Farah v. Comm'r

T.C. Memo. 2007-369
UNITED STATES TAX COURT
J. RAMSAY FARAH AND ELIZABETH FARAH, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 23412-05. Filed December 19, 2007.
Jurist Bruce Howard, for petitioners.
Jay A. Roberts and Ann M. Welhaf, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
HAINES, Judge: Respondent determined a deficiency in
petitioners’ Federal income tax of $170,925 and a penalty under
section 6662(a) of $34,185, for 2001.1
1
Unless otherwise indicated, section references are to the
Internal Revenue Code, as amended. Rule references are to the
Tax Court Rules of Practice and Procedure. Amounts are rounded
to the nearest dollar.
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After concessions,2 the issues for decision are: (1)
Whether petitioners may exclude the gain on the sale of their
Berlin home under section 121; (2) whether petitioners may also
exclude the gain on the sale of the South Point Road lot under
section 121; and (3) whether petitioners are liable for a penalty
under section 6662(a).
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulation of facts, the exhibits attached thereto, and the
stipulation of settled issues are incorporated herein by this
reference. At the time they filed their petition, petitioners
resided in Hagerstown, Maryland.
Background
In 1976, petitioner Dr. J. Ramsay Farah (Dr. Farah) opened
his pediatric medical practice in Hagerstown, Maryland.3 Over
the years, petitioner Elizabeth Farah (Ms. Farah) also worked for
the medical practice assisting with various administrative
duties. However, she always worked from her home.
2
Petitioners concede they are not entitled to a loss of
$45,733 from their Schedule E, Supplemental Income and Loss,
rental real estate activities, and they are not entitled to
Schedule C, Profit or Loss From Business, deductions of $64,915.
Petitioners also concede they failed to report State income tax
refunds of $3,354.
3
At various times from 1980 through 1998, Dr. Farah operated
medical offices in Waynesboro, Pennsylvania, and Boonsboro,
Maryland, in addition to his Hagerstown practice.
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On November 13, 1976, Dr. Farah was appointed to the medical
staff of Washington County Hospital in Hagerstown, Maryland. In
May 1977, petitioners purchased a large, historic house located
at 1003 The Terrace, Hagerstown, Maryland (Hagerstown house). At
the time of trial in this case, petitioners still owned the
Hagerstown house. Dr. Farah has always maintained an office in
the Hagerstown house. Since 1980, he has used the Hagerstown
address as the business address for his medical practice and
myriad other business activities.
In addition to their work in the medical practice, since
1992, petitioners have been general partners in the Boonsboro
Medical Center Partnership (Boonsboro Partnership), which owns
and leases office space to various tenants including physicians.
Dr. and Ms. Farah own a 71.74-percent and 1.74-percent interest
in the Boonsboro Partnership, respectively.
The Purchase of the Berlin House and the South Point Road Lot
On October 18, 1989, petitioners purchased a piece of
waterfront property consisting of 3.27 acres and a house located
at 5922 South Point Road, Berlin, Maryland (Berlin house).
Petitioners intended to use it as a summer home and eventually
make it their retirement home.
The property was originally listed for sale for $399,000.
However, the sellers accepted petitioners’ offer of significantly
less, either $315,000 as respondent contends or $365,000 as
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petitioners contend. The contract for sale lists the purchase
price as $315,000. The form HUD-1 settlement sheet issued at the
closing also lists the total purchase price as $315,000. An
addendum to the contract provides that $50,000 is to be paid for
“personal property not specifically included in the contract for
purchase.” Petitioners executed a promissory note in the amount
of $50,000 in favor of the sellers. The note carried a term of 5
years and called for $5,000 of interest to be paid.
Over the years, petitioners made significant improvements to
the Berlin house, costing a total of $274,375, to make it a
suitable retirement home. In addition to improving the house,
petitioners required additional land for a yard and septic
drainage field as most of the property surrounding the Berlin
house was marshland. To that end, petitioners planned to
purchase the 2.39 acre unimproved lot adjacent to the Berlin
house, known as Lot 1, Minor Subdivision of W.V. Krewatch Land,
South Point Road Berlin, Maryland (South Point Road lot).
On April 6, 1991, on the advice of counsel, petitioners
formed the J. Ramsay Farah Family Partnership (Family
Partnership), a Maryland general partnership for the purpose of
owning and developing the South Point Road lot. Petitioners
purchased the land through the partnership to help protect the
property from liabilities arising from Dr. Farah’s medical
practice. Dr. Farah was told by counsel that holding the land
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with his children would make it difficult to attach. Upon
formation of the Family Partnership, Dr. and Ms. Farah each held
a 35-percent interest. Two of their four children, Frederick
Farah (then age 17) and Veronica Farah (then age 11), each owned
15-percent interests.4 The partnership agreement was signed by
Dr. and Ms. Farah. It was not signed by either of their
children, nor did either child make a capital contribution to the
Family Partnership. The Family Partnership did not register as a
business entity in the State of Maryland or obtain an employee
identification number.
