayer introduces
credible evidence of a factual matter, but that section does not apply where a
taxpayer fails to satisfy the related requirements. See, e.g., sec. 7491(a)(2)(A), (B),
and (C). Petitioner has failed to establish that it meets all of those requirements.
The single exception is that respondent bears the burden of proof as to the
fair market value of the real property underlying the deficiency for the one-day
taxable year. These cases are appealable to the Court of Appeals for the Ninth
Circuit (absent the parties’ stipulation to the contrary), and this Court will follow a
decision of that court which is “squarely in point”. See Golsen v. Commissioner,
- 32 -
54 T.C. 742, 757 (1970), aff’d, 445 F.2d 985 (10th Cir. 1971). The Court of
Appeals for the Ninth Circuit has indicated, on at least three occasions, that the
presumption of correctness that attaches to a notice of deficiency is forfeited where
the Commissioner adopts a litigating position different from the valuation stated in
a deficiency notice. See Estate of Mitchell v. Commissioner, 250 F.3d 696, 701-
702 (9th Cir. 2001), aff’g in part, vacating in part and remanding 103 T.C. 520(1994) and T.C. Memo. 1997-461; Estate of Simplot v. Commissioner, 249 F.3d
1191, 1193-1194 (9th Cir. 2001), rev’g and remanding 112 T.C. 130 (1999);
Morrissey v. Commissioner, 243 F.3d 1145, 1148-1149 (9th Cir. 2001), rev’g and
remanding Estate of Kaufman v. Commissioner, T.C. Memo. 1999-119.16
Respondent’s litigating position as to the fair market value of the real property
underlying the deficiency in the one-day taxable year differs from the value stated
in the deficiency notice.
16
In each of these cases, the Commissioner determined an estate tax
deficiency on the basis of an increase in the fair market value over that reported on
the estate tax return and later submitted expert reports supporting the
Commissioner’s concessions that the fair market value was less than that
determined in the statutory notice. See Estate of Mitchell v. Commissioner, 250
F.3d 696, 698-699 (9th Cir. 2001), aff’g in part, vacating in part and remanding
103 T.C. 520 (1994) and T.C. Memo. 1997-461; Estate of Simplot v.
Commissioner, 249 F.3d 1191, 1193-1194 (9th Cir. 2001), rev’g and remanding
112 T.C. 130 (1999); Morrissey v. Commissioner, 243 F.3d 1145, 1149 (9th Cir.
2001), rev’g and remanding Estate of Kaufman v. Commissioner, T.C. Memo.
1999-119.
- 33 -
II. Period of Limitations
Petitioner argues that the three-year period of limitations of section 6501(a)
precludes respondent from assessing any tax for the one-day taxable year. To that
end, petitioner asserts, it filed a Form 990 for 2003 that commenced the period of
limitations for the one-day taxable year. Respondent argues that the period of
limitations for the one-day taxable year never began because, respondent asserts
(among other reasons), petitioner did not file a valid Form 990 for any part of
2003. We agree with respondent.
Section 6501(a) generally provides that the Commissioner must assess any
income tax for a taxable year within three years after the return was filed. For this
purpose, section 6501(g)(2) provides that “[i]f a taxpayer determines in good faith
that it is an exempt organization and files a return as such under section 6033, and
if such taxpayer is thereafter held to be a taxable organization for the taxable year
for which the return is filed, such return shall be deemed the return of the
organization”. Section 6033(a)(1) requires, with limited exceptions not applicable
here, that every organization exempt from tax under section 501(a) file an annual
return listing certain information, and section 1.6033-2(a)(2)(i), Proced. & Admin.
Regs., generally states that the return shall be filed on Form 990. Section 6062
requires that a corporation’s “president, vice-president, treasurer, assistant
- 34 -
treasurer, chief accounting officer or any other officer duly authorized so to act”
sign the corporation’s income tax return. Filing an unsigned form is not the filing
of a valid return for purposes of commencing the running of the period of
limitations. See Lucas v. Pilliod Lumber Co., 281 U.S. 245 (1930); Elliott v.
Commissioner, 113 T.C. 125 (1999); see also Richardson v. Commissioner, 72
T.C. 818, 823-824 (1979) (and the cases cited thereat). This is true even where the
IRS accepts and processes the unsigned return. See Pilliod Lumber Co., 281 U.S.
at 249; Plunkett v. Commissioner, 118 F.2d 644, 650 (1st Cir. 1941), aff’g 41
B.T.A. 700 (1940).
The parties dispute whether petitioner’s Form 990 for 2003 that was
submitted to the IRS was signed by one of petitioner’s officers. Petitioner asserts
in its brief that the form was signed by Ms. Sandoval but that neither petitioner nor
respondent has been able to produce a copy of the signed form. Petitioner asserts
alternatively that the return was signed by Mr. Molnar as a director who was duly
authorized to sign the return on petitioner’s behalf. We disagree with petitioner on
both points.17
17
Petitioner argues that the term “officer” in sec. 6062 naturally includes a
corporation’s director even if the director is not also a corporate officer. We need
not and do not decide that issue.
- 35 -
Exhibit 24-J is a joint exhibit that was entered into evidence through a
stipulation that the exhibit “is a true and correct copy of the Form 990 Return of
Organization Exempt from Income Tax filed by CGL [petitioner] for tax year
2003.” The form bears no signature on the line for the “signature of officer”. Nor
does it list any date on the corresponding line for the date, or any information on
the corresponding line for “Type or print name and title”. In the section that is
labeled “Paid Preparer’s Use Only”, a signature was reportedly entered on
November 4, 2004, by a preparer who worked for Molnar and Associates. The
preparer’s signature is illegible, however, and the return does not otherwise
identify the preparer. The signature does not appear to be that of either Chad
Enniss or Ms. Sandoval, who the return reports are petitioner’s only officers. Nor
does the return contain any other signatures.
Petitioner asks the Court to find as a fact that Ms. Sandoval signed
petitioner’s Form 990 for 2003 notwithstanding the fact that Exhibit 24-J contains
no such signature and that the parties have stipulated that the exhibit is a true copy
of petitioner’s Form 990 for 2003. To that end, petitioner invites the Court to
minimize the significance of the stipulation by observing that Ms. Sandoval
testified at trial that “I think I signed the [2002 through 2004] returns.” Ms.
Sandoval also testified that “I believe I did” sign petitioner’s returns for 2002
- 36 -
through 2004. We decline petitioner’s invitation to make its desired finding. A
stipulation that only one of the parties thereto challenges is generally treated as a
conclusive admission to the extent of its terms, and the party is not allowed to
qualify, change, or contradict any or all parts of a stipulation unless justice
requires.18 See Rule 91(e); Spencer v. Commissioner, 110 T.C. 62, 81 (1998);
Modern Am. Life Ins. Co. v. Commissioner, 92 T.C. 1230, 1249 (1989); see also
Bail Bonds by Marvin Nelson, Inc. v. Commissioner, 820 F.2d 1543, 1547-1548
(9th Cir. 1987), aff’g T.C. Memo. 1986-23. We are not persuaded that Ms.
Sandoval’s equivocal testimony supports a conclusion that justice requires that we
disregard any part of the parties’ stipulation that Exhibit 24-J “is a true and correct
copy of the Form 990 Return of Organization Exempt from Income Tax filed by
CGL [petitioner] for tax year 2003”.
Nor are we persuaded that the Form 990 which petitioner submitted to
respondent for 2003 was appropriately signed by one of petitioner’s officers
through the preparer’s signing of his or her name as the return preparer. The
preparer’s signature is illegible, as stated above, and the record does not otherwise
18
We note that the parties’ Joint Stipulation of Facts further states “that
either party may introduce other and further evidence not inconsistent with the
facts herein stipulated unless otherwise stated as reserved.” (Emphasis added.)
Stipulation 27, referencing Exhibit 24-J, does not reserve the issue as to its
accuracy but does state: “The truth of assertions within stipulated exhibits may be
rebutted or corroborated with additional evidence.”
- 37 -
allow us to definitively find the preparer’s identity. Even if we were to assume that
the preparer’s signature on the Form 990 for 2003 was Mr. Molnar’s, an
assumption which we do not find as a fact notwithstanding petitioner’s request that
we do so, our view would stay the same. The preparer’s signature on that form is
explicitly that of an individual in his or her capacity as the preparer of the return; it
is not explicitly that of an officer of petitioner in his or her capacity as such.
Contrary to petitioner’s suggestion, the fact that the preparer signed his or her
name under penalties of perjury, as was required for the corporate officer’s
signature as well, is not enough to carry the day. We conclude that petitioner did
not file a Form 990 for 2003 which commenced the period of limitations for that
year and that the period remains open.19 See sec. 6501(c)(3).
III. Section 953(d) Election
A. Validity of Election
A foreign corporation may elect to be taxed as a domestic entity if the
corporation would qualify under the Code as an “insurance company” (if it were a
domestic entity) and it meets the other requirements set forth in section 953(d).
The parties dispute one of the other requirements, which the IRS included in
19
Petitioner also argues that the period of limitations began to run in April
2006 when it gave a Form 1120-F for 2003 to the IRS. We disagree. The IRS
never accepted that return, and the return was never filed.
- 38 -
Notice 89-79, 1989-2 C.B. 392, as guidance for a foreign corporation’s making a
section 953(d) election.20 See also sec. 953(d)(1)(C) and (D) (authorizing the
Secretary to prescribe rules to ensure that taxes imposed on the corporation are
paid and stating that the foreign corporation must make the requisite election). The
disputed requirement is that a “responsible corporate officer” sign a corporation’s
election statement.
