Appeal from a Decision of the United States Tax Court. Tax Ct. No. 1589-90. Carolyn Miller Parr, Tax Court Judge, Presiding.
Before: Stephen Reinhardt, Edward Leavy, Circuit Judges, and Robert E. Coyle,*fn1 District Judge. Opinion by Judge Coyle; Partial Concurrence and Partial Dissent by Judge Reinhardt.
Taxpayer William Little appeals from the Tax Court's decision imposing additions to tax for negligence, pursuant to 26 U.S.C. § 6653(a), and additions to tax for substantial understatement of tax, pursuant to 26 U.S.C. § 6661, for the tax years 1984, 1985, and 1986. The Commissioner determined that Taxpayer was not entitled to capital gain treatment on his real estate sales, because the properties sold were "dealer property," held primarily for sale to customers in the ordinary course of his business. The Tax Court agreed with the Commissioner and sustained the deficiencies and additions to tax. On appeal Taxpayer has abandoned his claim to capital gain treatment, and challenges only the additions to tax. This Court affirms the Tax Court for the reasons stated herein.
FACTS AND PROCEDURAL HISTORY
In 1972, Taxpayer began buying real estate extensively, primarily at foreclosure sales. Many of the properties purchased were rented for several years before being sold. Of the properties rented, most were rented on a monthly basis, and Taxpayer retained the right to terminate the lease after giving 30 days notice. This enabled him to sell the properties at optimal times. During the tax years at issue, 1984 through 1986, Taxpayer employed approximately 30 or 40 people in his real estate business. Taxpayer relied on a number of brokers, agents, and escrow companies to execute the sale of his real properties. Taxpayer was closely involved with all aspects of his real estate business, including purchase, rental and sales activities.
From 1979 through 1986, Taxpayer's real estate transactions were continuous and substantial. Although the Taxpayer sold fewer than 20 properties in each of the years 1979 through 1982, he sold 68 properties in each of the years 1983 and 1984, he sold 104 properties in 1985, and he sold 149 properties in 1986. After 1982, the properties that Taxpayer intended to sell before expiration of the long-term capital gains holding period were purchased and sold by his wholly owned subchapter S corporation, 2974 Properties, Inc. ("the corporation"), and the properties the Taxpayer intended to hold for the long-term capital gains holding period (which would be eligible for the capital gains deduction*fn2 if they were capital assets) were purchased and sold by him as an individual. The corporation averaged 50 to 75 real estate sales each year during the three year period from 1984 through 1986. The corporation did not claim capital gain treatment on its sales. Taxpayer claimed capital gain treatment on most of his sales. The real estate activities and finances of Taxpayer and of his corporation were virtually indistinguishable.
In order to maximize his capital gains deduction before its repeal under the Tax Reform Act of 1986, on December 30, 1986, Taxpayer transferred 31 of his properties to various real estate agents with whom he regularly did business. Taxpayer signed a grant nominally transferring the property into the transferee's name, and then had the transferee execute a deed of trust and a promissory note in favor of the Taxpayer for the amount of his equity in the property transferred. He then had the trust and grant deeds recorded. The transactions involved no money, and the transferees did not consider themselves to be the owners of the transferred properties. They participated only to help the Taxpayer obtain capital gains deductions.
Taxpayer received rental income of approximately $7,536,000 for the three years. This consisted of $2,600,000 in each of 1984 and 1985 and $2,336,000 in 1986. After deducting expenses and depreciation, Taxpayer claimed rental losses totaling $3,091,645 for the three years: including losses of $609,000 in 1984, $976,780 in 1985, and $1,505,865 in 1986. Proceeds from Taxpayer's real estate sales during the same three year period exceeded $17,500,000.
In March 1987, Taxpayer employed John Ko as an accountant. Mr. Ko observed that the Taxpayers records were in disorder and that the Taxpayer lacked competent employees. Mr. Ko was immediately required to prepare Taxpayer's individual federal income tax returns for 1977 through 1979, which were delinquent. He was also required to prepare Taxpayer's individual return for 1986. Although the 1986 return was filed on time, Mr. Ko lacked adequate time to prepare it properly. Therefore, Mr. Ko attached a disclaimer, entitled "Status of Tax Return Filed," which stated:
This return has been prepared on the basis of available information at this time. While the Taxpayer believed that the liability stated hereon is correct, it may be necessary to submit a Form 1040-X within the period of one year to clarify certain items. It is not expected that the liability on said Form 1040-X will be less than shown hereon.
