*This opinion supplements our previously filed opinion in

National Industrial Investors, Inc. v. Commissioner, T.C. Memo.

1996-151.

T.C. Memo. 1996-423

UNITED STATES TAX COURT

NATIONAL INDUSTRIAL INVESTORS, INC., Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent*

Docket No. 24863-93. Filed September 18, 1996.

P, a California corporation, substantially

prevailed in a Tax Court case involving the deduction

of business expenses, interest, depreciation, and net

operating loss carryovers. P then moved for an award

of reasonable administrative and litigation costs

pursuant to section 7430, I.R.C. 

1. Held: P's administrative costs were incurred prior

to the issuance of the statutory notice of deficiency

and are therefore not recoverable. 

2. Held, further, R's litigation position was

substantially justified as to all contended issues, and

P is therefore not entitled to an award of litigation

costs.
Donald Del Grande, for petitioner.

Elaine L. Sierra, for respondent.

SUPPLEMENTAL MEMORANDUM OPINION

NIMS, Judge: This matter is before the Court on

petitioner's Motion for Litigation and Administrative Costs

(motion for costs) filed pursuant to Rule 231 and section 7430 on

April 26, 1996. Unless otherwise indicated, all Rule references

are to the Tax Court Rules of Practice and Procedure. All

section references are to sections of the Internal Revenue Code

in effect during 1989 and 1990. 

The merits of the underlying case were decided in National

Industrial Investors, Inc. v. Commissioner, T.C. Memo. 1996-151,

filed March 26, 1996, and to the extent necessary for the

disposition of this motion, the facts and holdings in T.C. Memo.

1996-151 are incorporated herein by this reference. We shall

repeat the facts as necessary to clarify the following

discussion.

Respondent issued a statutory notice of deficiency on

September 16, 1993. A petition was filed on November 22, 1993. 

At that time, petitioner (NII), a California corporation, had its

principal office at 956 Jackling Drive, Hillsborough, California

94010. On January 18, 1994, respondent filed an answer to the

petition, which she subsequently amended twice. The trial took

place on December 6, 1994 at San Francisco, California, and
- 3 -

petitioner thereafter filed its motion for costs. Respondent

filed notice of objection to petitioner's motion for costs on

June 28, 1996, pursuant to the Court's Order. No hearing has

been requested and none is necessary. Rule 232(a)(3). The

issues for decision are: (1) Whether petitioner qualifies as a

"prevailing party" for purposes of section 7430 and, if so, (2)

whether the administrative and litigation costs petitioner seeks

are reasonable.

 A taxpayer considered a prevailing party in a civil tax

proceeding may be awarded a judgment for reasonable

administrative and litigation costs incurred in that proceeding. 

Sec. 7430(a)(1) and (2). A taxpayer must satisfy several

conjunctive requirements to be deemed a prevailing party. Sec.

7430(c); Polyco, Inc. v. Commissioner, 91 T.C. 963, 964 (1988);

see Minahan v. Commissioner, 88 T.C. 492, 497 (1987). The

taxpayer must:

(1) Establish that the position of the United States in the

civil proceeding was not substantially justified (sec.

7430(c)(4)(A)(i));

(2) substantially prevail in the litigation (sec.

7430(c)(4)(A)(ii)); and

(3) if the taxpayer is a corporation, meet the net worth and

number of employee requirements of 28 U.S.C. sec. 2412(d)(2)(B) 
- 4 -

(1994) (as in effect on the date of the enactment of the Tax

Reform Act of 1986, Pub. L. 99-514, sec. 1551(h)(3), 100 Stat.

2085, 2753) (sec. 7430(c)(4)(A)(iii)).

Courts will not award litigation costs under section 7430(a)

unless a prevailing party has exhausted the administrative

remedies available to such party with the IRS. Sec. 7430(b)(1). 

Moreover, no award for reasonable administrative or litigation

costs may be made with respect to any portion of the civil

proceeding during which a prevailing party has "unreasonably

protracted" such proceeding. Sec. 7430(b)(4).