Ms. Gilpin signed petitioner’s section 953(d) election statement under
penalty of perjury in her stated capacity as petitioner’s secretary, and she was a
“responsible corporate officer” if she was petitioner’s “president, vice-president,
treasurer, assistant treasurer, chief accounting officer, or any other officer duly
authorized so to act.” See sec. 6062; see also Notice 89-79, supra. Ms. Gilpin’s
signing of her name on the election statement is prima facie evidence that
petitioner authorized her to make the election on its behalf. See sec. 6062.
Petitioner argues that its section 953(d) election was invalid because,
petitioner states, Ms. Gilpin was not an officer authorized to sign the election
statement. We are unpersuaded that Ms. Gilpin lacked the requisite authority to
sign the statement. The fact that Ms. Gilpin signed the election under penalty of
20
Notice 89-79, 1989-2 C.B. 392, was modified and superseded by Rev.
Proc. 2003-47, 2003-2 C.B. 55, but that action is not effective as to the election
here.
- 39 -
perjury in her stated capacity as petitioner’s officer and that petitioner then filed
the election with the IRS speaks loudly as to petitioner’s and Ms. Gilpin’s
understanding that Ms. Gilpin was then an officer authorized to make the election.
The same is true as to petitioner’s later reliance on the elected status in applying
for tax-exempt status under section 501(c)(15) and the fact that petitioner during
this proceeding has not come forward with any credible documentary or
testimonial evidence directly refuting that Ms. Gilpin was an officer who was
properly authorized on November 16, 1998, to make the election. We also bear in
mind that petitioner, after it filed the election statement with the IRS, confirmed its
understanding that the election was valid by submitting on or about March 20,
2000, a power of attorney that referenced the election without any dispute as to its
validity and that petitioner has repeatedly filed Federal returns consistent with its
election. The mere fact that some or all of the Forms 990 that petitioner filed with
the IRS may have failed to include a copy of petitioner’s election statement and
that Notice 89-79, supra, instructs a taxpayer to attach its election statement to its
“annual income tax return, Form 1120PC or Form 1120L,” does not mean, as
petitioner concludes, that petitioner’s election is rendered invalid ab initio. Nor do
we agree with petitioner’s assertion that respondent was on notice as to the identity
of petitioner’s officers so as to know, as petitioner now claims, that Ms. Gilpin was
- 40 -
not petitioner’s officer at the time of the election. We conclude that petitioner’s
section 953(d) election was valid. While respondent argues alternatively that the
doctrine of estoppel precludes petitioner from contesting the validity of its section
953(d) election, we need not and do not address this alternative argument.21
B. Termination of Election
A foreign corporation’s election under section 953(d) to be taxed as a
domestic corporation applies for the year in which the election is made and to all
subsequent years, unless terminated or revoked with the Secretary’s consent. See
sec. 953(d)(2). Such an election is terminated when the corporation fails to meet
the election requirements prescribed under section 953(d)(1). See sec.
21
We also need not decide respondent’s request to amend the answer to
allege an affirmative defense of equitable estoppel to petitioner’s claim that the
election was invalid for lack of signature by a corporate officer. We note,
however, that any such amendment appears unnecessary because the petition does
not allege that the election was invalid. Rule 34(b)(4) and (5) requires that the
petition contain “[c]lear and concise assignments of each and every error which the
petitioner alleges to have been committed” and “[c]lear and concise lettered
statements of the facts on which petitioner bases the assignments of error”,
respectively. The petition states simply that respondent erred in determining that
the election was revoked during the subject years, thus indicating that petitioner’s
view as set forth in the petition is that the election is still in place (which, of
course, is contrary to its claim now that the election was invalid from the
beginning). We also note that a pleading need not be amended when issues not
raised by the pleadings are tried by express or implied consent. See Rule 41(b)(1).
It appears that the parties have tried the issue by express or implied consent and
that respondent’s amendment simply formalizes respondent’s position as to
petitioner’s invalid election claim raised outside of the pleadings. We will deny
respondent’s request as moot.
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953(d)(2)(B). The termination applies for all taxable years beginning after the year
in which the corporation failed to meet the election requirements prescribed under
section 953(d)(1). See sec. 953(d)(2)(B).
Petitioner concedes it was not operating as an insurance company during
2002. Petitioner therefore failed to satisfy that requirement for maintaining the
section 953(d) election throughout 2002, see sec. 953(d)(1)(B), and its election was
thereby terminated. The termination applied to all of petitioner’s taxable years
after 2002. See id.
IV. Consequences of Termination
Respondent determined that the termination of petitioner’s section 953(d)
election caused petitioner to be treated as a taxable corporation which is deemed to
have sold its assets to a controlled foreign corporation on January 1, 2003 (which,
respondent determined, was a one-day taxable year in and of itself). We agree with
this determination.
Upon termination of a corporation’s election under section 953(d), the
corporation is treated for purposes of section 367 as a domestic corporation which
transfers all of its assets to a foreign corporation in an exchange to which section
354 applies. See sec. 953(d)(5). The transfer is deemed to occur on the first day of
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the taxable year following the revocation of the election. See id. The “first day”
here is January 1, 2003.
Under section 367(a)(1), a foreign corporation receiving property in an
exchange to which section 354 applies is generally not considered a corporation for
purposes of determining the extent to which gain is recognized by the transferor.
Thus, absent an exception, the termination of a corporation’s election under section
953(d) results in a deemed transfer of the domestic corporation’s assets to a foreign
corporation in an exchange that is taxable to the domestic corporation. After the
deemed transfer on the “first day”, the taxpayer’s taxable year as a domestic
corporation naturally terminates as of the end of that day, given that it is no longer
taxed as a domestic corporation, and the taxable year of the deemed transferee
foreign corporation then begins and naturally runs through the end of the
transferor’s taxable year as ascertained as if the transfer had not occurred.
Petitioner’s primary activity during 2002 was managing the real property
that its disregarded entity, EFR, owned. All of the real property was in the United
States, and the activities related to the management of these properties were
performed within the United States by members of the Enniss family. As no
exception was applicable at the time of the deemed exchange on January 1, 2003,
petitioner’s deemed transfer of property is a taxable exchange for which petitioner
- 43 -
must recognize gain under section 367. Because petitioner failed to file a Federal
income tax return for its taxable year beginning and ending on January 1, 2003,
respondent determined petitioner’s income tax liability for that one-day taxable
year taking into account, inter alia, the deemed sale.
Petitioner argues that section 367 was not intended to apply in the setting at
hand. We disagree. By its terms, section 953(d)(5) provides that the termination
of petitioner’s section 953(d) election requires that petitioner, “[f]or purposes of
section 367”, be “treated as a domestic corporation transferring (as of the 1st day
of such subsequent taxable year) all of its property to a foreign corporation in
connection with an exchange to which section 354 applies.” We read nothing in
section 953, or in section 367, or in the regulations under either provision, that
would trump the quoted rule of section 953(d)(5). While petitioner looks to
strands of legislative history to support its argument of a contrary legislative intent,
the best source of legislative intent is found in the text of the statute. See Bedroc
Ltd., L.L.C. v. United States, 541 U.S. 176, 177 (2004); United States v. Lanier,
520 U.S. 259, 267 n.6 (1997); Conn. Nat’l Bank v. Germain, 503 U.S. 249,
253-254 (1992). Absent absurd, unreasonable, or futile results, there is “no more
persuasive evidence of the purpose of a statute than the words by which the
legislature undertook to give expression to its wishes.” United States v. Am.
- 44 -
Trucking Ass’ns, Inc., 310 U.S. 534, 543 (1940); cf. Albertson’s, Inc. v.
Commissioner, 42 F.3d 537, 545 (9th Cir. 1994), aff’g 95 T.C. 415 (1990).
Congress has specifically and unambiguously provided in section 953(d)(5) that a
termination of a section 953(d) election results in a transfer of property within the
rules of section 367, and there is nothing that is absurd, unreasonable, or futile in
applying that text as written. We are not unmindful that unequivocal evidence of a
clear legislative intent may sometimes override the words of a statute and lead to a
different result, but that unequivocal bar is a high one to clear. See Consumer
Prod. Safety Comm’n v. GTE Sylvania, Inc., 447 U.S. 102, 108 (1980); Landreth
v. Commissioner, 859 F.2d 643, 646 n.6 (9th Cir. 1988), aff’g T.C. Memo. 1986-
242; Halpern v. Commissioner, 96 T.C. 895, 899 (1991). The legislative history
here provides scant and unpersuasive support for a holding contrary to that which
we reach.22
Petitioner also argues from a factual point of view that petitioner was not
EFR’s owner. As petitioner sees it, EFR was a limited liability company that the
Enniss family owned directly. Moreover, petitioner asserts, even if the facts
formally establish that petitioner was EFR’s owner, the substance of the facts
22
Petitioner argues from an equitable point of view that sec. 367 should not
apply because, petitioner states, it will be taxed on the unrealized gain when it
eventually sells the properties. We disagree that equity plays any part in our
interpretation and implementation of secs. 367 and 953(d)(5) in the setting at hand.
- 45 -
trumps their form and requires a contrary finding that the Enniss family directly
owned EFR. We disagree in both regards. The record establishes, and we have so
found, that petitioner owned EFR. We note in support of this finding, but not as
the sole reason for the finding, that petitioner’s statements in its returns are
admissions that may be overcome only through cogent evidence, see Waring v.
Commissioner, 412 F.2d 800, 801 (3d Cir. 1969), aff’g per curiam T.C. Memo.
