106 T.C. No. 3

UNITED STATES TAX COURT

JAMES H. SWANSON AND JOSEPHINE A. SWANSON, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 21203-92. Filed February 14, 1996.

Ps filed a motion for reasonable litigation costs

pursuant to Rule 231, Tax Court Rules of Practice and

Procedure, and sec. 7430, I.R.C., claiming that R was

not substantially justified in determining that: (1)

Prohibited transactions had occurred under sec. 4975,

I.R.C., with respect to a domestic international sales

corporation, a foreign sales corporation, and two

individual retirement accounts; and (2) the sale of Ps'

Illinois residence to P's closely held corporation was

a sham transaction.

1. Held: R was not substantially justified with

respect to the first issue, but was substantially

justified with respect to the second issue.

2. Held, further, net worth, for purposes of the

Equal Access to Justice Act, 28 U.S.C. sec.

2412(d)(2)(B) (1994), as incorporated by sec.

7430(c)(4)(A)(iii), is determined based upon the cost

of acquisition rather than the fair market value of
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1 Unless otherwise indicated, all section references are to

the Internal Revenue Code. All Rule references are to the Tax

Court Rules of Practice and Procedure.

assets, and was less than $2 million each with respect

to Ps on the date their petition was filed.

3. Held, further, Ps' failure to request an Appeals

Office conference did not constitute a "[refusal] * * * 

to participate in an Appeals office conference" within the

meaning of sec. 301.7430-1(e)(2)(ii), Proced. & Admin. 

Regs., and, because no 30-day letter was issued to 

Ps prior to the mailing of their notice of deficiency,

Ps are deemed to have per se exhausted their

administrative remedies for purposes of sec.

7430(b)(1). 

4. Held, further, Ps have not unreasonably

protracted the proceedings within the meaning of sec.

7430(b)(4).

5. Held, further, the amount sought by Ps for

litigation costs in this matter is not reasonable and

must be adjusted to comport with the record.

Neal J. Block and Maura Ann McBreen, for petitioners.

Gregory J. Stull, for respondent.

 OPINION

DAWSON, Judge: This case was assigned to Special Trial

Judge John F. Dean pursuant to the provisions of section

7443A(b)(4) and Rules 180, 181, and 183.1 The Court agrees with

and adopts the Special Trial Judge's opinion, which is set forth

below.
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OPINION OF THE SPECIAL TRIAL JUDGE

DEAN, Special Trial Judge: This matter is before the Court

pursuant to petitioners' motion for award of reasonable

litigation costs under section 7430 and Rule 231.

References to petitioner are to James H. Swanson.

The matter before us involves petitioners' combined use of a

domestic international sales corporation, a foreign sales

corporation, and two separate individual retirement accounts as a

means of deferring the recognition of income. Respondent

zealously strove to characterize this arrangement, as well as an

unrelated sale by petitioners of their Illinois residence, as tax

avoidance schemes. A protracted period of entrenchment ensued,

during which the parties firmly established their respective

positions, neither side wavering from its conviction that it was

in the right. Ultimately, however, these issues were resolved by

respondent's notice of no objection to petitioners' motion for

partial summary judgment as well as the entry of an agreed

decision document, which was later set aside and filed as a

stipulation of settlement. As a consequence, petitioners now

seek redress for what they claim were unreasonable positions

taken by respondent.
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2 Initially organized as a corporation in the State of

Illinois, Swansons' Tool was subsequently merged into a newly

formed Florida corporation of the same name on Dec. 30, 1983.

A. Factual Background

Petitioners resided in Florida at the time the petition was

filed. At all times relevant to the following discussion,

petitioner was the sole shareholder of H & S Swansons' Tool

Company (hereinafter, Swansons' Tool), which has operated as a

Florida corporation since 1983.2 Swansons' Tool elected to be

taxed as a subchapter S corporation effective in 1987. 

Swansons' Tool is in the business of building and painting

component parts for various equipment manufacturers. As a part

of these activities, Swansons' Tool manufactures and exports

property for use outside the United States.

1. The DISC and IRA #1

Following the advice of experienced counsel, petitioner

arranged in the early part of January 1985 for the organization

of Swansons' Worldwide, Inc., a domestic international sales

corporation (hereinafter the DISC or Worldwide). During this

period, petitioner also arranged for the formation of an

individual retirement account (hereinafter IRA #1).

The articles of incorporation for Worldwide were filed on

January 9, 1985, and under the terms thereof petitioner was 

named the corporation's initial director. Shortly thereafter,
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3 The following dividends were paid by Worldwide to IRA #1

during the taxable years 1986 through 1988:

Paid Date Fiscal Year Amount

 4/8/86 12/31/86 $244,576

 2/10/87 12/31/87 126,155

12/29/87 12/31/87 100,519

(continued...)

Worldwide filed a Form 4876A, Election to be Treated as an

Interest Charge DISC. 