In the instant case, respondent agrees that petitioner has: 

(1) Substantially prevailed with respect to the amount in

controversy; (2) exhausted the administrative remedies available

to it; (3) not unreasonably protracted the proceedings; and (4)

shown that the net worth and number of employees requirements

have been met. Respondent contends, however, that her position

was substantially justified so that petitioner is not a

prevailing party for purposes of section 7430. In the

alternative, respondent argues the amount of administrative and

litigation costs claimed by petitioner is unreasonable. 

Since petitioner's motion for costs was filed prior to the

enactment of the Taxpayer Bill of Rights 2, Pub. L. 104-168, sec.

701, 110 Stat. 1452, 1463 (1996), it bears the burden of proving

that respondent's position in the proceedings was not
- 5 -

substantially justified or was unreasonable. Sec.

7430(c)(4)(A)(i); Rule 232(e); Polyco, Inc. v. Commissioner,

supra at 965; Minahan v. Commissioner, supra at 498; DeVenney v.

Commissioner, 85 T.C. 927, 928-930 (1985). The pre-1986 version

of section 7430 used the term "unreasonable". The Tax Reform Act

of 1986 replaced "unreasonable" with "not substantially

justified". Powers v. Commissioner, 100 T.C. 457, 471 (1993). 

This Court and others have concluded that the substantial

justification standard is essentially the prior law's

reasonableness standard couched in new language. Huffman v.

Commissioner, 978 F.2d 1139, 1147 n.8 (9th Cir. 1992), affg. in

part, revg. in part and remanding T.C. Memo. 1991-144; Powers v.

Commissioner, supra at 471; Rutana v. Commissioner, 88 T.C. 1329,

1333 (1987).

For purposes of the administrative proceedings in this case,

respondent's position is that which she stated in the notice of

deficiency. Sec. 7430(c)(7)(B). See Huffman v. Commissioner,

supra at 1143-1147. For purposes of the court proceedings in

this case, respondent's position is that which she set forth in

the answer to the petition, as subsequently amended. Sec.

7430(c)(7)(A); see Huffman v. Commissioner, supra at 1147-1148. 

The administrative and litigation positions of respondent

are substantially justified if they have a reasonable basis in

both law and fact or are sufficient to satisfy a reasonable
- 6 -

person. E.g., Anthony v. United States, 987 F.2d 670, 674 (10th

Cir. 1993); Norgaard v. Commissioner, 939 F.2d 874, 881 (9th Cir.

1991), affg. in part and revg. in part T.C. Memo. 1989-390;

Powers v. Commissioner, supra at 472. For a position to be

substantially justified, "substantial evidence" must exist to

support it. Pierce v. Underwood, 487 U.S. 552, 564 (1988). 

"That phrase does not mean a large or considerable amount of

evidence, but rather 'such relevant evidence as a reasonable mind

might accept as adequate to support a conclusion.'" Id. at 564-

565 (quoting Consolidated Edison Co. v. NLRB, 305 U.S. 197, 229

(1938)). Respondent's position may be incorrect but

substantially justified "if a reasonable person could think it

correct". Id. at 566 n.2. Thus, whether respondent acted

reasonably in the instant case ultimately turns upon the facts

available to her which formed the legal basis for the position

she took in the deficiency notice and during the litigation. 

DeVenney v. Commissioner, supra at 930. 

The fact that the Commissioner eventually loses or concedes

a case does not by itself establish that her position is

unreasonable. Estate of Perry v. Commissioner, 931 F.2d 1044,

1046 (5th Cir. 1991); Swanson v. Commissioner, 106 T.C. 76, 94

(1996). However, it "clearly remains" a factor to be considered. 

Heasley v. Commissioner, 967 F.2d 116, 120 (5th Cir. 1992), affg.
- 7 -

in part and revg. in part T.C. Memo. 1991-189; Estate of Perry,

931 F.2d at 1046; Powers v. Commissioner, supra at 471. Where

the facts on which the Commissioner relies are not "unusually

scanty or unworthy of belief," the failure of the facts to

convince the Court of the ultimate persuasiveness of the

respondent's position generally is not reason to hold that her

position is unreasonable or without substantial justification. 

VanderPol v. Commissioner, 91 T.C. 367, 370 (1988).