1968-126; Estate of Hall v. Commissioner, 92 T.C. 312, 337-338 (1989), and that
petitioner filed a Form 990 for 2002 and 2003, each of which listed petitioner as
the sole owner of EFR.23 We also note that EFR has never filed a partnership (or
corporate) tax return with regard to any of the subject years.24
Nor do we believe that the substance of the facts supports petitioner’s
proposed finding. The U.S. Supreme Court “has observed repeatedly that, while a
taxpayer is free to organize his affairs as he chooses, nevertheless, once having
done so, he must accept the tax consequences of his choice, whether contemplated
or not, * * * and may not enjoy the benefit of some other route he might have
23
While petitioner’s Form 990 for 2003 failed to be a valid return because it
was not signed by one of petitioner’s officers, petitioner’s preparation and filing of
the document with the IRS expressed petitioner’s understanding that petitioner was
the sole owner of EFR.
24
Ms. Sandoval and Reid Enniss each testified in a conclusory manner (and
without further elaboration) that they were members of EFR. We do not accept
this testimony as the credible evidence in the record disproves it.
- 46 -
chosen to follow but did not.” Commissioner v. Nat’l Alfalfa Dehydrating &
Milling Co., 417 U.S. 134, 149 (1974) (citations omitted); see also Wilkin v.
United States, 809 F.2d 1400, 1402 (9th Cir. 1987); Lomas Santa Fe, Inc. v.
Commissioner, 693 F.2d 71, 73 (9th Cir. 1982), aff’g 74 T.C. 662 (1980).25 Thus,
petitioner and the Enniss family, while they were entitled at the start to structure
their affairs so that the Enniss family members owned EFR as of the relevant time,
must now accept the consequences of instead causing petitioner to be EFR’s sole
owner (although their actions on this point probably resulted from questionable
legal advice). EFR’s ownership as structured by its controlling owners must “be
given its tax effect in accord with what actually occurred and not in accord with
what might have occurred.” Commissioner v. Nat’l Alfalfa Dehydrating & Milling
Co., 417 U.S. at 148. We note in passing, however, that we disagree with
petitioner’s primary premise for finding that the members of the Enniss family
were in substance EFR’s owners. The mere fact that petitioner and the Enniss
family may have treated EFR as an independent entity for purposes of management
25
Of course, where the issue is one of law as to the proper substantive
characterization of facts, the label used by the taxpayer may not always be
determinative if it is incorrect. See Selfe v. United States, 778 F.2d 769, 774 (11th
Cir. 1985); Pinson v. Commissioner, T.C. Memo. 2000-208; LDS, Inc. v.
Commissioner, T.C. Memo. 1986-293.
- 47 -
and operations, as petitioner asserts, does not necessarily mean that EFR was
owned by the Enniss family rather than by petitioner.
V. Subject of Exchange
Petitioner asserts that it never owned the real property and that it may not be
taxed as to any property that EFR owned. We disagree. For Federal income tax
purposes, although petitioner may not have actually owned the real property that
EFR owned, petitioner is deemed to own EFR’s real property because EFR’s
owners chose to characterize EFR as an entity that is disregarded as separate from
its owners. See secs. 301.7701-1(a)(4), 301.7701-3(b)(1), Proced. & Admin.
Regs.; cf. Samueli v. Commissioner, 132 T.C. 37, 39 n.3 (2009) (where a grantor
trust was a disregarded entity that owned an interest in a limited liability company,
the Court treated the grantor as the owner of that interest), aff’d and remanded on
another issue, 661 F.3d 399 (9th Cir. 2011). Our disregard of the entity EFR
essentially means that we view the facts as if EFR did not exist for Federal income
tax purposes and as if EFR’s sole owner, petitioner, was the sole owner of EFR’s
assets. Cf. Samueli v. Commissioner, 132 T.C. at 39 n.3.
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VI. Fair Market Value of Disputed Property
A. Overview
The parties dispute the applicable fair market value of four of the property
groups. These groups are property groups 1, 3, 4, and 5. We proceed to determine
those values.
A determination of fair market value is a factual inquiry in which the trier of
fact must weigh all relevant evidence of value and draw appropriate inferences.
See Commissioner v. Scottish Am. Inv. Co., 323 U.S. 119, 123-125 (1944);
Helvering v. Nat’l Grocery Co., 304 U.S. 282, 294 (1938); Zmuda v.
Commissioner, 79 T.C. 714, 726 (1982), aff’d, 731 F.2d 1417 (9th Cir. 1984). Fair
market value is measured as of the applicable valuation date, which in this case is
January 1, 2003. See Estate of Proios v. Commissioner, T.C. Memo. 1994-442;
Thornton v. Commissioner, T.C. Memo. 1988-479, aff’d without published
opinion, 908 F.2d 977 (9th Cir. 1990). The willing buyer and the willing seller are
hypothetical persons, instead of specific individuals or entities, and the
characteristics of these hypothetical persons are not always the same as the
personal characteristics of the actual seller or a particular buyer. See Propstra v.
United States, 680 F.2d 1248, 1251-1252 (9th Cir. 1982); Estate of Bright v.
United States, 658 F.2d 999, 1005-1006 (5th Cir. 1981); Estate of Newhouse v.
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Commissioner, 94 T.C. 193, 218 (1990). The views of both hypothetical persons
are taken into account, and focusing too much on the view of one of these persons,
to the neglect of the view of the other, is contrary to a determination of fair market
value. See Estate of Scanlan v. Commissioner, T.C. Memo. 1996-331, 72 T.C.M.
(CCH) 160 (1996), aff’d without published opinion, 116 F.3d 1476 (5th Cir. 1997);
Estate of Cloutier v. Commissioner, T.C. Memo. 1996-49. Fair market value
reflects the highest and best use of the property on the valuation date, and it takes
into account special uses that are realistically available because of the property’s
adaptability to a particular business. See Mitchell v. United States, 267 U.S. 341,
344-345 (1925); United States v. Meadow Brook Club, 259 F.2d 41, 45 (2d Cir.
1958); Stanley Works & Subs. v. Commissioner, 87 T.C. 389, 400 (1986).
Property is generally valued without regard to events occurring after the valuation
date to the extent that those subsequent events were not reasonably foreseeable on
the date of valuation. See Ithaca Trust Co. v. United States, 279 U.S. 151 (1929);
Trust Servs. of Am., Inc. v. United States, 885 F.2d 561, 569 (9th Cir. 1989);
Bergquist v. Commissioner, 131 T.C. 8, 17 (2008); Estate of Giovacchini v.
Commissioner, T.C. Memo. 2013-27.
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B. Approaches Used To Determine Fair Market Value
1. Overview
Generally, three approaches are used to determine the fair market value of
property. See United States v. 99.66 Acres of Land, 970 F.2d 651, 655 (9th Cir.
1992). These approaches are: (1) the market approach, (2) the income approach,
and (3) the asset-based approach. See Bank One Corp. v. Commissioner, 120 T.C.
174, 306 (2003), aff’d in part, vacated in part and remanded on another issue sub
nom., JP Morgan Chase & Co. v. Commissioner, 458 F.3d 564 (7th Cir. 2006);
Cohan v. Commissioner, T.C. Memo. 2012-8. The question of which approach to
apply in a case is a question of law. Powers v. Commissioner, 312 U.S. 259, 260
(1941). Because neither party relies upon the asset-based approach, and we agree
that is not applicable in these cases, we limit our discussion of that approach to a
brief explanation of it.
2. Three Approaches
a. Market Approach
The market approach requires a comparison of the subject property with
similar property sold in an arm’s-length transaction in the same timeframe. The
market approach values the subject property by taking into account the sale prices
of the comparable property and the differences between the comparable property
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and the subject property. See Estate of Spruill v. Commissioner, 88 T.C. 1197,
1229 n.24 (1987); Wolfsen Land & Cattle Co. v. Commissioner, 72 T.C. 1, 19-20
(1979). The market approach measures value properly only when the comparable
property has qualities substantially similar to those of the subject property. See
Wolfsen Land & Cattle Co. v. Commissioner, 72 T.C. at 19-20. Where
comparable properties are present, the market approach is generally the best
determinant of value. See Whitehouse Hotel Ltd. P’ship v. Commissioner, 131
T.C. 112, 156 (2008), vacated and remanded on another issue, 615 F.3d 321 (5th
Cir. 2010); Van Zelst v. Commissioner, T.C. Memo. 1995-396, aff’d, 100 F.3d
1259 (7th Cir. 1996). Moreover, while unforeseeable events occurring after the
valuation date are generally not taken into account in determining a property’s fair
market value, a sale of other property within a reasonable time after the valuation
date may be a proper starting point for the measure of the property’s fair market
value. See Estate of Scanlan v. Commissioner, 72 T.C.M. (CCH), at 162-163
(adjustments made to redemption price to account for passage of time and the
change in the setting from the date of the decedent’s death to the date of the later
redemption); see also Estate of Trompeter v. Commissioner, T.C. Memo. 1998-35,
75 T.C.M. (CCH) 1653, 1660-1661 (1998), vacated and remanded on other
grounds, 279 F.3d 767 (9th Cir. 2002).
- 52 -
b. Income Approach
The income approach relates to capitalization of income and discounted
cashflow. This approach values property by computing the present value of the
estimated future cashflow as to that property. The estimated cashflow is
ascertained by taking the sum of the present value of the available cashflow and the
present value of the asset’s residual value.
c. Asset-Based Approach
The asset-based approach generally values property by determining the cost
to reproduce it less applicable depreciation or amortization.