On the day of its formation, the Family Partnership
completed the purchase of the South Point Road lot. At the time
of purchase, the only structure on the lot was a tool shed.
There was no separate electricity line, well, sewer line, or
septic system. At the closing, petitioners paid $51,880 in cash.
The balance of the purchase price was financed through a
promissory note and a purchase money mortgage to the seller made
by the Family Partnership.
Petitioners made improvements to the South Point Road lot.
They constructed a bulkhead and concrete path that extended along
the shoreline from the Berlin Residence property into the South
Point Road lot to protect the property from the water. They also
constructed a fence that went around both properties. The lots
4
Petitioners also had two older children, Patrick Farah and
another whose name was not disclosed in the record.
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were landscaped, and petitioners constructed a chain link dog
enclosure.
Petitioners’ Move to Berlin
In the spring of 1997, Veronica Farah, petitioners’
daughter, was accepted as a freshman at Salisbury State
University. It was the only school to which she applied.
Salisbury State University is located in Salisbury, Maryland,
approximately a 30-minute drive from petitioners’ Berlin house.
At that time, Veronica required heightened parental
supervision and support, including the regular administration of
medication. To support their daughter, petitioners planned to
move with her to the Berlin house. In preparation for the move,
Dr. Farah put his Hagerstown medical practice up for sale in
September 1997. He also closed his Boonsboro practice. In June
1998, Dr. Farah completed the sale of his Hagerstown medical
practice.
Ms. Farah moved to the Berlin House in July 1997 to be with
Veronica, who was enrolled full time at Salisbury State
University from the fall term of 1997 through the fall term of
2001. In addition to her studies, she worked part time at
various restaurants and night clubs in Ocean City, Maryland. Ms.
Farah drove Veronica to and from class, as well as to and from
her part-time jobs. Both Veronica and Ms. Farah received medical
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treatment, including surgery, in Salisbury, Maryland, near
petitioners’ Berlin home.
While living in Hagerstown, petitioners were involved in
several social and community activities, such as the Rotary Club,
the Northwood Swim Club, the YMCA, and the Maryland Symphony
Orchestra. Around the time of their move to the Berlin residence
they discontinued their membership or involvement with these
activities.
In May 1998, Dr. Farah began working part-time for Sierra
Military Health (Sierra) as an Associate Medical Director at
Sierra’s office, located in Baltimore, Maryland. Among many
other responsibilities, Sierra credentials hospitals that provide
care to military personnel and their dependents.
In October 1998, Dr. Farah was promoted to full medical
director working in quality assurance. The position required
that he work 3 days a week at Sierra’s Baltimore office.
Baltimore is approximately 75 miles from Hagerstown and 138 miles
from Berlin. Dr. Farah traveled extensively from Baltimore to
various clinics and medical facilities located along the east
coast from Maine to northern Virginia. Dr. Farah continued his
employment with Sierra until March 28, 2005.
His position with Sierra required that he perform a half-day
of clinical work each week, which he did with Towson Express,
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located in Towson, Maryland, a suburb of Baltimore. Towson is
approximately 78 miles from Hagerstown and 152 miles from Berlin.
Until October 1998, Dr. Farah served as Medical Director at
Victor Cullen Academy, a home for juvenile detainees, located in
Sabillasville, Maryland. On October 7, 1998, his Service
Agreement with Victor Cullen Academy was terminated because he no
longer lived within 20 miles of the facility. Hagerstown is
approximately 17 miles from Sabillasville. Berlin is more than
200 miles from Sabillasville.
On April 30, 1999, Dr. Farah neglected to renew his
membership on the medical staff of Washington County Hospital, in
Hagerstown. Although Dr. Farah traveled extensively, as often as
possible he returned to Berlin at the end of a workday. He was
always in Berlin on weekends and other nonworking days to be with
his family.
Use of the Hagerstown House from July 1997 to September 2001
Before the completion of the sale of his medical practice in
June 1998, Dr. Farah spent considerable time in the Hagerstown
house. After the sale of his practice, Dr. Farah visited the
Hagerstown house more frequently than his wife did. He would
return at least once a month to collect bulk mail sent there.
In contrast, Ms. Farah rarely went to the Hagerstown house.
In August of 1999, she stayed in the Hagerstown house for the
baptism of her grandson and to renew her driver’s license. To
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perform her management duties with the Boonsboro Partnership, Ms.