Issue 1. Whether Petitioner Qualifies as a Prevailing Party

A. Recovery of Administrative Costs

Section 7430, for present purposes, limits recoverable

administrative costs to those incurred on or after the date of

the notice of deficiency and up to the time the petition was

filed. Sec. 7430(c)(2). See Huffman v. Commissioner, supra at

1145. Petitioner claims $2,312.55 as recoverable administrative

costs, based on accounting fees of $2,724 incurred between

December 7, 1991 and August 15, 1992, and legal fees of $1,375

incurred from June 24, 1992 to March 9, 1993. However, the

notice of deficiency was not issued until September 16, 1993. 

Petitioner thus seeks administrative costs for accounting and

legal fees that it admittedly incurred prior to the date of the

statutory notice of deficiency. Consequently, we hold that

petitioner cannot recover any of these costs.

B. Recovery of Litigation Costs
- 8 -

Petitioner seeks recovery of litigation fees and costs in

the total amount of $25,121.17. In her original answer,

respondent averred that petitioner had not fully substantiated

claimed expenditures, their deductibility, or their business

purpose, thereby denying petitioner's allegations that it had

paid or incurred all the expenses in dispute as ordinary and

necessary business expenses. Moreover, respondent denied that

petitioner was entitled to claim depreciation deductions as well

as deductions for disputed net operating loss carryovers. 

Respondent also disputed petitioner's contention that no part of

any underpayment was attributable to negligence or failure to

comply with applicable rules or regulations. As revised in

subsequent amendments to the answer, respondent's litigation

position came to include an issue of unreported services income

and a related addition to tax for negligence. 

In some cases courts have adopted an issue-by-issue approach

to section 7430, apportioning the requested awards between those

issues for which respondent was, and those issues for which

respondent was not, substantially justified. See Powers v.

Commissioner, 51 F.3d 34, 35 (5th Cir. 1995); Swanson v.

Commissioner, supra. We follow that approach here and separately

discuss whether respondent's position on each issue was

substantially justified. 

(1) Disallowed Current Business Expenses 
- 9 -

Respondent disallowed the claimed business expenses for 1989

and 1990 as a result of petitioner's failure to substantiate the

expenditures and/or their business purpose. At trial, we held

that expenses respondent had found unsubstantiated were, in large

part, not allowable, reflecting the reasonableness of

respondent's position at least as to the inadequately documented

expenses. 

Respondent conceded some deductions and admitted that

petitioner had substantiated some of the expenditures that had

been in controversy, although she maintained that such

expenditures lacked a business purpose. The Court substantially

sustained petitioner as to many of these expenses. Although

respondent has conceded that petitioner has not unreasonably

protracted the proceedings, we note that petitioner repeatedly

failed to respond adequately to respondent's requests for records

and documents, and refused to permit respondent the opportunity

to meet with Frances Byrne, petitioner's president, to explore

further the nature of its business and the purpose of the

corporation's expenditures. Moreover, correspondence between the

parties' counsel reveals that records introduced at trial were

not continually available to respondent's counsel and some were

produced as late as November 1994, one year after the petition
- 10 -

was originally filed. In light of the lack of evidence available

to respondent, her position was not unreasonable. 

Furthermore, respondent's litigation position disputing

expenses that the Court ultimately found allowable did not rest

on evidence that was scant or unworthy of belief. VanderPol v.

Commissioner, supra at 370. Respondent relied on testimony and

trial exhibits showing that petitioner's only asset and

overwhelming source of its income during 1989 and 1990 was a

triple net lease, a purely passive activity. Testimony from

petitioner's own accountant tended to show that petitioner's

business records did not reflect income from activities other

than holding the leased premises. Moreover, a reasonable person

could discount evidence of founder and former principal

shareholder Charles Byrne's consulting activities on behalf of

NII that endeavored to show petitioner did not engage solely in a

passive activity. Therefore, respondent reasonably argued that

such a passive activity would generate virtually none of the

disallowed deductions, other than interest and depreciation

expenses, discussed infra pp. 10-14.

The Court holds that respondent was substantially justified

in maintaining her position on the issue of current business

expenses, so that the parties could present their conflicting

evidence to the Court and so we could judge the weight to be
- 11 -

given to testimony concerning the business purpose of the claimed

expenses. See DeVenney v. Commissioner, 85 T.C. at 930; Boyle v.

Commissioner, T.C. Memo. 1995-74; Creske v. Commissioner, T.C.