A Form 5305, Individual Retirement Trust Account, was filed

on January 28, 1985, establishing Florida National Bank

(hereinafter Florida National) as trustee of IRA #1, and

petitioner as the grantor for whose benefit the IRA was

established. Under the terms of the IRA agreement, petitioner

retained the power to direct IRA #1's investments.

On the same day that the Form 5305 was filed, petitioner

directed Florida National to execute a subscription agreement for

2,500 shares of Worldwide original issue stock. The shares were

subsequently issued to IRA #1, which became the sole shareholder

of Worldwide.

For the taxable years 1985 to 1988, Swansons' Tool paid

commissions to Worldwide with respect to the sale by Swansons'

Tool of export property, as defined by section 993(c). In those

same years, petitioner, who had been named president of

Worldwide, directed, with Florida National's consent, that

Worldwide pay dividends to IRA #1.3 Commissions paid to
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3(...continued)

12/30/88 12/31 88 122,352

 Total 593,602

No distributions were made to petitioners from the trust during

the years at issue.

4 Under sec. 991, except for the taxes imposed by ch. 5, a

DISC is not subject to income tax.

Worldwide received preferential treatment,4 and the dividends

paid to IRA #1 were tax deferred pursuant to section 408. Thus,

the net effect of these transactions was to defer recognition of

dividend income that otherwise would have flowed through to any

shareholders of the DISC.

In 1988, IRA #1 was transferred from Florida National Bank

to First Florida Bank, N.A. (hereinafter First Florida), as

custodian. Swansons' Tool stopped paying commissions to

Worldwide after December 31, 1988, as petitioners no longer

considered such payments to be advantageous from a tax planning

perspective.

2. The FSC and IRA #2

In January 1989, petitioner directed First Florida to

transfer $5,000 from IRA #1 to a new individual retirement

custodial account (hereinafter IRA #2). Under the terms of the

IRA agreement, First Florida was named custodian of IRA #2, and

petitioner was named as the grantor for whose benefit the IRA was

established. Under the terms of the IRA agreement, petitioner
- 7 -

5 The Tax Reform Act of 1986 (TRA), Pub. L. 99-514, sec.

301(a), 100 Stat. 2085, 2216, eliminated the deduction under sec.

(continued...)

reserved the right to serve as the "Investment Manager" of

IRA #2.

Contemporaneous with the formation of IRA #2, petitioner

incorporated H & S Swansons' Trading Company (hereinafter

Swansons' Trading or the FSC). Petitioner directed First Florida

to execute a subscription agreement for 2,500 newly issued shares

of Swansons' Trading stock. The shares were subsequently issued

to IRA #2, which became the corporation's sole shareholder. 

Swansons' Trading filed a Form 8279, Election To Be Treated as a

FSC or as a Small FSC, on March 31, 1989, and paid a dividend to

IRA #2 in the amount of $28,000 during the taxable year 1990.

3. The Algonquin Property

In anticipation of Swansons' Tool's transferring its

operations to Florida, petitioners moved during 1981 from their

Algonquin, Illinois, residence (hereinafter, the Algonquin

property or the property) to a condominium in St. Petersburg,

Florida. The Algonquin property was not advertised for sale

until sometime during 1983.

Conscious of a change in the Internal Revenue Code which

would eliminate preferential treatment of capital gain recognized

on the sale of their home, petitioners sought to sell the

Algonquin property prior to December 31, 1986.5 As time was
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5(...continued)

1202 for 60 percent of net long-term capital gains. The repeal

was effective for tax years beginning after Dec. 31, 1986.

clearly a factor, petitioners arranged to sell the property to a

trust of which Swansons' Tool was the beneficiary. Accordingly,

on December 19, 1986, petitioners conveyed the Algonquin property

to "Trust No. 234, Barry D. Elman, trustee," (hereinafter Trust 

No. 234) under a Deed in Trust, which was received and filed by

the Recorder for the city of McHenry, Illinois. As a consequence

of this transaction, petitioners reported a long-term capital

gain of $141,120.78 on Schedule D, Capital Gains and Losses, of

their 1986 Federal income tax return, reflecting a $225,000 sale

price and an $83,879 basis.

Petitioners continued paying the electric bills, heating,

exterior maintenance, and house sitting expenses of the Algonquin

property through May or June of 1987. In March of 1988,

Swansons' Tool reimbursed petitioners for maintenance and repair

expenses incurred during the time period December 1986 through

May 1987, as well as the expense of moving petitioners' personal

belongings in September 1987. Swansons' Tool capitalized these

expenditures as part of its basis in the Algonquin property. 

Subsequent to the signing of a "Real Estate Sales Contract"

during March of 1988, the Algonquin property was sold by

Swansons' Tool to an unrelated third party on June 23, 1988.
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Petitioners' daughter, Jill, resided at the Algonquin

residence from May of 1987 through June of 1988. Although the

record is not clear as to the extent of usage, it appears that

petitioners also periodically stayed at the residence subsequent

to its sale on December 19, 1986.