In addition, Mr. Ko was required to file returns for Taxpayer's corporation for its 1984, 1985, and 1986 tax years.
Upon audit, the Commissioner determined that pursuant to I.R.C. § 1221(1), Taxpayer was not entitled to capital gain treatment on his real estate sales because he sold the properties as a real estate dealer. The Commissioner also determined that Taxpayer was liable for: (1) additions to tax for negligence under I.R.C. § 6653(a) for all three years, because the understatements in tax resulting from the improperly claimed capital gain treatment was due to Taxpayer's negligence or disregard of rules and regulations; (2) additions to tax for substantial understatement of tax liability under I.R.C. § 6661 for all three years; and (3) an addition to tax for late filing under I.R.C. § 6651 for 1985. Accordingly, the Commissioner issued a notice of deficiency to Taxpayer and Taxpayer timely petitioned the Tax Court for relief.
In the Tax Court, the Taxpayer argued that the length of the holding period was the decisive factor in distinguishing property held by a dealer for sale to customers in the ordinary course of business from property held for investment. He maintained that his corporation was the real estate "dealer," handling the short term holdings, and that he individually handled only the "investment" properties, i.e., only the longer-term holdings. In view of the disallowance of the claimed capital gains deductions, Taxpayer sought to avoid taxation altogether on the sham transfers reported in 1986 which attempted to beat the repeal of favorable capital gains treatment. Taxpayer argued that he should be relieved from the negligence penalty on the ground that his claimed capital gain treatment was not due to negligence, but resulted from a good faith dispute over a complex issue. Taxpayer also argued that he should be relieved from the penalty for substantial understatement of tax liability on the grounds that he had substantial authority to support the claimed long-term capital gain tax treatment and that he adequately disclosed the issue and facts by reporting the transactions on the returns.
In its opinion, the Tax Court noted that when Dispositions of property extend over a long period of time and are especially numerous, the likelihood of capital gain is very slight. Conversely, the Taxpayer's capital gain treatment is afforded greater credence when sales are few and isolated. The court found that, here, the continuous and substantial purchases and sales of properties by Taxpayer established that they were executed in the ordinary course of his business as a real estate dealer. The court found that Taxpayer's active involvement in all aspects of the real estate business further supported the Conclusion that the properties were held for sale to customers in the ordinary course of business.
The Tax Court rejected Taxpayer's contention that his corporation was the real estate dealer, and that he, individually, was the real estate investor. The Tax Court determined that the holding period alone is not dispositive. In light of the other factors in this case, the Tax Court rejected Taxpayer's argument that he held properties as an individual for investment. Rather, the court concluded that the "primary purpose" for which they were held was for sale to customers, because the proceeds from the sales far outweighed any rental proceeds. The court ruled that Taxpayer engaged in the business of buying and selling real estate, held the property primarily for sale to customers, and the sales of property occurred in the ordinary course of petitioner's business.
The court rejected Taxpayer's attempt to have the IRS disregard the bogus 1986 transfers, so that Taxpayer could pay tax on the gains in subsequent years when the properties were actually sold. The court held that where, as here, the Taxpayer has clearly attempted to deceive the government by claiming bogus transactions, he cannot simply concede deceit and avoid the transaction if it proves to be disadvantageous from a tax perspective.
The court sustained the negligence penalty. The court rejected Taxpayer's contention that the understatements were due to an honest difference of opinion regarding a complex issue. The court found, instead, that his claim of capital gains deductions on the sales was unreasonable in light of the fact that he had been in the real estate business for several years and obtained most of his income from real estate sales. The court found that Taxpayer's poor record keeping practices and failure to file his 1985 return on time were consistent with negligence.
Finally, the court sustained the addition to tax for substantial underpayment of tax liability. The court found that Taxpayer failed to supply substantial authority for his claim of capital gains deductions on the sales. The court also found that Taxpayer failed to provide adequate disclosure on the return or in attachments thereto of the true nature of his real estate transactions or ...