C. Expert Witnesses
1. Background
Each party retained experts to value the properties at issue. Petitioner
retained and called Harry B. Holzhauer as a real estate expert and Warren R.
Coalson as a mining expert. Respondent retained and called Norman Eichel as a
real estate expert and John A. Hecht as a mining expert. Respondent also called
Steve C. Cortner to testify in rebuttal to a portion of Mr. Coalson’s testimony and
recalled Mr. Eichel and Mr. Hecht to testify in rebuttal to the respective testimony
of Mr. Holzhauer and Mr. Coalson. Petitioner recalled Mr. Holzhauer and Mr.
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Coalson to testify in rebuttal to the respective testimony of Mr. Eichel and Mr.
Hecht.
2. Qualifications of Experts
a. Mr. Holzhauer
Petitioner retained Mr. Holzhauer to ascertain the fair market value of the
subject nine property groups. Mr. Holzhauer has appraised real estate for over
three decades, and he holds the Appraisal Institute designation of MAI, SRA, and
SRPA.26 He has previously testified in Federal and State courts as an expert
witness. He has taught classes on appraisal at colleges and for professional
organizations for approximately two decades. He has developed a course for the
IRS on the uniform standards of professional appraisal practice, and he has taught
that course for the IRS to IRS agents nationwide.
The Court recognized Mr. Holzhauer as an expert in the field of real estate
appraisals, with no objection by respondent.
26
The designation of MAI is awarded to qualifying members of the
American Institute of Real Estate Appraisers, and it is the most highly recognized
appraisal designation within the appraisal community. The designations SRA
(senior residential appraiser) and SRPA (senior real estate property appraiser) are
awarded to qualifying members of the Society of Real Estate Appraisers.
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b. Mr. Coalson
Petitioner retained Mr. Coalson to ascertain the cost of reclaiming the mined
property, to help determine the value for the mineral resources that remained on the
property, and to estimate the amount of potentially developable land that would be
created by site reclamation. Mr. Coalson is a mining consultant with over 30 years
of experience in the mining industry, inclusive of 23 years of consulting on mining.
He has a bachelor of arts degree, with a double major in geography and
environmental reclamation, and he has previously testified as an expert on (among
other matters) property and mineral resource valuation. For approximately the last
20 years, he has been the president of a company that he founded, which provides
environmental and mine permitting services.
The Court recognized Mr. Coalson as an expert in the field of mining, with
no objection by respondent.
c. Mr. Eichel
Respondent retained Eichel, Inc., to ascertain the fair market value of the
subject nine property groups. Eichel, Inc., is a real estate research and appraisal
firm which specializes in the valuation of real estate in the Los Angeles, California,
and surrounding areas, and in litigation consulting with respect to real estate
valuation matters. Eichel, Inc.’s president is Mr. Eichel. Mr. Eichel has a bachelor
- 55 -
of science degree from the University of Southern California with a major in
finance, and he performed graduate work in the field of real estate research. Mr.
Eichel holds the Appraisal Institute designation of MAI.
The Court recognized Mr. Eichel as an expert in the field of real estate
appraisals, with no objection by petitioner.
d. Mr. Hecht
Respondent retained Sespe Consulting, Inc. (Sespe), and its president Mr.
Hecht, to estimate the cost to reclaim property group 1 as of the valuation date,
among other things. Mr. Hecht holds a bachelor of science degree in electrical
engineering from Valparaiso University and a professional degree in geophysics
from Colorado School of Mines. He has worked professionally in the mining
industry for almost three decades, and he is a certified registered professional
engineer in the State of California and a registered environmental assessor. He
currently is the president of Sespe, an environmental and engineering consulting
firm, where he devotes approximately 65% of his work to mining and construction
material projects (mainly reclamation planning, preparing reclamation plans, and
financial cost estimates) in California.
The Court recognized Mr. Hecht as an expert in the field of mining, with no
objection by petitioner.
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e. Mr. Cortner
Mr. Hecht (through his firm) retained Mr. Cortner to determine some costs
of product and materials and to assist Mr. Hecht with the applicable reclamation
standards. Mr. Cortner has worked in the mining industry in southern California,
mostly in and around San Diego County, for over 35 years. The Court did not
specifically recognize Mr. Cortner as an expert but allowed him to testify as a fact
witness in rebuttal to a portion of Mr. Coalson’s testimony.
D. Applicable Standards
Each expert testified on direct examination primarily through his expert
report, see Rule 143(g)(1), which the Court accepted into evidence. Each expert
then generally testified on cross-examination, redirect examination, and recross-
examination, through the typical question and answer process.
We may accept or reject the findings and conclusions of the experts,
according to our own judgment. See Helvering v. Nat’l Grocery Co., 304 U.S. at
294-295; Parker v. Commissioner, 86 T.C. 547, 561-562 (1986). In addition, we
may be selective in deciding what parts (if any) of their opinions to accept. See
Parker v. Commissioner, 86 T.C. at 561-562. We also may reach a determination
of value based on our own examination of the evidence in the record. Silverman v.
Commissioner, 538 F.2d 927, 933 (2d Cir. 1976), aff’g T.C. Memo. 1974-285.
- 57 -
E. Analysis
1. Nine Property Groups
Mr. Holzhauer and Mr. Eichel each valued the nine property groups
discussed herein. As part of his analysis, Mr. Holzhauer reduced his total value of
the nine property groups by 15% to apply a “bulk discount” and then rounded that
number to reach his final total value. Mr. Eichel did not apply a similar discount to
his total value.
The parties later agreed on the applicable fair market values of property
groups 2, 6, 7, 8, and 9. The fair market values that Mr. Holzhauer and Mr. Eichel
ascertained and the agreed amounts are as follows:
Property group Mr. Holzhauer Mr. Eichel Agreed value
1
1 $5,000,000 $15,876,000 ---
2 300,000 2,100,000 $500,000
3 3,625,000 5,425,000 ---
4 5,000,000 6,250,000 ---
5 450,000 5,000,000 ---
6 310,000 425,000 367,500
7 962,000 918,000 918,000
8 126,000 126,000 126,000
9 210,000 145,000 145,000
Total 15,983,000 36,265,000 ---
Discount 2,397,450 -0- ---
Net 13,585,550 36,265,000 ---
Rounded 13,600,000 36,265,000 ---
1
Mr. Eichel in his original written expert witness report valued
this property at $16,200,000 but revised this number in his rebuttal
- 58 -
report to $15,876,000 to correct for a computational error of $324,000
that he discovered in his original written expert witness report and
direct testimony.
We are therefore left to decide the fair market values of the remaining
property groups as well as the appropriateness of a “bulk discount”. In rendering
our decisions, we are aided by the testimony of each of the four experts, all of
whom we consider to be qualified in their areas of expertise. Each expert testified
in favor of the party who called him, and we have weighed the experts’ testimony
with due regard to their qualifications, the credible evidence in the record, and our
judgment. See Estate of Christ v. Commissioner, 480 F.2d 171, 174 (9th Cir.
1973), aff’g 54 T.C. 493 (1970); Chiu v. Commissioner, 84 T.C. 722, 734 (1985).
On some matters, we were persuaded more by petitioner’s experts than by
respondent’s experts, while on other matters we were persuaded more by
respondent’s experts than by petitioner’s experts.
- 59 -
2. Property Group 1
a. Overview
We summarize each expert’s valuation of property group 1 as follows:
2003 2004 2005
Mr. Holzhauer Mr. Eichel Mr. Holzhauer Mr. Eichel Mr. Holzhauer Mr. Eichel
Tonnage 188,000 148,164 188,000 193,455 188,000 122,037
Royalty rate (per ton) $4 --- $4.14 --- $4.28 ---
Sale price --- $14.50 --- $15 --- $15.50
Sales revenue --- $2,148,378 --- $2,901,825 --- $1,891,574
Fill material fees --- $70,000 --- $130,000 --- $400,000
Gross income1 $752,000 $2,218,378 $778,320 $3,031,825 $805,561 $2,291,574
Reclamation costs --- --- --- --- --- ---
Selling costs --- --- --- --- --- ---
Real estate taxes $28,500 $53,500 $29,070 $54,570 $29,651 $55,661
Production cost --- $592,656 --- $773,820 --- $549,167
Fill material processing --- $5,000 --- $5,000 --- $200,000
SG&A --- $200,000 --- $200,000 --- $200,000
Net operating income $723,500 $1,367,222 $749,250 $1,998,435 $775,910 $1,286,746
Reclamation costs --- --- --- --- --- ---
Zoning action --- --- --- --- --- ---
Land sale --- --- --- --- --- ---
Permit compliance --- $250,000 --- --- --- ---
Total --- $1,117,222 --- $1,998,435 --- $1,286,746
Discount factor2 .8811 .7763 .6839
PV NOI $637,445 $604,180 $550,948
- 60 -
2006 2007 2008
Mr. Holzhauer Mr. Eichel Mr. Holzhauer Mr. Eichel Mr. Holzhauer Mr. Eichel
Tonnage 188,000 148,623 188,000 66,377 --- 26,568
Royalty rate (per ton) $4.43 --- $4.59 --- --- ---
Sale price --- $16 --- $16 --- $14.50
Sales revenue --- $2,377,968 --- $1,062,032 --- $385,497
Fill material fees --- $1,200,000 --- $375,000 --- $250,000
Gross income1 $833,756 $3,577,968 $862,937 $1,437,032 --- $635,497
Reclamation costs --- --- --- --- $24,600,000 ---
Selling costs --- --- --- --- --- ---
Real estate taxes $30,244 $56,775 $30,849 $57,910 $31,466 $59,068
Production cost --- $743,115 --- $356,074 --- $150,211
Fill material processing --- $600,000 --- $125,000 --- $25,000
SG&A --- $200,000 --- $200,000 --- $200,000
Net operating income $803,511 $1,978,078 $832,088 $689,048 ($24,631,466) $201,218
Reclamation costs --- --- --- --- --- ---
Zoning action --- --- --- $34,000 --- $33,000
Land sale --- --- --- --- --- ---
Permit compliance --- --- --- --- — ---
Total --- $1,978,078 --- $655,048 $168,218
Discount factor2 .6026 .5309 .4678
PV NOI $502,407 $458,142 ($11,522,600)
2009 2010 Total
Mr. Holzhauer Mr. Eichel Mr. Eichel Mr. Holzhauer
Tonnage --- 29,126 --- ---
Royalty rate (per ton) --- --- --- ---
Sale price --- $14 --- ---
Sales revenue --- $407,764 --- ---
Fill material fees --- $250,000 $125,000 ---
Gross income $34,505,673 $657,764 $125,000 ---
Reclamation costs --- --- --- ---
Selling costs $1,035,170 --- --- ---
Real estate taxes $32,096 $60,250 $61,455 ---
Production cost --- $164,562 --- ---
Fill material processing --- $25,000 --- ---
SG&A --- $200,000 $25,000 ---
Net operating income $33,438,407 $207,952 $38,545 ---
Reclamation costs --- --- $2,547,529 ---
Zoning action --- $33,000 --- ---
Land sale
Parcel A-D --- --- $18,220,000 ---
Parcel E --- --- $15,188,500 ---
Total --- $174,952 $30,899,516 ---
Discount factor2 .4121 --- ---
PV NOI $13,779,967 --- $5,040,211
NPV @14% $15,876,320 ---
Rounded $15,876,000 $5,000,000
1
For each year 2005 through 2007, the gross income shown in Mr.