4. The Notice of Deficiency

Despite petitioners' agreement to extend the period of

limitations in their case until June 30, 1992, petitioners did

not receive a 30-day letter prior to the notice of deficiency. 

Petitioners agreed to the extension in the hope of resolving the

case at the administrative level.

In the notice of deficiency, dated June 29, 1992, respondent

set forth one primary and three alternative positions for

determining deficiencies in petitioners' Federal income taxes and

additions to tax for negligence with respect to petitioners'

1986, 1988, 1989, and 1990 taxable years. Of relevance to the

present matter were respondent's determinations that: (1)

"Prohibited transactions" had occurred which resulted in the

termination of IRA's #1 and #2; and (2) the sale of the Algonquin

property to a trust in 1986 was a "sham" transaction which could

not be recognized for tax purposes.

a. "Prohibited Transactions"

Because the notice of deficiency failed to adequately

explain respondent's bases for determining deficiencies 
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and additions to tax with respect to the years at issue, 

petitioners requested and received the revenue agent's report in

their case. As demonstrated by the revenue agent's report,

respondent identified, as alternative positions, two "prohibited

transactions" which resulted in the loss of IRA #1's status as a

trust under section 408. First, respondent concluded that:

Mr. Swanson is a disqualified person within the meaning

of section 4975(e)(2)(A) of the Code as a fiduciary

because he has the express authority to control the

investments of * * * [IRA #1].

Mr. Swanson is also an Officer and Director of

Swansons' Worldwide. Therefore, direct or indirect

transactions described by section 4975(c)(1) between

Swansons' Worldwide and * * * [IRA #1] constitute

prohibited transactions.

Mr. Swanson, as an Officer and Director of Worldwide

directed the payment of dividends from Worldwide to 

* * * [IRA #1] * * * * The payment of dividends is a

prohibited transaction within the meaning of section

4975(c)(1)(E) of the Code as an act of self-dealing

where a disqualified person who is a fiduciary deals

with the assets of the plan in his own interest. The

dividend paid to * * * [IRA #1] December 30, 1988 will

cause the IRA to cease to be an IRA effective January

1, 1988 by reason of section 408(e)(1). Therefore, by

operation of section 408(d)(1), the fair market value

of the IRA is deemed distributed January 1, 1988. 

[Emphasis added.]

As further demonstrated by the revenue agent's report,

respondent's second basis for disqualifying IRA #1 under section

408 was that:

In his capacity as fiduciary of * * * [IRA #1], Mr.

Swanson directed the bank custodian, Florida National

Bank, to purchase all of the stock of Swansons'
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Worldwide. At the time of the purchase, Mr. Swanson

was the sole director of Swansons' Worldwide.

The sale of stock by Swansons' Worldwide to

Mr. Swanson's Individual Retirement Account

constitutes a prohibited transaction within the meaning

of section 4975(c)(1)(A) of the Code. The sale

occurred February 15, 1985. By operation of section

408(e)(2)(A) of the Code, the Individual Retirement

Account ceases to be an Individual Retirement Account

effective January 1, 1985.

Effective January 1, 1985 the Individual Retirement

Account is not exempt from tax under section 408(e)(1)

of the Code. The fair market value of the account,

including the 2500 shares of Swansons' Worldwide, is

deemed to have been distributed to Mr. Swanson in

accordance with section 408(e)(2)(B) of the Code. 

Therefore, Mr. Swanson effectively became the sole

shareholder of Swansons' Worldwide, Inc. with the loss

of the IRA's tax exemption. [Emphasis added.]

Although the record is not entirely clear on the matter, it

appears that respondent imputed to IRA #2 the prohibited

transactions found with respect to IRA #1 and used similar

reasoning to disqualify IRA #2 as a valid trust under section

408(a). 

b. "Sham Transaction"

With respect to the Algonquin property, respondent concluded

in the notice of deficiency that:

the purported sale of your personal residence located

in Algonquin, Illinois by you in 1986 to Trust #234,

Barry D. Elman, Trustee, of which your corporation, H &

S Swansons' Tool Company, Inc. is the beneficiary, can

not be recognized for tax purposes. The purported sale

in 1986 was no more than a sham transaction which was

entered into for tax avoidance purposes. It is

determined that the purported sale served no other
- 12 -

6 Respondent used substantially similar language in setting

forth one primary and two alternative positions on this issue. 

purpose than to enable you to obtain the tax benefit of

a long term capital gain deduction of 60 percent that

would not have been available had the sale occurred in

tax years subsequent to 1986. * * * [Emphasis added.6]

5. The Petition, Answer, Motion for Summary Judgment, and

Settlement Agreement

In their petition, filed September 21, 1992, petitioners

stated with respect to respondent's determination of "prohibited

transactions" that: (1) At all pertinent times IRA #1 was the

sole shareholder of Worldwide; (2) since the 2,500 shares of

Worldwide issued to IRA #1 were original issue, no sale or

exchange of the stock occurred; (3) from and after the dates of

his appointment as director and president of Worldwide,

Mr. Swanson engaged in no activities on behalf of Worldwide which

benefited him other than as a beneficiary of IRA #1; (4) IRA #1

was not maintained, sponsored, or contributed to by Worldwide

during the years at issue; (5) at no time did Worldwide have any

active employees; and (6) Mr. Swanson engaged in no activities on

behalf of Swansons' Trading which benefited him other than as a

beneficiary of IRA #2.