Memo. 1990-318, affd. 946 F.2d 43 (7th Cir. 1991); Porter v.

Commissioner, T.C. Memo. 1986-465.

(2) Disallowed Current Interest Expenses 

Petitioner argues that respondent unreasonably refused to

stipulate before trial the deductibility of interest on a

$475,000 San Franciso Federal Savings mortgage (the San Francisco

loan) on certain leased property (the Burke property). However,

petitioner's representatives did not complete and sign the

stipulation until December 3, 1994--3 days before trial. 

Moreover, petitioner was dilatory in providing evidence to show

NII's complete debt obligations, providing some information on

the loans as late as November 1, 1994. Cf. DeVenney v.

Commissioner, 85 T.C. at 933, a case in which respondent was held

not to have unreasonably refused to concede an issue where

petitioners withheld crucial evidence in the form of witnesses

and their testimony. Respondent might have conceded the issue

many months prior to trial if petitioner had provided its records

when originally requested. See Currie v. Commissioner, T.C.

Memo. 1989-23. In light of such behavior, the Court holds that

respondent was substantially justified in waiting until her

opening argument to concede the deductibility of the San
- 12 -

Francisco Federal mortgage interest expense for 1989 and 1990. 

See Ashburn v. United States, 740 F.2d 843, 850 (11th Cir. 1984);

Brice v. Commissioner, T.C. Memo. 1990-355, affd. without

published opinion 940 F.2d 667 (9th Cir. 1991); R.C. Lindsey

Plumbing, Inc. v. Commissioner, T.C. Memo. 1988-73; Rouffy v.

Commissioner, T.C. Memo. 1987-5. 

 At trial, respondent continued to dispute whether interest

on another obligation secured by the Burke property, namely, the

McMahon note, was currently deductible, arguing that the "all

events" test had not been satisfied. See United States v.

General Dynamics Corp., 481 U.S. 239 (1987); Guardian Inv. Corp.

v. Phinney, 253 F.2d 326, 331 (5th Cir. 1958). The McMahon note

provided for 7-percent interest compounded annually starting on

January 1, 1988, with any unpaid principal and interest due and

payable on December 31, 1997. The terms of the McMahon note

required no payment until December 31, 1997, the day before the

termination of the Burke lease. If the Burke property were sold,

however, the note would become immediately due and payable. 

Respondent argued that the interest expense on the McMahon note

was not allowable since the payment of the principal was

contingent and dependent on the disposition of the Burke property

and the note was subordinated to another obligation. Id. at 331. 

Although we found respondent's logic on this issue "less

than compelling" at trial, that does not mean that her position
- 13 -

lacked any reasonable basis; i.e., was not substantially

justified. See VanderPol v. Commissioner, 91 T.C. at 370. There

was no indication that respondent's evidence was unusually scanty

or unworthy of belief, nor any reason to suspect that respondent

had taken her position for any other purpose other than to

prevail in the litigation. We have stated in the past: 

Petitioners point only to the ultimate failure of

respondent's * * * [argument] * * * to show that * * *

[her] position was unreasonable. * * * If a party can

be chastised for such a failure, then every losing

party must be so chastised. Such an interpretation

does not manifest Congress' intention in enacting * * *

 [section 7430]. [Id.; citations omitted.]

(3) Disallowed Current Depreciation Deductions 

Respondent disallowed depreciation deductions of roughly

$13,000 in both 1989 and 1990, claiming that petitioner failed to

establish the depreciable basis and a method of depreciation for

the Burke property. The Court substantially sustained petitioner

at trial, although we ordered depreciation deductions to be

recalculated in a slightly lower amount. We found that Senter

Associates (Senter), a partnership, incorporated and formed

petitioner, contributing all Senter's assets in a section 351

transaction in which no gain was recognized, and that the basis

of the Burke property was carried over to petitioner from Senter.

Despite our determination in favor of petitioner, we note

that NII provided incomplete documents to establish the
- 14 -

depreciable basis in the Burke property and the underlying

transactions, and that the facts surrounding NII's acquisition of

the property in connection with the formation of NII were

extremely murky. Respondent reasonably argued that the old books

and records relied upon by petitioner were insufficient to prove

the basis of the Burke property, since they were often unreliable

and incomplete. Cf. Southern Pac. Transp. Co. v. Commissioner,

75 T.C. 497, 830-832 (1980) (holding that the taxpayer's

accounting records, standing alone, could not establish the cost

basis of its assets). 