Holzhauer’s columns is slightly different from the product of his royalty rate
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shown for the year, and 188,000. Mr. Holzhauer first calculated the gross income
for 2003 and then calculated the gross income for each year 2004 through 2007
by increasing the previous year’s gross income by 3.5%. Mr. Holzhauer then
backed into his royalty rates by dividing the income for the year by 188,000, and
rounding the quotient to the nearest cent.
2
For each year 2003 through 2007, the PV NOI shown in this chart is
slightly different from the product of the net operating income shown for the year
and the discount factor shown for the year. Mr. Holzhauer rounded his discount
factors shown in this chart to the nearest ten-thousandths, but he apparently did
not round the factors when performing his calculations. For 2003, Mr. Holzhauer
multiplied his discount factor by net operating income to arrive at his PV NOI.
For each of the other years 2004 through 2007, Mr. Holzhauer multiplied his
discount factor by gross income to arrive at his PV NOI.
With a single exception, we find that Mr. Holzhauer’s analysis underlying
his $5 million value is a better measure of property group 1’s fair market value
than Mr. Eichel’s analysis underlying his $15,876,000 value, notwithstanding that
Mr. Holzhauer’s analysis sometimes appears to be outcome driven. While both
Mr. Holzhauer and Mr. Eichel generally ascertained their values as the sum of the
present value of the remaining mineable sand on the property plus the present
value of the residuary interest in the property, only Mr. Holzhauer adequately
recognized as of the valuation date that the property was primarily in poor
condition, out of compliance with the MUP, and zoned primarily for agricultural
use; that the property’s value stemmed mainly from the underlying real property;
and that the mining operation was conducted by Enniss, Inc., not petitioner. Mr.
Holzhauer also opined most persuasively that the highest and best use of property
group 1 was to extract the remaining sand, then perform reclamation, and then to
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redevelop or to sell the land; and that the value of the remaining sand was best
derived on the basis of the net income from royalties that a third party would pay
for extracting the sand, see, e.g., Terrene Invs., Ltd. v. Commissioner, T.C. Memo.
2007-218 (the Court used a royalty-based income capitalization method to value a
tract of land with sand and gravel deposits), as opposed to, as Mr. Eichel
concluded, an extraction of the sand by the land owner.27 The single exception is
that Mr. Holzhauer, in contrast to Mr. Eichel, improperly minimized the value that
inhered in the tipping fees that the owner of property group 1 would receive as to
the property. We turn to discuss some specifics of Mr. Holzhauer’s valuation and
our discussion of the tipping fees.
b. Value of Remaining Mineable Sand
i. Background
Mr. Holzhauer ascertained his value of the remaining mineable sand by
relying upon Mr. Coalson’s opinion of the volume of the remaining sand, the rate
of extraction, and the per-ton value for the remaining material.
27
Mr. Eichel also considered various sales of property that occurred in 2007
to ascertain the fair market value of property group 1 (and property groups 3 and
4). We disagree with his use of those sales which occurred too far after the
valuation date.
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ii. Mineable Sand
Mr. Coalson calculated the volume of extractable sand on the basis of a
review of the site of and MUP conditions of parcels A through D as of the
valuation date. He concluded that no material remained for excavation in the lake
portions of property group 1 and estimated the recoverable material as the product
of: (1) the undisturbed acreage on parcels B, C, and D (taking into account certain
setbacks as required under the MUP); (2) an assumed excavation depth in
conformity with the MUP; and (3) a conversion factor for cubic yards per
acre/foot. He arrived at an estimated volume of 625,000 cubic yards of remaining
sand and applied the appropriate conversion factor of 1.5 tons per cubic yard to
reasonably calculate that 940,000 tons of recoverable salable sand remained on the
premises. The then-current market price for washed sand was $14.50 per ton in
2003, a total value in place at 2003 prices of $13,640,000.28 He likewise
reasonably assumed that the remaining sand would be mined at the same
approximate rate that it was previously mined (plus or minus 200,000 tons a year)
and reasonably concluded that the mine life was five years given that the mine was
five years from depletion as of the valuation date. He conservatively ascertained
28
There appears to be a rounding or math error of $10,000 (i.e., 940,000 x
$9.50 = $13,630,000).
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that the remaining sand would be extracted at an even rate over the five-year period
(in other words, at 188,000 tons (940,000/5) per year).29
Mr. Coalson opined credibly that as of the valuation date there was a high
demand in San Diego County for 940,000 tons of sand. He valued the remaining
sand under two scenarios: (1) the property owner mines the sand and (2) a third
party mines the sand and pays the property owner a royalty for the sand. As to the
first scenario, i.e., the owner mines the sand, Mr. Coalson explained that the owner
would first have to acquire a permit to mine the sand and that the permit process
had previously taken 18 years in the case of one site in San Diego County. As to
the second scenario, i.e., a third party mines the sand and pays a royalty for the
sand, Mr. Coalson explained that royalty arrangements were common in
circumstances where the owner did not want to develop a mining plan, hire
consultants, and get the requisite permit. He opined that an owner of a sand mine
in San Diego County would likely enter into a royalty agreement with a mining
company rather than mine the property itself. He estimated a “very generous
royalty rate” of $4 per ton for sand mined by the third party, explaining that his
29
Mr. Eichel, on the other hand, estimated that the remaining sand was
734,368 tons and that this sand would be extracted over a seven-year period at
rates that he improperly ascertained through his consideration of data that was not
reasonably foreseeable as of the valuation date. In line with this estimate, Mr.
Eichel also unpersuasively concluded that property group 1 would be sold in 2010.
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estimate was derived from two royalty agreements that his company aggressively
negotiated in Lakeside during 2002, and opined reasonably that the owner would
expect a 3.5% annual increase in that rate to take into account inflation. Mr.
Holzhauer concluded that the real property owner would pay the real estate taxes
and the reclamation costs.
Mr. Holzhauer projected that $24.6 million of reclamation costs would be
owed in 2008, the year after the sand was excavated. Mr. Coalson had estimated
that the reclamation costs would total $24,913,003, using unadjusted 2003 price
data to estimate that amount, and Mr. Holzhauer first rounded that amount to $25
million and then ultimately concluded that reclamation costs would total $24.6
million. Mr. Holzhauer did not explain why he ultimately reduced the $25 million
to $24.6 million.
As Mr. Coalson saw it, as of the valuation date, the volume of fill required to
reclaim the mining pits in the sand mine was 1,982,500 cubic yards determined as
follows:30
30
Mr. Hecht opined that no fill need be added to the northerly lake or to a
portion of the southerly excavation area. We disagree. Mr. Coalson testified
persuasively that the northerly lake had to be filled, noting among other things that
the sand in the lake was very permeable, as contrasted with the compacted sand
found in the pits, and that fill had to be added to the lake to raise the bottom of the
lake to its required depth. As to the southerly extracted area, Mr. Hecht opined that
this area need not be filled because nothing was extracted from that area during
(continued...)
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Fill area Cubic yards
Northerly Lake 372,500
Southerly Lake 985,000
Remaining southerly extraction area 625,000
Total volume backfill required 1,982,500
Mr. Coalson logically determined these amounts by multiplying the area that was
required to be filled by the depth of the area. Mr. Coalson determined on the basis
of his review of the market that the fill would cost $9.50 per cubic yard, or
$18,833,750 in total (1,982,500 x $9.50), which takes into account both the price to
purchase specialized fill and to transport the fill to the site. Mr. Coalson also took
into account various other secondary costs relating to the property’s reclamation
and arrived at a total reclamation cost of $24,913,003 (which, as previously
mentioned, Mr. Holzhauer rounded down to $24.6 million).