With respect to the Algonquin residence, petitioners stated,

in pertinent part, that: (1) On December 19, 1986, petitioners

conveyed the Algonquin property by a Deed in Trust to a trust of
- 13 -

which Swansons' Tool was the beneficiary; (2) the transfer

documents conveyed full legal and beneficial ownership from

petitioners to this trust; (3) at no time did petitioners act in

any manner that was inconsistent with their transfer of all their

right, title, and interest in the Algonquin property; and (4)

subsequent to the sale, petitioners had no rights as tenants of

the property other than as tenants at will.

Respondent filed an answer on November 13, 1992, denying, or

denying for lack of knowledge, each of the allegations listed

above.

Petitioners filed a motion for partial summary judgment on

March 22, 1993. In their motion, petitioners restated their

position, as set forth in their petition, that no prohibited

transactions had occurred with respect to IRA's #1 and #2.

On July 12, 1993, respondent filed a notice of no objection

to petitioners' motion for partial summary judgment, thereby

ending the controversy on the DISC and FSC issues.

Respondent conceded the Algonquin property issue in a

settlement agreement entered into on January 24, 1994. The

parties agreed at that time to a total deficiency of $11,372.40,

which reflected an amount conceded by petitioners in their

petition as capital gain inadvertently omitted from their 1988

Federal income tax. A stipulated decision (hereinafter the

decision) was submitted by the parties and entered on February 9,

1994.
- 14 -

6. Motion for Award of Reasonable Litigation Costs

On March 14, 1994, this Court received petitioner Josephine

Swanson's motion for award of reasonable litigation costs

(hereinafter also referred to as the motion). Finding that it

was not petitioner Josephine Swanson's intent that the decision

entered on February 9, 1994, be conclusive as to the issue of

attorney's fees, the Court ordered on April 29, 1994, that the

decision be vacated and set aside. The Court further ordered

that the decision of February 9, 1994, be filed as a stipulation

of settlement, that petitioner Josephine Swanson's motion for

award of reasonable litigation costs be filed, and that

respondent file a response to petitioner Josephine Swanson's

motion in accordance with Rule 232(c).

Respondent's objection to petitioner Josephine Swanson's

motion for award of reasonable litigation costs was filed on June

29, 1994. Petitioners sought leave to file a response to

respondent's objection by a motion filed August 3, 1994, which

was granted.

Petitioners filed an amendment to the motion for award of

reasonable litigation costs (hereinafter amendment to motion) on

August 1, 1994, pursuant to which petitioner James Swanson joined

petitioner Josephine Swanson as a party to the motion.

Petitioners filed their response to respondent's objection

to petitioners' motion for award of reasonable litigation costs

on September 15, 1994.
- 15 -

Following a conference call with the parties on March 20,

1995, the parties were ordered to file a stipulation of facts

with respect to items of net worth reported by petitioners on

attachment II of their amendment to motion. They were further

ordered to file a stipulation of facts regarding the issue of

attorney's fees paid or incurred by petitioners. If the parties

could not stipulate facts with respect to either issue, they were

ordered to file a status report with the Court on or before

May 1, 1995.

On May 1, 1995, the parties participated in a conference

call, during which they agreed to stipulate certain items of net

worth reported on attachment II of petitioners' amendment to

motion. The parties also agreed to stipulate that petitioners

paid or incurred fees in this matter. The parties disagreed,

however, as to the proper method for determining the acquisition

cost of specific items on attachment II of petitioners' amendment

to motion. With respect to these items, the parties were ordered

to file, on or before June 1, 1995, simultaneous memoranda of

law, and, on or before July 3, 1995, answering memoranda of law.

B. Discussion

As an initial matter, we reject respondent's argument that

it was improper for us to have vacated the decision of

February 9, 1994, thereby allowing petitioners to file their

motion for award of reasonable litigation costs. This Court may,

in its sound discretion, set aside a decision that has not yet
- 16 -

7 Respondent argues that our consideration of whether she was

(continued...)

become final. See, e.g., Cassuto v. Commissioner, 93 T.C. 256,

260 (1989), affd. in part, revd. in part, and remanded on another

issue 936 F.2d 736 (2d. Cir. 1991). Having so held, we turn to

the merits of petitioners' motion.