Farah rarely went to the Boonsboro building. She handled all
bills and tenant issues by mail or by phone from Berlin.
Although they spent little time in Hagerstown, petitioners
always used the Hagerstown address as their mailing address.
They used the Hagerstown address on their voter registrations,
their vehicle registrations, their driver’s licenses, and on all
Federal and State income tax returns. During the relevant years,
Maryland imposed a local income tax based on the county in which
the taxpayer lived. Although the rates changed year to year, a
taxpayer domiciled in Hagerstown paid a tax rate of approximately
2.5 percent, while a taxpayer domiciled in Berlin paid only 1
percent during the relevant period. See Md. Code Ann., Tax-Gen.
sec. 10-106 (LexisNexis 2004).
All bills associated with the Berlin house were sent to
Hagerstown. Petitioners also used the Hagerstown address as
their mailing address for two shoreline construction permits
obtained for the Berlin house.
Petitioners did not stop water or utility service to the
Hagerstown house at any time. Both water usage and electricity
usage remained consistent from July 1997 through January 2007.5
5
The average quarterly water usage at the Hagerstown house
from July 15, 1997 through Oct. 12, 2001 was 128.22 units. The
average quarterly water usage at the Hagerstown house from Oct.
12, 2001 through Jan. 23, 2007 was 113.45 units. The average
(continued...)
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Christina Farah, who would later marry and divorce
petitioners’ son, moved into the Hagerstown house with
petitioners in 1996. She left in July 1997 to live in Texas with
petitioners’ son, Patrick Farah. She returned to Hagerstown in
January 1998 and stayed until October 1998. Christina’s first
son was born November 27, 1998, in Dallas, Texas. Petitioners
spent Christmas of 1998 in Dallas with Patrick and Christina.
Christina returned to Hagerstown in January of 1999. After that,
she would go to Dallas periodically for visits usually lasting a
week or a weekend. Because Christina’s husband was abusive at
times, petitioners allowed her to stay in the Hagerstown house
rent-free to provide a safe and secure environment for Christina
and her children, petitioners’ grandchildren.
Christina often forwarded petitioners’ mail to them at their
Berlin home. She also spent holidays with petitioners at their
Berlin home. When Christina was not in Hagerstown, petitioners’
son Frederick Farah, who liked to use the hot tub at the
Hagerstown house with his friends, would go there to forward the
mail.
5
(...continued)
electricity usage at petitioners’ Hagerstown house from July 15,
1997 through Oct. 11, 2001 was 2,867.62 kilowatt hours. The
average electricity usage at petitioners’ Hagerstown house from
Nov. 9, 2001 through Feb. 14, 2007 was 3,080.23 kilowatt hours.
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Petitioners’ Move Back to Hagerstown and the Sale of the Berlin
House and the South Point Road Lot
In January 2001, Ms. Farah was diagnosed with an aggressive
and rare form of lung cancer requiring major surgery and medical
followup. At that time, petitioners were unsure of her chances
of survival and their prospects for the future. As they needed
additional funds, and felt Ms. Farah’s future medical needs would
be best served in a major medical center, petitioners decided to
sell the Berlin house and the South Point Road lot.
In March 2001, Dr. Farah consulted with his attorney
regarding his estate plan and the sale of the two properties. On
March 11, 2001, petitioners entered into a listing agreement to
sell the Berlin residence, together with the South Point Road
lot. The listing agreement listed the owner of the South Point
Road lot as the Family Partnership. Petitioners never considered
selling the properties separately.
In the spring of 2001, Dr. Farah was a candidate for a
position on the Maryland Board of Physician Quality Assurance
(BPQA). Dr. Farah’s candidate submission to the BPQA
represented that he resided in Hagerstown, Maryland. In May
2001, Dr. Farah began working part time as the Medical Director
for Colonial Management Group in Hagerstown, Maryland.
Consequently, Dr. Farah began spending more time in Hagerstown.
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On September 24, 2001, petitioners had most of the
furnishings of the Berlin house packed and shipped to Hagerstown.
On October 27, 2001, both the Berlin house and the South Point
Road lot were sold to one buyer for a total of $1,300,000. At
the closing, the settlement company prepared separate form HUD-1
settlement sheets for the Berlin house and the South Point Road
lot. Petitioners did not know there would be separate settlement
sheets for the two properties until the day of the closing. The
separate settlement sheets allocated $800,000 of the sales
proceeds to the Berlin residence and $500,000 to the South Point
Road lot. The allocation of the $1,300,000 between the two
properties was not negotiated by petitioners or the buyer. The
settlement sheet for the South Point Road lot listed the Family
Partnership as the owner. No change in ownership of the South
Point Road lot was recorded between its purchase in 1991 by the
Family Partnership and its sale in 2001.