Mr. Holzhauer concluded that the owner of the sand mine would receive no
income from the acceptance of fill because, Mr. Holzhauer stated, this income does
30
(...continued)
2003. Mr. Coalson opined, however, that the sand on property group 1 would be
extracted over a five-year period. Mr. Hecht acknowledged in his testimony that
the 625,000 cubic yards of fill would appropriately be taken into account if the
amount of sand was extracted in 2003 but that applicable financial standards do not
take this amount into account because the extraction is after one year. We do not
believe that the referenced one-year rule is an appropriate guide to ascertaining the
fair market value of property group 1. Instead, we believe that the hypothetical
willing buyer and the hypothetical willing seller would take into account all costs
associated with the property, whether the anticipated costs are to be incurred before
one year or afterwards.
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not relate to the real property value. Mr. Holzhauer rationalized that income
generated from tipping fees had “nothing to do” with the owner of the land into
which the fill was deposited. Mr. Coalson (and thus Mr. Holzhauer) did not
consider whether the owner of property group 1 could receive free fill from the
Hanson site because he believed that Hanson desired a buyer for its fill and would
not give its fill to a competitor for free. Mr. Coalson also opined that Hanson’s
excess fill was dedicated to fill one of its own projects and was unavailable to fill
property group 1. Mr. Coalson also asserted, without further elaboration, that
accepting free fill was contrary to “state policy” because its availability at the time
of need could not be foreseen with any certainty.
We disagree with Mr. Holzhauer that the ability to receive tipping fees with
respect to property group 1 has nothing to do with the owner of the property or,
more importantly, with a determination of the fair market value of property group
1. Mr. Eichel persuasively opined that these fees belong to the owner of the
property, and he took the fees into account in his analysis. Moreover, as we see it,
a hypothetical willing buyer and a hypothetical willing seller would both take into
account the ability to receive tipping fees from property group 1 when agreeing on
the purchase price of that property. The ability to receive income as to property is
an important attribute of the property and factors into its value. To say the least,
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net-income-producing property is certainly worth more than the exact same
property that does not produce net income.
That said, we believe that a hypothetical purchaser would not assume, as of
the valuation date, that it could receive the relevant industry minimum $2 per ton
tipping fee or benefit from free fill over the next five years of the sand mine
operation plus any additional time required to complete the land reclamation
project. Tipping fees and free fill are factually speculative, depending on
time-sensitive nearby demand and nearby supply, and could be achieved only as
long as San Diego County and the California Department of Conservation
permitted the sand mine operation and/or reclamation activities to continue. Any
such continuation was speculative, as of the valuation date, in view of the
uncontradicted testimony that SMARA, Cal. Pub. Rec. secs. 2710 and 2773,
required an appropriate financial assurance mechanism to ensure that adequate
funds to complete all required reclamation work are available when mining ends.31
The sand mine was out of compliance with that provision given that an appropriate
reclamation financial assurance plan was not then in place. The original 1990s
31
See generally People ex rel. Dept. of Conservation v. El Dorado County,
116 P.3d 567 (Cal. 2005), as to procedural enforcement matters and People ex rel.
Connell v. Ferreira, 2003 WL 22022032 (Cal. Ct. App. 2003), and McCain v.
County of Lassen, 2003 WL 123065 (Cal. Ct. App. 2003), as to fines and penalties.
- 69 -
financial plan was obsolete because significant mining had occurred since then and
the posted $40,000 bond for that plan had expired.32
Other serious major problems with the MUP and with the reclamation plan
were present as of the valuation date. The MUP set numerous requirements that
were not met. The MUP required the construction of certain roads, but those roads
were not then built. Sand had been mined too close to the roadways to allow an
acceptable slope on the sides of the pits. Sand was mined in large quantities far
below the permitted maximum mining depth. Reclamation and channel work were
far behind schedule. The approved mining plan regulating which areas were to be
mined first and in which order, known as the mining phases, had been ignored on
account of flooding and the lack of channel work. Consequently, the sand mine’s
entire operation was at significant risk that the underlying business could, and
32
In 2005, San Diego County pursued the matter further and Enniss, Inc.,
after several meetings, persuaded the county to accept a $2.9 million letter of credit
coupled with Hanson’s representation that Enniss, Inc., could use fill available on
the Hanson site to reclaim Enniss, Inc.’s sand mine. Whether Enniss, Inc., could
have actually used the Hanson fill, however, was questionable because Hanson
also was considering using some or all of that fill for other projects. Moreover,
even if Hanson allowed Enniss, Inc., to use the fill, there was no certainty that the
required conveyor system which would require at least an easement over the
nearby properties could be constructed to transport the fill between the two sites.
Absent the Hanson fill, the necessary but then-absent bond or letter of credit to
keep the sand mine open would have had to be in the amount of approximately $20
million as the county had indicated that the bond or letter of credit would have to
reflect the cost of 2 million cubic yards of fill at $9.50 per cubic yard.
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would, be fined and/or shut down by San Diego County and/or by the California
Department of Conservation and the required reclamation work demanded
immediately.
Should that have occurred, there would be no further revenue from sand
sales or tipping fees until, if ever, government authorities approved a new MUP
and reclamation plan. Even worse, a shutdown would force use of the Hanson fill
if still available and permission for the conveyor system could be obtained, or if
not, suitable fill material would have to be purchased on the open market to
reclaim the land at great cost. These facts would be of great concern to a
hypothetical purchaser and would significantly temper its thinking regarding the
purchase price and any offsetting consideration of potential tipping fees and free
fill.
Still, sand mine owners and operators in San Diego County routinely
received tipping fees in exchange for allowing others to dump debris in the pits at
their mines. We fail to see why a hypothetical owner of property group 1, to the
extent that it could, would not charge a tipping fee to do the same at that site.33
While Mr. Coalson testified that specialized fill had to be used to reclaim property
group 1, we are unpersuaded that this is the case as to all of the property. In fact,
33
Tipping fees are inversely related to hauling costs.
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as Mr. Hecht pointed out, environmental documents for property group 1 state
specifically that construction debris can be used to fill the pits.
Fill for dumping was available as of the valuation date, yet Mr. Coalson
improperly minimized the receipt of the tipping fees when ascertaining his value of
property group 1.34 The record does not allow us to find with precision the portion
of the 1,982,500 cubic yards of fill that the hypothetical owner of property group 1
would have to pay $9.50 for vis-a-vis the portion that the owner would pay nothing
for but instead would receive tipping fees. We believe it reasonable to reduce Mr.
Holzhauer’s calculation that the owner would pay $9.50 for each of the 1,982,500
cubic yards of fill by a stated amount in tipping fees and then apply the net amount
to the 1,982,500.
To the extent that Mr. Coalson asserted that State policy for determining an
appropriate financial assurance plan prohibits the receipt of fill for free would also
apply to receiving fill and a tipping fee, we are unpersuaded that any such policy is
34
The record does not allow us to find as of the valuation date the exact
amount of fill that could be received either for free or with a tipping fee. We note,
however, that on November 9, 2004, Chad Enniss informed the Department of
Planning and Land Use that five nearby named “truckers and dirt brokers” had
3,721,000 cubic yards of fill available for dumping within a one-year period and
that these truckers and brokers had expressed a desire to dump their product at the
sand mine. He also named 20 other dirt and rubble producers in the county and
stated that the 25 total producers were “just a small list of company’s that haul,
dump, or produce dirt or rubble”.
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as cut and dried as Mr. Coalson stated. Mr. Coalson did not explain or otherwise
elaborate on his asserted policy, and the record establishes apart from the
determination and approval of financial assurance plans that in the real operating
world sand mines regularly received tipping fees during the relevant period. At the
same time, we are unpersuaded that the hypothetical buyer and the hypothetical
seller would have concluded, as of the valuation date, that fill for property group 1
could be obtained and economically transported from the Hanson site.
Valuation is an inexact science which does not call for scientific precision,
see, e.g., Frazee v. Commissioner, 98 T.C. 554, 577 (1992), and we believe that
simply reducing the $9.50 cost by three-fourths of the minimal but customary $2
per ton in tipping fees (i.e., by $1.50 per ton) is the best measure for the overall
cost of the fill related to property group 1 to adequately consider the risk of a
government shutdown and to blend the amount of fill that would be purchased vis-
a-vis the amount of fill that would be accepted for a fee. The parties should factor
these tipping fees into Mr. Holzhauer’s calculation in their Rule 155
computation(s).35
35
As a point of clarification, Mr. Holzhauer’s $24.6 million of reclamation
costs in 2008 should be reduced by $4,460,625 in tipping fees (i.e., $1.50 per ton x
the 1.5 tons per cubic yard conversion rate x 1,982,500 cubic yards). We recognize
that each cubic yard of fill received with a tipping fee will likewise produce a
savings of $9.50 per cubic yard and have blended that savings into our
(continued...)
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c. Residuary Interest in Property
Mr. Holzhauer calculated a value for the reclaimed sand mine on the basis of
his valuation of the underlying individual parcels. His calculation assumed a
highest and best use of each lot primarily as storage. He reviewed 12 real property
sales as part of his analysis. The sites of the properties underlying these sales were
as follows:
Sale 1 12566 Vigilante Rd., Lakeside CA
Sale 2 9120 Jamacha Rd., Spring Valley CA
Sale 3 Woodside Ave. and Wheatlands Rd., Santee CA
Sale 4 ES Rockville St., Santee CA
Sale 5 SWC Jamacha Blvd. and Folex Way, Spring Valley CA
Sale 6 1596 North Johnson Ave., El Cajon CA
Sale 7 10007 Riverford Rd., Lakeside CA
Sale 8 Woodside Ave., North of Marilla Dr., Lakeside CA
Sale 9 Woodside Ave. and Hartley Rd., Santee CA
Sale 10 11322 North Woodside Ave., Santee CA
Sale 11 SEC Riverford Rd. & Riverside Dr., Lakeside CA
Sale 12 NWC Mapleview St. & Channel Rd., Lakeside, CA
The pertinent information underlying the sales (as adjusted to reflect additional
costs to the buyers for items such as required fill or grading and adjustments for
size to reflect actual useable land) is as follows:36
35
(...continued)
$1.50-per-ton calculation.