Section 7430 provides that, in any court proceeding brought

by or against the United States, the "prevailing party" may be

awarded reasonable litigation costs. Sec. 7430(a). To qualify

as a "prevailing party" for purposes of section 7430, 

petitioners must establish that: (1) The position of the United

States in the proceeding was not substantially justified; (2)

they substantially prevailed with respect to the amount in

controversy, or with respect to the most significant issue

presented; and (3) they met the net worth requirements of 28

U.S.C. sec. 2412(d)(2)(B) (1994), on the date the petition was

filed. Sec. 7430(c)(4)(A). Petitioners must also establish that

they exhausted the administrative remedies available to them

within the Internal Revenue Service and that they did not

unreasonably protract the proceedings. Sec. 7430(b)(1), (4). 

Petitioners bear the burden of proof with respect to each of the

preceding requirements. Rule 232(e).

Although it is conceded that petitioners substantially

prevailed in this case, respondent does not agree that her

litigation position was not substantially justified.7
- 17 -

7(...continued)

substantially justified in this matter should be based, in part,

on the outcome of a related case involving IRA #1. In docket No.

21109-92, respondent determined, and IRA #1 ultimately conceded,

that IRA #1 had unrelated business income for the taxable year

1988. IRA #1's concession in docket No. 21109-92, however,

appears to have been a direct result of respondent's filing her

notice of no objection to petitioners' motion for summary

judgment in this case. In any event, we give no weight to the

outcome of docket No. 21109-92 because it resulted from an

agreement between the parties to that docket rather than a

judicial determination.

Furthermore, respondent asserts that petitioners: (1) Have not

satisfied the net worth requirements, (2) failed to exhaust the

administrative remedies available to them within the Internal

Revenue Service, (3) unreasonably protracted the proceedings, and

(4) have not shown that the costs they have claimed are

reasonable. We will address each contested point in turn.

1. Whether Respondent's Litigation Position Was

Substantially Justified

In 1986, Congress amended section 7430 to conform that

provision more closely to the Equal Access to Justice Act 

(EAJA). Tax Reform Act of 1986, Pub. L. 99-514, sec. 1551, 100

Stat. 2085, 2752. Where the prior statute required taxpayers to

prove that the Government's position in a proceeding was

"unreasonable," the statute as amended now requires a showing

that the position of the United States was "not substantially

justified." Sec. 7430(c)(4)(A)(i). This Court has concluded

that the substantially justified standard is essentially a

continuation of the prior law's reasonableness standard. Sher v.
- 18 -

8 Respondent's litigation position for purposes of this matter

is that taken on Nov. 13, 1992, the date the answer was filed. 

See Han v. Commissioner, T.C. Memo. 1993-386. 

9 To the extent respondent has cited for support cases which

discuss sec. 7430 prior to its amendment in 1986 by TRA sec.

1551, 100 Stat. 2085, 2752, and in 1988 by the Technical and

Miscellaneous Revenue Act of 1988, Pub. L. 100-647, sec. 6239,

102 Stat. 3342, 3743, we find them to be inapposite. See Sansom

v. United States, 703 F. Supp. 1505 (N.D. Fla. 1988).

Commissioner, 89 T.C. 79, 84 (1987), affd. 861 F.2d 131 (5th Cir.

1988). Thus, a position that is "substantially justified" is one

that is "justified to a degree that could satisfy a reasonable

person" or that has a "reasonable basis both in law and fact."

Pierce v. Underwood, 487 U.S. 552, 565 (1988) (internal quote

marks omitted) (defining "substantially justified" in the context

of the EAJA).

Petitioners have not sought an award of administrative costs

in this matter. Accordingly, we need only examine the question

of whether respondent's litigation position was substantially

justified.8

Respondent argues that we may not consider positions she

took prior to the filing of the answer in determining whether her

litigation position was substantially justified. In support,

respondent cites, among other cases,9 Huffman v. Commissioner,

978 F.2d 1139 (9th Cir. 1992), affg. in part and revg. in part

T.C. Memo. 1991-144.
- 19 -

10 Respondent's administrative position for purposes of this

matter is that taken on June 29, 1992, the date of the notice of

deficiency. Sec. 7430(c)(2).

Respondent is correct in stating that Huffman approves of a

bifurcated analysis under section 7430, pursuant to which the two

stages of a case, the administrative proceeding and the court

proceeding, are considered separately. This bifurcated analysis:

not only ensures that the prevailing taxpayer is

reimbursed for pre-litigation and litigation costs, but

also supports Congress's intent that before an award of

attorney's fees is made, the taxpayer must meet the

burden of proving that the Government's position was

not substantially justified. It affords another

opportunity for the United States to reconsider an

inappropriate position. [Id. at 1146.]

Respondent's arguments on this point appear moot, however, as we

find no discernible difference between the administrative and

litigation positions she took in this matter.10 See Lennox v.