Petitioners’ 2001 Return and the Notice of Deficiency
On August 15, 2002, petitioners filed their joint Form 1040,
U.S. Individual Income Tax Return, for 2001. On the Schedule C,
Profit or Loss From Business, attached to their return,
petitioners reported gross receipts of $16,798 and expenses of
$93,145, resulting in a loss of $76,347. Some of the expenses on
the Schedule C related to Dr. Farah’s employment with Sierra.
Dr. Farah did not maintain his own records for his work
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activities with Sierra. Instead, he relied on records maintained
by Sierra, which were destroyed in the fall of 2004.
The Schedule D, Capital Gains and Losses, attached to their
2001 return reported an amount realized of $600,000 from the sale
of their Berlin house and a corresponding adjusted basis of
$600,000. The Schedule D did not report the sale of the South
Point Road lot. The Schedule E, Supplemental Income and Loss,
reported a loss from the Boonsboro Partnership of $45,733.
On September 19, 2005, respondent issued petitioners a
notice of deficiency, disallowing petitioners’ Schedule C
expenses and Schedule E loss. Respondent also adjusted
petitioners’ income to include a capital gain of $660,371 on the
sale of the Berlin house and the South Point Road lot.
OPINION
A. Burden of Proof
Generally the taxpayer bears the burden of proving the
Commissioner’s determinations are erroneous. Rule 142(a).
However, the burden of proof with respect to a factual issue
relevant to the liability of a taxpayer for tax may shift to the
Commissioner under section 7491(a) if the taxpayer has produced
credible evidence relating to the issue, has met his
substantiation requirements, maintained records, and cooperated
with the Secretary’s reasonable requests for documents,
witnesses, and meetings.
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On brief, petitioners argue that the burden of proof on the
issue of whether the Berlin house was petitioners’ principal
residence should shift to respondent. Our resolution of the
issue is based on the preponderance of the evidence rather than
the allocation of the burden of proof; therefore, we need not
address petitioners’ section 7491(a) argument. See Estate of
Bongard v. Commissioner, 124 T.C. 95, 111 (2005). Petitioners
bear the burden of proof on all other issues affecting their
liability for the deficiency in their Federal income tax.
B. Section 121 and Principal Residence
Section 121 provides for the exclusion from gross income of
up to $250,000 of gain from the sale or exchange of property, if
the property was owned and used by the taxpayer as the taxpayer’s
principal residence for periods aggregating 2 years or more
during the 5-year period preceding the sale or exchange. A
husband and wife filing a joint return may exclude a maximum of
$500,000 of the gain from gross income if at least one spouse
meets the ownership requirement and both spouses meet the use
requirement of section 121(a). Sec. 121(b).
Petitioners argue that they may exclude the gain from the
sale of the Berlin house and the South Point Road lot from their
gross income pursuant to section 121 because they owned and used
the two properties as their principal residence from July 1997
through September 2001. Respondent argues petitioners are not
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entitled to the exclusion for either property because the
Hagerstown house was petitioners’ principal residence at all
times.
Whether a residence qualifies as the taxpayer’s principal
residence for purposes of section 121 is a question of fact that
is resolved with reference to all the facts and circumstances.
Sec. 1.121-1(b)(2), Income Tax Regs.; see also Thomas v.
Commissioner, 92 T.C. 206, 244 (1989); Clapham v.
Commissioner, 63 T.C. 505, 508 (1975). “If a taxpayer alternates
between 2 properties, using each as a residence for successive
periods of time, the property that the taxpayer uses a majority
of the time during the year ordinarily will be considered the
taxpayer’s principal residence.” Sec. 1.121-1(b)(2), Income Tax
Regs.6 In order to meet the 2-year use requirement, occupancy of
the residence is required.7 Sec. 1.121-1(c)(2)(i), Income Tax
Regs.
6
Sec. 1.121-1, Income Tax Regs., generally applies to sales
and exchanges that occurred on or after Dec. 24, 2002. However,
for sales or exchanges of a principal residence before Dec. 24,
2002, but after May 7, 1997, taxpayers may elect to apply sec.
1.121-1, Income Tax Regs., by filing a return for the taxable
year of the sale or exchange that does not include the gain from
the sale. Sec. 1.121-4(j), Income Tax Regs. The sale of the
Berlin residence took place on Oct. 27, 2001. Petitioners’ 2001
return did not include the gain from the sale of the Berlin
residence. Therefore, sec. 1.121-1, Income Tax Regs., applies to
the sale. Nevertheless, our decision in this case would be the
same whether or not sec. 1.121-1, Income Tax Regs., applied.