The record was almost devoid of evidence of Senter

Associate's basis in the Burke property. Moreover, the

incorporation arrangement was unusual in that the only evidence

that Charles Byrne held an interest in Senter was his testimony

that he had loaned one of the partners money to invest in Senter,

with the understanding that half of that interest would later be

transferred to him. A reasonable person could conclude such

testimony lacked credibility and that the exact nature of the

alleged sale of the Burke property to Senter and Senter's basis

in the property required the Court's determination. 

In Smith v. United States, 850 F.2d 242, 246 (5th Cir.

1988), the Court observed: "The more difficult it is to appraise

a building * * * the more leeway we must give the IRS before
- 15 -

concluding that its position is 'unreasonable' or 'not

substantially justified.'" Analogously, the more difficult a

building's basis is to establish, the more leeway the Court

should accord the IRS before concluding its position is

unreasonable. As a result, we hold respondent substantially

justified in her position on this issue.

(4) Net Operating Loss Carryforwards

Respondent denied net operating losses claimed by petitioner

in excess of $250,000 in 1989 and used as part of the carryover

loss for 1990 based on NII's failure to establish that any losses

were in fact incurred in the years 1976, 1978-1985, and 1988. 

Petitioner's net operating loss carryovers were premised on: (a)

Business expenses; (b) interest expenses; (c) depreciation

deductions; and (d) losses of petitioner's subsidiaries incurred

in those years. 

In October of 1989 petitioner destroyed most of the

underlying documentation for its expenses from 1971 to 1984 or

1985, keeping only its unaudited books of original entry, other

books based on them and some checks for its two wholly owned

subsidiaries, National For Sale by Owner Realty Corp. (Sale by

Owner) and Far Western Real Estate Corp. (Far Western). The

Court found NII not entitled to most of the operating losses from

the prior years that were carried over to 1989, except for
- 16 -

depreciation and interest expenses and the expenses of Sale by

Owner and Far Western. 

(a) Respondent contended that petitioner did not establish

that prior year losses were based on deductible business expenses

under section 162, rather than on nondeductible personal expenses

under section 262. Moreover, petitioner's own accountant could

not vouch for the accuracy of NII's extant books and records, and

virtually no other testimony concerned their accuracy. The fact

that respondent prevailed on this issue at trial confirms that

her position was substantially justified. 

(b) Interest expense deductions for several loans secured

by the Burke property, including the San Francisco Loan, also

formed part of the claimed net operating losses from years prior

to 1989 and 1990. The property collateralized a $75,000 loan

from a group of investors (Investor Group loan) from June 10,

1982, until October 29, 1985. On September 27, 1985, Owens

Financial Group, Inc., lent petitioner $85,000 (Owens loan). 

 Respondent conceded in her opening statement that

petitioner was entitled to deduct the interest on the San

Francisco Loan in 1989 and 1990 (see supra pp. 10-11), but did

not concede the deductibility of the 1988 interest on that loan,

which substantially contributed to petitioner's net operating

loss for that year. Documents verifying the purpose of interest
- 17 -

expenses and the use of the loan proceeds were not provided to

the examining agent, and petitioner repeatedly failed to respond

adequately to requests for records and documents. Moreover, we

invited petitioner to move to reopen the record for the sole

purpose of offering additional evidence regarding the San

Francisco Loan interest deduction for the period of March 4, 1988

to December 31, 1988. The lack of evidence in the record

suggests that respondent reasonably contested the deduction for

this period. 

For the Investor Group and Owens loans, we observed that the

interest rates were unknown but found that a reasonable rate of

interest on these notes would be 5-1/2 percent simple interest

per annum. We directed that interest deductions from these notes

were to be recalculated on this basis under Rule 155. Since the

interest rate was unknown and had to be determined by the Court,

and the ending balance for the Investor Group loan was not in

evidence, respondent reasonably contested these deductions as

well.