Commissioner, 998 F.2d 244, 247-249 (5th Cir. 1993) (holding that

the Government's position must be analyzed in the context of the

circumstances that caused it to take that position), revg. in

part and remanding T.C. Memo. 1992-382.

a. The DISC Issue

Petitioners contend that respondent was not substantially

justified in maintaining throughout the proceedings that

prohibited transactions had occurred with respect to IRA #1, and

by implication, IRA #2. We agree. 
- 20 -

11 A "plan" is defined by sec. 4975(e)(1) to encompass an

individual retirement account as described under sec. 408.

12 As applicable to the following discussion, sec. 4975(e)(2)

defines a disqualified person as:

(A) a fiduciary;

* * * * * * *

(C) an employer any of whose employees are covered

by the plan;

(D) an employee organization, any of whose members

are covered by the plan;

* * * * * * *

(G) a corporation, partnership, or trust or estate

of which (or in which) 50 percent or more of--

(i) the combined voting power of all

classes of stock entitled to vote or the

total value of shares of all classes of stock

of such corporation,

(ii) the capital interest or profits

interest of such partnership, or

(iii) the beneficial interest of such

trust or estate, is owned directly or

indirectly, or held by persons described in

subparagraph (A), (B), (C), (D), or (E);

* * * * * * *

(H) an officer, director (or an individual having

(continued...)

As stated previously, respondent based her determination of

prohibited transactions on section 4975(c)(1)(A) and (E). 

Section 4975(c)(1)(A) defines a prohibited transaction as 

including any "sale or exchange, or leasing, of any property

between a plan[11] and a disqualified person".12 Section
- 21 -

12(...continued)

powers or responsibilities similar to those of officers

or directors), a 10 percent or more shareholder, or a

highly compensated employee (earning 10 percent or more

of the yearly wages of an employer) of a person

described in subparagraph (C), (D), (E), or (G)

* * * [Emphasis added.]

13 In pertinent part, a "fiduciary" is defined by sec.

4975(e)(3) as any person who:

(A) exercises any discretionary authority or

discretionary control respecting management of such

plan or exercises any authority or control respecting

management or disposition of its assets, [or]

* * * * * * *

(C) has any discretionary authority or

discretionary responsibility in the administration of

such plan.

At all relevant times, petitioner maintained and exercised

the right to direct IRA #1's investments. Petitioner, therefore,

was clearly a "fiduciary" with respect to IRA #1 and thereby a

"disqualified person" as defined under sec. 4975(e)(2)(A). 

Furthermore, as petitioner was the sole individual for whose

benefit IRA #1 was established, IRA #1 itself was a disqualified

person pursuant to sec. 4975(e)(2)(G)(iii).

4975(c)(1)(E) further defines a prohibited transaction as

including any "act by a disqualified person who is a fiduciary[13]

whereby he deals with the income or assets of a plan in his own

interest or for his own account".

We find that it was unreasonable for respondent to maintain

that a prohibited transaction occurred when Worldwide's stock was

acquired by IRA #1. The stock acquired in that transaction was

newly issued--prior to that point in time, Worldwide had no

shares or shareholders. A corporation without shares or
- 22 -

14 Furthermore, we find that at the time of the stock issuance,

Worldwide was not, within the meaning of sec. 4975(e)(2)(C), an

"employer", any of whose employees were beneficiaries of IRA #1. 

Although sec. 4975 does not define the term "employer", we find

guidance in sec. 3(5) of the Employee Retirement Income Security

Act of 1974 (ERISA), Pub. L. 93-406, 88 Stat. 829, 834. In

pertinent part, ERISA sec. 3(5) provides that, for plans such as

an IRA, an "'employer' means any person acting directly as an

employer, or indirectly in the interest of an employer, in

relation to an employee benefit plan * * *." Because Worldwide

did not maintain, sponsor, or directly contribute to IRA #1, we

find that Worldwide was not acting as an "employer" in relation

to an employee plan, and was not, therefore, a disqualified

person under sec. 4975(e)(2)(C). As there is no evidence that

Worldwide was an "employee organization", any of whose members

were participants in IRA #1, we also find that Worldwide was not

a disqualified person under sec. 4975(e)(2)(D).

15 Sec. 4975(e)(4) incorporates the constructive ownership rule

of sec. 267(c)(1), which states that:

Stock owned, directly or indirectly, by or for a

corporation, partnership, estate, or trust shall be

considered as being owned proportionately by or for its

shareholders, partners, or beneficiaries * * *

Petitioner, as the sole individual for whose benefit IRA #1 

was established, was therefore beneficial owner of all the

outstanding shares of Worldwide after they were issued. Because

petitioner, as the sole beneficial shareholder of Worldwide, was

also a "fiduciary" with respect to IRA #1, Worldwide thus met the

definition of a disqualified person under sec. 4975(e)(2)(G).

Contrary to respondent's representations, petitioner was not

a "disqualified person" as president and director of Worldwide

until after the stock was issued to IRA #1. Sec. 4975(e)(2)(H). 