7
Short temporary absences, such as for vacation, are counted
as periods of use. Sec. 1.121-1(c)(2)(i), Income Tax Regs.
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For example, if an individual owns homes in New York and
Florida, spending 7 months of the year in the New York home, and
5 months in the Florida home, absent facts and circumstances
indicating otherwise, the New York home is the individual’s
principal residence for all of the year. Sec. 1.121-1(b)(4),
Example (1), Income Tax Regs. In contrast, if an individual who
owns homes in Maine and Montana, lives in the Maine home for 2
years, then lives in the Montana home for 2 years, and then
returns to Maine, each house is her principal residence while she
lives there. Sec. 1.121-1(b)(4), Example (2), Income Tax Regs.
In addition to the use of the property, other relevant
factors in determining a taxpayer’s principal residence, include,
but are not limited to:
(i) The taxpayer’s place of employment;
(ii) The principal place of abode of the
taxpayer’s family members;
(iii) The address listed on the taxpayer’s federal
and state tax returns, driver’s license, automobile
registration, and voter registration card;
(iv) The taxpayer’s mailing address for bills and
correspondence;
(v) The location of the taxpayer’s banks; and
(vi) The location of religious organizations and
recreational clubs with which the taxpayer is
affiliated.
Sec. 1.121-1(b)(2), Income Tax Regs.
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1. The Berlin House
First, we turn to whether the Berlin house, without regard
to the adjacent South Point Road lot, was petitioners’ principal
residence. Respondent does not dispute that petitioners owned
the Berlin house. Rather, the dispute centers on petitioners’
use of the Berlin house as their principal residence. Ms.
Farah’s use of the Berlin house is similar to section 1.121-
1(b)(4), Example (2), Income Tax Regs. From 1977 to July 1997
she lived in Hagerstown. After it was purchased in 1989, she
occasionally visited the Berlin house. In July 1997, she moved
to Berlin, rarely returning to the Hagerstown house until
September 2001, when she moved back to Hagerstown because of the
impending sale of the Berlin house.
Dr. Farah’s residency is not as simple. After his wife
moved to Berlin, Dr. Farah continued to spend significant time in
Hagerstown until the sale of his medical practice in June 1998.
After the sale of his medical practice, he spent far less time in
Berlin than his wife because of his work schedule.
In May 1998, he began working for Sierra, a job that
required him to be in Baltimore 3 days a week. Baltimore is
approximately 75 miles from Hagerstown and 138 miles from Berlin.
The job also required that he travel extensively, though the
record is unclear whether that travel substituted for his 3 days
in Baltimore.
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In addition to his employment with Sierra, Dr. Farah also
worked at a clinic a half day a week in Towson, Maryland, a
suburb of Baltimore. Towson is approximately 78 miles from
Hagerstown and 152 miles from Berlin. Petitioners credibly
testified that Dr. Farah returned to Berlin on the weekends and
on all nonworkdays. They also credibly testified that he
returned approximately once a month to the Hagerstown house after
the sale of his practice, and before he began working in
Hagerstown in May 2001. The record is unclear, however, as to
where Dr. Farah stayed while working in Baltimore and Towson, and
how often his work required him to travel to various medical
facilities. What is clear is that between the sale of his
medical practice in June 1998 and his return to work in
Hagerstown in May 2001, Dr. Farah spent significantly more time
in Berlin than he did in Hagerstown.
Respondent argues that the consistent usage of utilities
between 1997 and 2007 in the Hagerstown house indicates that
petitioners spent significant time there. However, the
consistent utility usage is explained by the occupation of the
Hagerstown house by petitioners’ daughter-in-law, Christina
Farah, and after January 1999, her newborn son.
Respondent argues that because Dr. Farah’s employment with
Sierra called for him to work in Baltimore, which is closer to
Hagerstown than Berlin, his principal residence must be in
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Hagerstown. However, Dr. Farah’s employment history indicates he
stopped residing in Hagerstown in June 1998. Around the time he
began work for Sierra, Dr. Farah sold his Hagerstown practice,
gave up his privileges at the local Hagerstown hospital, and was
terminated from employment with the Victor Cullen Academy because
he no longer lived in Hagerstown or elsewhere within a 20-mile
radius of the facility.
Respondent relies heavily on the fact that petitioners used
the Hagerstown address on their tax returns, driver’s licenses,
vehicle registrations, and voter registrations. Petitioners
explain that they did not change their mailing address because
they wanted to maintain a consistent appearance considering Dr.