36
M54 and IG zoning is general industrial use. IL zoning is light industrial
use. S88 zoning is limited industrial use.
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Square
Sale # Sale date Sale price Acreage feet1 Price/SF Zoning Use
1 Oct 02 $635,094 1.08 47,045 $13.50 M58 Industrial development; outdoor storage
2 May 02 650,000 1.09 47,480 13.69 M54 Industrial development; outdoor storage
3 May 02 681,507 1.39 60,548 11.26 IL Industrial development
4 Apr 01 750,000 1.50 65,340 11.48 IL Church parking
5 Apr 03 1,310,000 2.36 102,802 12.74 M58 To build ministorage
6 Mar 04 1,277,000 3.81 165,964 7.69 M Industrial development; outdoor storage 2
7 Apr 02 1,335,000 3.86 168,142 7.94 S88 Industrial development
8 Aug 03 1,218,500 4.78 208,217 5.85 S88 Industrial development
9 Jul 03 2,251,177 5.44 236,966 9.50 IL Industrial development
10 Sep 04 2,200,000 7.29 317,552 6.93 IG Industrial development; outdoor storage 2
11 Feb 00 2,711,500 8.00 348.480 7.78 S88 Industrial development
12 Jun 04 2,140,000 20.06 873,814 2.45 S88 Preservation
1
One acre equals 43,560 square feet.
2
The use for outdoor storage depends on a conditional permit.
Mr. Eichel’s comparable sales, by contrast, involved many properties which were
sold in 2007 and other properties which were not actually comparable to the
properties underlying property group 1.
Mr. Holzhauer considered sales 1, 2, 6, and 10 to be the most relevant to his
analysis because they each were actually used or going to be used for outdoor
storage. He reasonably concluded that sale 1 was the most relevant sale because
the underlying parcel was on Vigilante Road and had been purchased primarily for
outdoor storage. He also reasonably considered sales 2, 6, and 10 to ascertain the
square-foot value of the reclaimed land because the reclaimed land was much
larger than the property underlying sale 1. He concluded from these four
comparable sales that the sand mine parcels, when fully reclaimed, had an average
value as of the valuation date of $8 per square foot (or approximately $24.5 million
in total). He then applied a real estate appreciation factor of 5% per year to arrive
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at a future residuary value of $34,505,673 in 2009 for the fully reclaimed
properties and reduced that value by selling expenses of approximately 3%
($1,035,170) to be incurred when the reclaimed property was sold in 2009. Costs
included annual real estate taxes of 1.5% of the market value of the property, with
a 2% annual increase ($32,096 per year by 2009).
d. Applicable Discount Rate
Mr. Holzhauer applied a 13.5% discount rate to capitalize cashflows arising
from property group 1 to arrive at a final present value for the property of
$5,040,211 before consideration of the cost to comply with certain MUPs and the
value of real property improvements (e.g., a 4,300-square-foot office building on
parcel E). After considering these items, $330,000 and $400,000, respectively, he
arrived at a value of $4,995,000, which he rounded to $5 million. He opined that
this rate was appropriate because an investment in royalties from a sand mine
carried a high risk, given the regulatory risk, reclamation risks, and the risk of
demand and pricing for sand. He reviewed the yield rates listed in a reliable survey
of real property economic indicators and chose 13.5% as a rate that was slightly
less than the mean rate for higher risk properties.
We agree that Mr. Holzhauer’s 13.5% rate is a reasonable rate to apply in the
setting at hand and in conjunction with our resolution of the fill dirt costs.
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Discount rates are generally set at the rates of return that property buyers in the
marketplace will demand to invest in property, see, e.g., Terrene Invs., Ltd. v.
Commissioner, T.C. Memo. 2007-218, and the rate to apply in a given case must
reflect an adequate return on investment with due respect to the attendant risks in
the investment. As of the valuation date, an investment in property group 1 was a
high risk, given among other things that the property was in poor condition and
many of the MUP and reclamation plan conditions were not met. The 13.5% rate,
which falls within the lower half of the high risk rates included in the referenced
survey, is reasonable in that it reflects a sensible return on investment as of January
1, 2003, when considering the attendant risks in investing in property group 1.
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3. Property Groups 3 and 4
These property groups include eight parcels on either side of Vigilante Road.
Mr. Holzhauer opined that the applicable fair market value of property groups 3
and 4 were $3,625,000 and $5 million, respectively.37 He arrived at those values
by applying a sales comparison approach and by comparing the attributes of the
parcels underlying property groups 3 and 4 and the comparable properties. Mr.
Eichel ascertained that the rounded respective values were $5,425,000 and
$6,250,000 using a comparative sales analysis that reviewed the same properties he
reviewed to value the residuary interest in property group 1. As was similarly true
in the case of property group 1, the properties underlying Mr. Eichel’s comparable
37
He broke down these amounts as follows:
Property Acres Value/SF Value
G 2.86 $10 $1,245,816
H 4.70 9 1,842,588
I .88 14 536,659
Total 3,625,063
Total (as rounded) 3,625,000
J 1.05 13 594,594
K 2.37 12 1,238,846
L 1.14 14 695,218
M 1.29 13.50 758,597
N 3.93 10 1,711,908
Total 4,999,163
Total (as rounded) 5,000,000
- 78 -
sales were for the most part not comparable to the parcels in property groups 3 and
4 or the sales were too far removed from the valuation date.
We find Mr. Holzhauer’s analysis underlying his values to be more
persuasive than Mr. Eichel’s analysis underlying his values. Mr. Holzhauer
determined the highest and best use for property groups 3 and 4 to be continued
use for open storage or outdoor manufacturing. He valued property groups 3 and 4
using 11 of the 12 comparable sales he analyzed in valuing the reclaimed land in
property group 1 (he concluded that the remaining sale was not pertinent to this
valuation). He ascertained that the mean of the 11 sales was $9.77 per square foot
and noted that the sales price per square foot tended to decrease for those sales as
the size of the property increased.
Mr. Holzhauer reasonably concluded that sale 1, the underlying parcel of
which was the smallest parcel in the 11 sales, was a good benchmark in valuing the
smallest parcels in property groups 3 and 4 because the property underlying sale 1
was on the same block as the properties underlying property groups 3 and 4. He
also reasonably concluded that sales 7, 8, and 9 provided guidance on the impact of
size on value. He acknowledged that group 3 property was sold in 2007, but here
where the sale was more than four years later he properly minimized or
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disregarded that sale either because the value of industrial properties had surged
since 2004 or the sale date was too far removed from the valuation date.38
4. Property Group 5
Mr. Holzhauer opined that the applicable fair market value of property group
5 was $450,000. Mr. Eichel ascertained that the applicable value was $5 million.
We find that the value was $3,975,000 (or, as explained below, $5 million as
adjusted to reflect an average 1% per month appreciation in the property from the
valuation date to the original option exercise date of August 12, 2004).
Mr. Eichel noted that property group 5 was under option as of the valuation
date for purchase at a price of $5 million. He noted that the property was later sold
to a national builder of homes and opined that a key element of the value of
property group 5 was the option purchase price. He analyzed other sales of similar
residential development land in the surrounding area and concluded that the $5
million option price for property group 5 was significantly lower than the other
38
Actual sales of the same property within a reasonable period after the
valuation date are relevant and admissible. See Estate of Giovacchini v.
Commissioner, T.C. Memo. 2013-27, at *50-*58 (and cases cited thereat). That
said, where relevant events materially affecting value were not reasonably
foreseeable on the valuation date, the price effect of those events should be
discounted or adjusted in determining value as of the valuation date, or the entire
subsequent sale should be disregarded.
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sale prices but that a reasonable purchaser would pay no more than $5 million for
property group 5.
Mr. Holzhauer minimized the fact that Santee was driving a development of
the property surrounding property group 5 and determined that the highest and best
use for property group 5 was mining with a remote possibility of future residential
development. He ascertained his $450,000 fair market value for property group 5
by first determining a trended value for the property on the basis of the price that
petitioner paid for the property approximately 54 months before the valuation date.
He then applied an appreciation rate of approximately 1% per month to reflect the
appreciation of industrial land. He concluded that the option agreement was
irrelevant to his valuation of property group 5 because, he stated, the rules of
valuation require that the property be valued as if it were for sale “free and clear”
of the option.
We disagree with Mr. Holzhauer’s analysis as to property group 5. Contrary
to his belief, the option agreement was not irrelevant in valuing property group 5.
In addition, contrary to petitioner’s statements in its brief, we do not ignore the
option agreement in valuing property group 5 or otherwise value that property as if
it were for sale free and clear of the option. The fact that property group 5 was
subject to the option agreement on the valuation date and that our hypothetical
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buyer and hypothetical seller are considered to know the same are important facts
that must be taken into account when valuing that property. In other words, the
hypothetical buyer and the hypothetical seller in buying and selling the property
would know that the option agreement, as it existed on the valuation date, had to be
consummated by August 12, 2004 (20-1/2 months after the valuation date). This
agreement further provided that the owner of the property immediately before
consummation of the option would either sell property group 5 to the optionee for
$5 million, or if it did not, the owner, petitioner, would sell the optionee the
referenced easements for $2 million, in which case the optionee at its cost would
improve the access road and stub utilities at the access road to all other approved
property lots.39 While the initial optionee may have been a strategic buyer as Mr.