Furthermore, petitioner was not a disqualified person under sec.

(continued...)

shareholders does not fit within the definition of a disqualified

person under section 4975(e)(2)(G).14 It was only after

Worldwide issued its stock to IRA #1 that petitioner held a

beneficial interest in Worldwide's stock, thereby causing

Worldwide to become a disqualified person under section

4975(e)(2)(G).15 Accordingly, the issuance of stock to IRA #1
- 23 -

15(...continued)

4975(e)(2)(H) solely due to his "shareholding" in Worldwide as

the constructive attribution rules provided under sec. 267 are

applicable only to sec. 4975(e)(2)(E)(i) and (G)(i). Sec.

4975(e)(4).

16 Ordinarily, controlling effect will be given to the plain

language of a statute unless to do so would produce absurd or

futile results. Rath v. Commissioner, 101 T.C. 196, 200 (1993)

(citing United States v. American Trucking Associations, 310 U.S.

534, 543-544 (1940)). As the Supreme Court has stated:

in the absence of a clearly expressed legislative

intention to the contrary, the language of the statute

itself must ordinarily be regarded as conclusive. 

Unless exceptional circumstances dictate otherwise,

when we find the terms of a statute unambiguous,

judicial inquiry is complete. [Burlington No. R. v.

Oklahoma Tax Commn., 481 U.S. 454, 461 (1987);

citations and internal quotation marks omitted.]

Accordingly, when, as here, a statute is clear on its face, we

require unequivocal evidence of a contrary purpose before

construing it in a manner that overrides the plain meaning of the

statutory words. Rath v. Commissioner, supra at 200-201 (citing

Halpern v. Commissioner, 96 T.C. 895, 899 (1991); Huntsberry v.

Commissioner, 83 T.C. 742, 747-748 (1984)). 

did not, within the plain meaning of section 4975(c)(1)(A),

qualify as a "sale or exchange, or leasing, of any property

between a plan and a disqualified person".16 Therefore,

respondent's litigation position with respect to this issue was

unreasonable as a matter of both law and fact.

We also find that respondent was not substantially justified

in maintaining that the payments of dividends by Worldwide to IRA

#1 qualified as prohibited transactions under section

4975(c)(1)(E). There is no support in that section for

respondent's contention that such payments constituted acts of

self-dealing, whereby petitioner, a "fiduciary", was dealing with
- 24 -

17 See the discussion supra note 16 regarding application of a

statute's plain meaning.

the assets of IRA #1 in his own interest. Section 4975(c)(1)(E)

addresses itself only to acts of disqualified persons who, as

fiduciaries, deal directly or indirectly with the income or

assets of a plan for their own benefit or account. Here, there

was no such direct or indirect dealing with the income or assets

of a plan, as the dividends paid by Worldwide did not become

income of IRA #1 until unqualifiedly made subject to the demand

of IRA #1. Sec. 1.301-1(b), Income Tax Regs. Furthermore,

respondent has never suggested that petitioner, acting as a

"fiduciary" or otherwise, ever dealt with the corpus of IRA #1

for his own benefit.

Based on the record, the only direct or indirect benefit

that petitioner realized from the payments of dividends by

Worldwide related solely to his status as a participant of IRA

#1. In this regard, petitioner benefited only insofar as IRA #1

accumulated assets for future distribution. Section 4975(d)(9)

states that section 4975(c) shall not apply to:

receipt by a disqualified person of any benefit to

which he may be entitled as a participant or

beneficiary in the plan, so long as the benefit is

computed and paid on a basis which is consistent with

the terms of the plan as applied to all other

participants and beneficiaries.

Thus, we find that under the plain meaning17 of section

4975(c)(1)(E), respondent was not substantially justified in
- 25 -

18 In a letter accompanying the revenue agent's report,

respondent stated that:

We believe the statutory Notice of Deficiency

adequately describes the adjustments asserted therein. 

Moreover, during the course of the examination your

client became fully cognizant of the transactions under

scrutiny. However, as a convenience to you, enclosed

is a copy of the revenue agent's report. Naturally, it

is not the Service's intent by this letter to in any

way limit the general language of the statutory notice. 

The Commissioner will stand on any ground fairly raised

by the statutory notice as a basis for her

determination.

In finding that respondent was not substantially justified with

respect to the DISC issue, we have considered all grounds upon

which respondent could fairly raise a question of prohibited

transactions under sec. 4975.

maintaining that the payments of dividends to IRA #1 constituted

prohibited transactions. Respondent's litigation position with

respect to this issue was unreasonable as a matter of both law

and fact.18

Respondent would have us believe that the delay in settling

the DISC issue was due to a statement in petitioners' motion for

partial summary judgment that IRA #1 was exempt from tax at all

times. In her memorandum in objection to petitioners' motion for

litigation costs, respondent contends that this was a "new and

overriding issue" that required her to determine whether "any

other" prohibited transactions had occurred during the period

covered by the notice of deficiency. We disagree.