Farah’s myriad professional and business activities, including
positions with various State medical boards. Since 1980, Dr.
Farah has used the Hagerstown address for all of his business
activities. Petitioners further argue that the addresses were
not changed on their tax returns, voter registrations, driver’s
licenses or vehicle registrations because they still resided in
Maryland, they still owned the Hagerstown house, they did not
believe that changing the address made any difference,8 and they
wanted all mail sent to a single address.
8
In fact, petitioners’ residency affected the amount of
Maryland local income tax petitioners paid. The local income tax
rate imposed on residents of Hagerstown is greater than that
imposed on residents of Berlin. See Md. Code Ann., Tax-Gen. sec.
10-106 (LexisNexis 2004).
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Respondent argues that petitioners’ lack of affiliation with
social organizations in the Berlin area indicates that the
Hagerstown house was their principal residence. Petitioners were
involved in the Rotary Club, the Northwood Swim Club, the YMCA,
and the Maryland Symphony Orchestra while living in Hagerstown.
The record indicates petitioners discontinued affiliation with
the Hagerstown organizations in 1997. Petitioners did not become
involved with similar organizations in Berlin. Petitioners
explain that they did not join a swim club in Berlin because they
lived on the water. Furthermore, they did not join similar
organizations because Dr. Farah spent a great deal of time
traveling, and Ms. Farah spent much of her time caring for her
daughter.
For the foregoing reasons, we hold on the preponderance of
the evidence that the Berlin house was Ms. Farah’s principal
residence from July 31, 1997 through September 24, 2001, and that
the Berlin house was Dr. Farah’s principal residence from June
30, 1998 through April 30, 2001. Therefore, petitioners have
each met the 2-year use requirement of section 121 and are
entitled to exclude up to $500,000 of the gain from the sale of
the Berlin house.9
9
The parties dispute whether the purchase price of the
Berlin house was $315,000 as respondent contends, or $365,000 as
petitioner contends. The parties stipulated that in addition to
the purchase price of the property, petitioners are entitled to
(continued...)
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2. The South Point Road Lot
Having decided that the gain on the sale of Berlin house was
excludable under section 121, we now must determine whether the
gain on the adjacent South Point Road lot is also excludable.
Generally, gain from the sale or exchange of vacant land is not
excludable under section 121 unless--
(A) The vacant land is adjacent to land containing
the dwelling unit of the taxpayer’s principal
residence;
(B) The taxpayer owned and used the vacant land as
part of the taxpayer’s principal residence;
(C) The taxpayer sells or exchanges the dwelling
unit in a sale or exchange that meets the requirements
of section 121 within 2 years before or 2 years after
the date of the sale or exchange of the vacant land;
and
(D) The requirements of section 121 have otherwise
been met with respect to the vacant land.
Sec. 1.121-1(b)(3)(i), Income Tax Regs.
Respondent contends that the South Point Road lot was owned
by the Family Partnership, and therefore, petitioners are not
entitled to exclude the gain under section 121. Petitioners
9
(...continued)
an increase in basis of $282,054 with respect to the cost of
improvements, taxes, and settlement charges. Accordingly, the
adjusted basis of the Berlin house at the time of sale was either
$597,054 or $647,054. The parties stipulated that petitioners
received net sales proceeds of $752,582. Therefore, petitioners
realized a capital gain of either $103,528 or $153,528 on the
sale of the Berlin house. As both of these amounts are less than
the $500,000 exclusion, we need not decide the basis of the
Berlin house.
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advance two theories to support their argument that they owned
the property. First, petitioners argue that the partnership was
never fully implemented and therefore should be disregarded.10
Petitioners argue alternatively that the partnership distributed
the South Point Road lot to petitioners in 1992. As we determine
that petitioners failed to meet their burden of proving that they
owned the property, we need not address whether petitioners have
met the other requirements of section 121. See also sec. 1.121-
1(b)(3)(i), Income Tax Regs.
All relevant documentary evidence shows that when the South
Point Road lot was sold in 2001, the seller was the Family
Partnership. Petitioners essentially ask us to apply the
substance over form doctrine. They argue that we should
disregard the form of the transaction (sale by the partnership)
and look instead to the purported substance of the transaction
(sale by petitioners).
10
Petitioners do not argue that the Family Partnership
should be “disregarded” as the term is used in sec. 301.7701-
3(a), Proced. & Admin. Regs., which provides that a noncorporate
entity with a single owner can elect to be disregarded as an
entity separate from its owner. Rather, petitioners argue that
the Family Partnership was an alternative means for petitioners
to hold the property in joint tenancy, and therefore, we should
look past the partnership to its purported substance.