(c) Our discussion, supra pp. 13-14, as to the substantial

justification of respondent's position regarding depreciation

deductions for 1989 and 1990 is equally applicable to

depreciation deductions that form part of petitioner's net

operating losses for prior years.
- 18 -

(d) The losses of petitioner's subsidiaries for the years

prior to 1989 and 1990 comprise the fourth category of net

operating loss carryforwards. We found claimed losses from two

of these subsidiaries, Controlled Casting Systems Corp. and

National Industrial Management Corp., unreliable and therefore

disregarded them. 

As for the subsidiary losses the Court did allow (see supra

p. 16), respondent's position was nevertheless justified based on

the lack of adequate substantiation alone. See Porter v.

Commissioner, T.C. Memo. 1986-465. No records, receipts, or

invoices of the subsidiaries' business transactions were

provided. Virtually the only documentary evidence of the

pertinent loss year expenses of NII's subsidiaries for prior

years is their unaudited books of original entry and general

ledgers, and some canceled checks. Since the records provided by

petitioner were not dispositive, respondent reasonably submitted

the issue to the Court for resolution. See Santa Maria v.

Commissioner, T.C. Memo. 1995-64; Grace Foreign Exch. Corp. v.

Commissioner, T.C. Memo. 1995-63. 

(4) Negligence Penalty Based on Resulting Underpayments 

We held petitioner liable for accuracy-related penalties for

negligence under section 6662(a) to the extent that the

deductions the Court denied resulted in an underpayment for 1989
- 19 -

and 1990. Petitioner's failure in numerous respects to comply

with the requirements for maintaining adequate records itself

warrants the negligence penalty. Yee v. Commissioner, T.C. Memo.

1985-379, affd. without published opinion 822 F.2d 62 (9th Cir.

1987). Among other things, petitioner destroyed books and

records needed to prove its net operating losses, failed to

maintain records necessary to substantiate its deductions, and

intermingled the nondeductible mileage of one car with the

deductible mileage of another. Thus, we hold respondent

substantially justified in her position regarding the negligence

penalties. 

(5) Lot 51 Services Income 

The deficiency in income tax asserted by respondent in an

amendment to her answer revolved around services performed by Far

Western for a third party, International Marketing Limited (IML),

sometime in the mid-1980s. As payment, IML gave petitioner a

parcel of land known as Lot 51. Despite being accrual method

taxpayers, petitioner and its subsidiary failed to include in

income the amount due for services performed for IML. Petitioner

subsequently conceded $112,000 of services income for 1990. As a

result, the Court holds respondent substantially justified in her

position on this issue. 

(6) Lot 51 Services Income Negligence Penalty 
- 20 -

Although we ruled that respondent failed to carry her burden

of proof to establish negligence for this penalty asserted in an

amendment to her answer, a factual and legal predicate existed

for respondent's position. Neither Charles Byrne nor the person

who represented the seller could explain the circumstances of the

Lot 51 transaction. See Grace Foreign Exch. Corp. v.

Commissioner, supra. 

Many facts indicated to respondent that the underpayment due

to the Lot 51 transaction resulted from petitioner's failure to

make a reasonable attempt to comply with the provisions of the

Internal Revenue Code, as required to establish negligence. 

Respondent demonstrated that petitioner's representatives knew of

certain documents in evidence in this case, and were familiar

with the Lot 51 transaction at the time the return was filed. 

NII's representatives knew that Lot 51 was of far greater value

than the $38,000 note given in exchange for it in 1990. 

Furthermore, Charles Byrne was sophisticated in business matters. 

Testimony revealed a lack of cooperation with respondent as well

as attempts to conceal the transaction and mislead petitioner's

own accountant. Finally, documentary evidence established the

substantial value of Lot 51. Thus, we hold that respondent was

substantially justified in her position.
- 21 -

Issue 2. Whether the Administrative and Litigation Costs Sought

by Petitioner Are Reasonable

Since we hold that petitioner cannot recover administrative

costs incurred prior to the issuance of the notice of deficiency,

and that petitioner is not entitled to litigation costs since

respondent was substantially justified in her position with

respect to all of the litigated issues, we need not address the

issue of whether the costs claimed by petitioner are reasonable. 

For all of the above reasons, we hold that petitioner is not

entitled to administrative and litigation costs pursuant to

section 7430. 

To reflect the foregoing,

An appropriate order

will be issued denying 

the motion for litigation

and administrative 

costs.