39
Petitioner invites the Court to find as a fact that the optionee had both an
option to purchase property group 5 for $5 million and an option to purchase the
easements for $2 million. We decline to do so. As we read the option agreement,
and as we ultimately find in consideration of the record as a whole, the option
applies only to the purchase of property group 5 for $5 million. To be sure, the
option agreement explicitly distinguishes the option from the mandatory sale of the
easements. The option agreement states in part:
In the event that Optionee does not exercise the Option
provided for herein, Optionor shall sell to Optionee an easement for
ingress and egress over the road across the Property shown on the
approved tentative map for the Master Project * * * [and that]
Optionor shall grant Optionee an easement over the land at the
entrance of the Master Project, not to exceed one-half acre, in order to
erect appropriate entry monumentation for the Master Project.
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Holzhauer opined, this does not mean, as Mr. Holzhauer concluded, that a
hypothetical willing buyer and a hypothetical willing seller would ignore the fact
that the optionee was contemplating buying the property at a future date for $5
million. Nor would the hypothetical willing buyer and the hypothetical willing
seller ignore the fact that the optionee was obligated to pay $2 million to the owner
of the property for easements on the property, make road improvements, and stub
utilities if the optionee did not exercise the option.
As we see it, forgetting for the moment any appreciation in property group 5
between the valuation date and the date that the option is consummated, that
property was worth at least approximately $2 million on the valuation date given
that the optionee, at a minimum, was going to pay $2 million for easements on the
property approximately 20-1/2 months later.40 The question, therefore, is how
much more than $2 million was it worth? Petitioner argues that the exercise of the
option was “very speculative” as of the valuation date and should be given no
weight. We disagree.
The optionee was committed to pay $2 million for the easements alone
(exclusive of the additional cost of the improvements), and we do not consider it
unreasonable to conclude that the optionee would pay the extra $3 million (or less,
40
We say “approximately” because the optionee also had to make certain
improvements to the property in return for the easements.
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when taking into account the improvement cost) to acquire the full bundle of the
property rights included in the 31.47 acres of property group 5. This is especially
true given that Santee was spearheading the development of the nearby property as
a residential development, and the record leads to the conclusion that a
hypothetical buyer and a hypothetical seller would both anticipate that the option
was going to be exercised at the $5 million strike price.41 To be sure, we doubt that
sophisticated longtime businessmen such as the members of the Enniss family
would encumber their property with the two-year option in return for a single
dollar and the permanent easement sale for $2 million were they not confident that
the option was likely to be exercised.
Mr. Eichel analyzed various similar properties and concluded that the fair
market value of property group 5 was at least $5 million. Respondent invites the
Court to set the applicable value at $5 million. We decline to do so. We believe
that the $5 million option price is a reliable guide to the fair market value of
property group 5 as of the exercise date but that the price must be adjusted to take
into account the time value of money (also appreciation in property group 5)
between August 12, 2004, and the valuation date. See Estate of Trompeter v.
41
The fact that the parties to the option agreement expected the development
to go through is also seen in part by observing that the option agreement provided
that FDC would pay EFR $2 million for the easements after the first final
subdivision map for the master project was approved.
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Commissioner, T.C. Memo. 1998-35; Estate of Scanlan v. Commissioner, T.C.
Memo. 1996-331. Similar property in the area was appreciating at the rate of 1%
per month, and we believe it appropriate to discount the $5 million option price by
20-1/2% to reflect (primarily but among other things) the passage of time from the
valuation date to August 12, 2004.
While, theoretically speaking, the fair market value of property group 5
should also take into account the risk that the optionee would not have the funds to
pay $5 million to exercise the option, the fact that Santee was pushing the
development of the nearby property and that we apply the 1% rate for each of the
20-1/2 months persuades us that this calculation best establishes the fair market
value of property group 5 as of the valuation date. We hold that the applicable fair
market value of property group 5 was $3,975,000 (i.e., $5 million x (1 - .205)).
5. Bulk Sale Discount
Mr. Holzhauer applied a bulk sale discount of 15% to the total value of the
nine property groups. Petitioner argues that the discount is appropriate to reflect
the fact that the nine groups of property are valued as if they were sold as of the
same time. While petitioner calls this discount a “bulk discount”, we understand
petitioner to refer to a “market absorption” or “blockage” discount. See Estate of
Auker v. Commissioner, T.C. Memo. 1998-185.
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We agree with petitioner that a 15% discount is reasonable under the facts
herein. Relevant evidence of value may include consideration of a market
absorption discount in that such a discount reflects the fact that the sale of a large
block of property in the same general location over a reasonable period of time
usually depresses the price for that property. See id.; see also Estate of Sturgis v.
Commissioner, T.C. Memo. 1987-415 (20% market absorption discount applied to
11,298.86 acres of undeveloped land); Carr v. Commissioner, T.C. Memo. 1985-19(30% market absorption discount applied to 175 developed lots; no discount
applied to 437.5 undeveloped lots); Estate of Folks v. Commissioner, T.C. Memo.
1982-43 (20% market absorption discount applied to five leased lumberyards with
the same tenant and in the same geographical area); Estate of Grootemaat v.
Commissioner, T.C. Memo. 1979-49 (15% market absorption discount applied to
undeveloped lots totaling 302 acres). We believe that the sale of the nine property
groups on or about the valuation date would depress the price for that property and,
under the facts at hand, conclude that the 15% discount that petitioner requests is a
reasonable measure of that depression.
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VII. Insurance Premiums
Respondent determined that petitioner failed to recognize insurance
premium income of $128,584, $882, $299,178, and $298,000 received respectively
in 2002, the one-day taxable year in 2003, the remaining taxable year in 2003, and
2004. Respondent determined these amounts on the basis of insurance revenues
that petitioner reported on its Forms 990 for 2002 through 2004. Respondent
continued to argue that these amounts were taxable as insurance premiums up until
respondent’s opening brief was filed. In that brief, respondent abandoned the
characterization of the amounts as insurance premiums income, arguing instead
that the amounts are rental income. Respondent asserts that the amounts petitioner
reportedly received as insurance premiums were actually received as rent because
the royalty rate set forth in the lease between EFR and Enniss, Inc., was not at fair
market value. Respondent asserts that EFR could extract whatever amount of rent
it deemed appropriate from Enniss, Inc., during the subject years because EFR
could change lease terms at its discretion and terminate at will the leasehold of
Enniss, Inc.
Petitioner argues in its pretrial memorandum (and in its opening brief) that
the disputed amounts do not reflect insurance premiums income because petitioner
failed to provide insurance. Instead, petitioner argues, the amounts are nontaxable
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contributions to capital pursuant to Carnation Co. v. Commissioner, 640 F.2d 1010(9th Cir. 1981) (holding that funds that a corporation received as insurance
premiums were recharacterized as nontaxable contributions to capital because the
corporation did not provide insurance), aff’g 71 T.C. 400 (1978). Petitioner argues
in its answering brief that it is prejudiced by respondent’s attempted
recharacterization of the disputed amounts at this late stage of this proceeding
because it never knew that it had to prove that the funds were not rent. Petitioner
asserts that it would have developed and presented evidence at trial showing that
the lease terms were at arm’s length had it known that respondent was going to
make the arguments that respondent now advances.
We agree with petitioner that respondent’s new position is untimely. A
party may not raise an issue for the first time on brief if the Court’s consideration
of the issue would surprise and prejudice the opposing party. See Smalley v.
Commissioner, 116 T.C. 450, 456 (2001); Seligman v. Commissioner, 84 T.C.
191, 198-199 (1985), aff’d, 796 F.2d 116 (5th Cir. 1986). In deciding whether the
opposing party will suffer prejudice, we consider the degree to which the opposing
party is surprised by the new issue and the opposing party’s need for additional
evidence to respond to the new issue. See Pagel, Inc. v. Commissioner, 91 T.C.
200, 212 (1988), aff’d, 905 F.2d 1190 (8th Cir. 1990). In addition, a party may not
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rely upon a new theory unless the opposing party has been provided with fair
warning of the intention to base an argument upon that theory. See id. at 211-212.
“Fair warning” means that a party’s ability to prepare its case was not prejudiced
by the other party’s failure to give notice, in the notice of deficiency or in the
pleadings, of the intention to rely on a particular theory. See id.
We conclude that respondent’s raising of the rental income issue in
respondent’s opening brief precluded or limited petitioner’s opportunity to present
pertinent evidence and that petitioner would be significantly prejudiced if we
decided that issue on the basis of the record at hand. Respondent had numerous
opportunities to raise the new theory, and the failure to raise this issue when
respondent could have done so waives the argument. See Aero Rental v.
Commissioner, 64 T.C. 331, 338 (1975). We decline to consider it. Because
petitioner did not provide insurance during the subject years, we conclude that the
funds that it received as insurance premiums could not have been received as such
but were instead received as contributions to its capital. See Carnation Co. v.
Commissioner, 640 F.2d at 1013-1014.
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The Court has considered all contentions, arguments, requests, and
statements that the parties made and has rejected those not discussed here because
they were without merit, moot, or irrelevant.
To reflect the foregoing,
Decisions will be entered under
Rule 155.