If a residence is owned by a single-owner entity that is
disregarded for Federal tax purposes under sec. 301.7701-3(a),
Proced. & Admin. Regs., the owner is treated as owning the
residence for purposes of the sec. 121 ownership requirement.
Sec. 1.121-1(c)(3)(ii), Income Tax Regs. As the Family
Partnership has multiple owners, it may not be disregarded under
sec. 301.7701-3(a), Proced. & Admin. Regs.
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We have observed that “‘the taxpayer may have less freedom
than the Commissioner to ignore the transactional form that he
has adopted.’” Ill. Power Co. v. Commissioner, 87 T.C. 1417,
1430 (1986) (quoting Bolger v. Commissioner, 59 T.C. 760, 767 n.4
(1973)). In applying the substance over form doctrine, we are
concerned with the intentions of the parties at the time of the
transaction. Groetzinger v. Commissioner, 87 T.C. 533, 542
(1986).
To prevail, the taxpayer must provide objective evidence
that the substance of the transaction is in accord with the
position argued by the taxpayer rather than the form set forth by
the relevant documents. Id. at 541. Furthermore, for substance,
as opposed to form, to control the tax consequences of a
transaction, the taxpayer must establish the claimed substance of
the transaction under a heightened burden of proof. Norwest
Corp. v Commissioner, 111 T.C. 105, 140, 145 (1998); Ill. Power
Co. v. Commissioner, supra at 1434. The strong proof standard
requires the taxpayer to present more than a preponderance of the
evidence in support of his characterization of the transaction.
Ill. Power Co. v. Commissioner, supra at 1434 n.15.
Petitioners argue that although the South Point Road lot was
purchased by the Family Partnership, the partnership was never
fully implemented, and therefore, it should be disregarded.
However, petitioners stipulated that the Family Partnership was
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formed. They stipulated that the partners were petitioners and
two of their children, and that the partnership purchased the
South Point Road lot.
Petitioners argue that because their children did not sign
the partnership agreement, contribute to the partnership, and
that the partnership did not register with the state or receive
an employee identification number, the partnership was not fully
implemented. In determining whether a partnership exists under
Maryland law, the controlling factor is the intent of the
partners to create a partnership. Cohen v. Orlove, 57 A.2d 810,
812 (Md. 1948). Petitioners admit they intended to form a
partnership to insulate the property from attachment by judgment
creditors. Their minor children were central to that goal
because petitioners believed partial ownership by the children
would make the property less susceptible to attachment by
judgment creditors.
Although petitioners’ children did not make contributions to
the partnership, partnerships that are created by gift may be
recognized for Federal tax purposes. See sec. 704(e); sec.
1.704-1(e), Income Tax Regs. That the partnership never
registered with the State of Maryland, nor obtained an employee
identification number is not dispositive.
At all relevant times, petitioners represented that the
property was held by the Family Partnership. It was not until
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receipt of the notice of deficiency that they began to hold
themselves out as the owners of the property. Therefore, we hold
that petitioners have failed to meet their burden of proving that
the Family Partnership was not fully implemented and should be
disregarded.
Petitioners argue alternatively that the Family Partnership
distributed the property to them in 1992. In support of their
position, petitioners introduced into evidence a document
purporting to assign the property to petitioners as tenants by
the entirety. The document is not a deed. The purported
transfer was not recorded, and thus record title to the South
Point Road lot remained with the Family Partnership until its
sale in 2001. The property was never titled in petitioners’
names. Therefore, property tax bills always listed the owner of
the property as the Family Partnership. Similarly, the listing
agreement and the form HUD-1 settlement sheet listed the owner as
the Family Partnership, not petitioners.
Petitioners argue that the property was transferred to
themselves to facilitate a refinancing of the South Point Road
lot and the Berlin house because the lender required the property
be held by petitioners individually. However, the record
indicates that after petitioners used the proceeds of the
refinancing to pay off the respective purchase loans, there was
no longer a mortgage on the South Point Road lot; the only
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mortgage was on the Berlin house. Furthermore, it is unlikely a
lender would require a change in ownership, but not require that
the change be reflected by recordation of a deed of transfer.
Maryland law recognizes that ownership of property may be,
either formally or informally, separated from title to property.
Vlamis v. De Weese, 140 A.2d 665 (Md. 1958). However, we cannot
treat lightly the formal manner in which property is held, lest
we subject legal titles to unnecessary uncertainties and
complicate the administration of law. Estate of Rosenblatt v.
Commissioner, T.C. Memo. 1977-12.
Petitioners had approximately 10 years in which to record
the change in ownership of the South Point Road lot, but they did
not. Petitioners contend they had been the owners of the lot
since 1992. However, when selling the property they listed the
Family Partnership as its owner. It was not until petitioners
realized ownership of the property through the Family Partnership
produced adverse tax consequences that they held themselves out
as the owners of the property. Petitioners were free to organize
their affairs as they chose; nevertheless, having done so, they
must accept the tax consequences of their choices, whether
contemplated or not. See Commissioner v. Natl. Alfalfa
Dehydrating & Milling Co., 417 U.S. 134, 149 (1974).
For the foregoing reasons, we hold that petitioners have
failed to meet their burden of proving they were the owners of
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the South Point Road lot. As they did not own the South Point
Road lot, petitioners are not entitled to exclude the gain on its
sale under section 121.11 Allied Marine Sys., Inc. v.
Commissioner, T.C. Memo. 1997-101, affd. without published
opinion sub nom. Gibbons v. Commissioner, 155 F.3d 558 (4th Cir.
1998).
C. Penalty Under Section 6662(a)
Section 6662(a) imposes a 20-percent penalty on the portion
of an underpayment attributable to negligence or disregard of the
rules or regulations. Although the Commissioner bears the
initial burden of production and must come forward with
sufficient evidence showing it is appropriate to impose an
accuracy-related penalty, the taxpayer bears the burden of proof
as to any exception to the penalty. See sec. 7491(c); Rule
142(a); Higbee v. Commissioner, 116 T.C. 438, 446-447 (2001). In
order to meet the burden of proof, a taxpayer must present
evidence sufficient to persuade the Court that the Commissioner’s
11
The parties have stipulated that the sale of the South
Point Road lot resulted in a gain of $278,962. In accordance
with the partnership agreement, petitioners had a combined 70
percent profits interest in the Family Partnership. Therefore,
there is a taxable gain to petitioners of their distributive
share of the gain in the amount of $195,273.
As the Family Partnership qualifies under the “small
partnership” exception to the partnership audit and litigation
procedures, secs. 6221-6233, respondent was not required to issue
a notice of final partnership administrative adjustment to the
Family Partnership. Sec. 6231(a)(1)(B).
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determination is incorrect. Higbee v. Commissioner, supra at
447.
Petitioners failed to keep adequate records related to their
business expenses, claimed highly inflated deductions,
misreported the gain from the sale of the Berlin house, and
failed to report the substantial gain from the sale of the South
Point Road lot. Therefore, respondent has met his burden of
production.
An accuracy-related penalty is not imposed on any portion
of the understatement as to which the taxpayer acted with
reasonable cause and in good faith. Sec. 6664(c)(1). Reliance
on the advice of a tax professional may constitute reasonable
cause and good faith, if under all the facts and circumstances
the reliance is reasonable and in good faith. Neonatology
Associates, P.A. v. Commissioner, 115 T.C. 43, 98 (2000), affd.
299 F.3d 221 (3d Cir. 2002); sec. 1.6664-4(c)(1), Income Tax
Regs. To qualify for this exception, a taxpayer must prove by a
preponderance of the evidence: (1) The adviser was a
competent professional who had sufficient expertise to justify
reliance; (2) the taxpayer provided necessary and accurate
information to the adviser; and (3) the taxpayer actually relied
in good faith on the adviser’s judgment. Neonatology Associates,
P.A. v. Commissioner, supra at 98-99.
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Petitioners argue that they sought professional tax advice
for the preparation and filing of their 2001 return. Petitioners
presented no evidence of the competence or expertise of their
return preparers. Therefore, petitioners have failed to meet the
first prong of the Neonatology test. See G. Kierstead Family
Holdings Trust v. Commissioner, T.C. Memo. 2007-158.
Petitioners further argue that they provided their return
preparers with all their raw financial data. Petitioners’ 2001
return listed the amount realized on the sale of their residence
as $600,000 and the adjusted basis as $600,000. Neither of these
numbers is accurate. The gross proceeds were $800,000, the net
proceeds were $752,582, and the adjusted basis was either
$597,054 or $647,054. Furthermore, the return did not report any
amount with respect to the $500,000 of gross proceeds received
from the sale of the South Point Road lot. Considering these
major errors and omissions, either petitioners failed to provide
their preparers with the necessary information, or the preparers
lacked the expertise to properly file a Federal income tax
return.
Because petitioners failed to prove they reasonably relied
on a competent tax professional, and because they failed to
assert any other basis for relief, we hold that petitioners
are liable for an accuracy-related penalty under section 6662(a).
In reaching our holdings, we have considered all arguments
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made, and, to the extent not mentioned, we conclude that they are
moot, irrelevant, or without merit.
To reflect the foregoing,
Decision will be entered
under Rule 155.