We need look no further than respondent's own memorandum to

divine that the true reason for her delay in conceding the DISC
- 26 -

issue was her desire to discover new facts with which to

resuscitate her meritless litigation position. The following

statements from respondent's memorandum are illuminating in this

regard:

due to the complexity of the prohibited transaction

rules and the many ways in which disqualified person

status can be achieved through specific relationships

described in I.R.C. § 4975(e)(2), it was imperative

that respondent explore other possible violations

before conceding that the facts (as represented by

petitioner's counsel) demonstrated no violation.

* * * * * * *

Petitioner husband established the IRA and created

a DISC inside of his IRA to shelter from current income

inclusion dividend payments made by an international

trading company in which he was the sole shareholder. 

But for the existence of the IRA, such dividends would

be currently taxable to him. If he had created the

DISC outside of the IRA, and then sold some or all of

the stock in the DISC to the IRA, the sale of stock in

the DISC to his IRA would clearly violate the

prohibited transactions rules under I.R.C. § 4975. 

Similarly, the payment of any dividends from his wholly

owned corporation to his IRA that effectively allows

him to avoid current income inclusion because he

assigned his interest in the DISC to his IRA arguably

represents an indirect benefit to him personally.

For example, both petitioner husband and

petitioner wife indirectly received a significant

current tax benefit derived from the payment of DISC

dividends into his IRA, rather than to the husband as a

direct shareholder. But for the creation and

maintenance of the IRA, petitioner husband (and, by

virtue of her election to file a joint return, the

petitioner wife) would have current income inclusion

for payments from the trading corporation to the DISC. 

Accordingly, the transactions between his wholly-owned

trading corporation to such entity are arguably

indirect prohibited transactions between disqualified

persons and the IRA. Also, since one slight variation

in the structure or operation of the petitioner's

transactions could have resulted in noncompliance with
- 27 -

19 See discussion of IRA #2 supra p. 11. 

the prohibited transactions rules, it was clearly

reasonable for respondent not to concede her position

on answer and to analyze thoroughly all positions

presented by petitioner's counsel during the litigation

stage of the case. [Emphasis added.]

We read the preceding statements as an acknowledgment by

respondent that her litigation position, as developed in the

administrative proceedings and adopted in her answer, was without

a foundation in fact or law. This case is distinguishable from

those in which respondent promptly conceded an unreasonable

position taken in her answer, thereby avoiding an award of

litigation costs. Nothing occurred between the filing of

respondent's answer and her notice of no objection to alter the

fact that she had misapplied the prohibited transaction rules of

section 4975 to petitioners' case. Accordingly, we find that

respondent's litigation position with respect to IRA #1 was not

substantially justified. Petitioners are therefore entitled to

an award of litigation costs under section 7430.

As respondent's determination of deficiencies with respect

to IRA #2 was inexorably linked to the fate of IRA #1, the award

of litigation costs is also intended to cover respondent's

litigation position with respect to IRA #2.19

b. The House Issue

Petitioners contend that respondent was not substantially

justified in determining that the sale of the Algonquin property
- 28 -

to Trust No. 234 was a sham transaction. Respondent, on the

other hand, argues that such a determination was reasonable,

particularly in light of the postsale use by petitioners and

their daughter.

A "sham" transaction is one which, though it may be proper

in form, lacks economic substance beyond the creation of tax

benefits. Karr v. Commissioner, 924 F.2d 1018, 1022-1023 (11th

Cir. 1991), affg. Smith v. Commissioner, 91 T.C. 733 (1988). In

the context of a sale transaction, as here, the inquiry is

whether the parties have in fact done what the form of their

agreement purports to do. Grodt & McKay Realty, Inc. v.

Commissioner, 77 T.C. 1221, 1237 (1981). 

The term "sale" is given its ordinary meaning for Federal

income tax purposes and is generally defined as a transfer of

property for money or a promise to pay money. Commissioner v.

Brown, 380 U.S. 563, 570-571 (1965). In deciding whether a

particular transaction constitutes a sale, the question of

whether the benefits and burdens of ownership have passed from

seller to buyer must be answered. This is a question of fact

which is to be ascertained from the intention of the parties, as

evidenced by the written agreements read in light of the

attendant facts and circumstances. Haggard v. Commissioner, 24

T.C. 1124, 1129 (1955), affd. 241 F.2d 288 (9th Cir. 1956).
- 29 -

Various factors to consider in making a determination as to

whether a sale has occurred were summarized in Grodt & McKay

Realty, Inc. v. Commissioner, supra at 1237-1238, as follows:

(1) Whether legal title passes; (2) how the parties

treat the transaction; (3) whether equity was acquired

in the property; (4) whether the contract creates a

present obligation on the seller to execute and deliver

a deed and a present obligation on the purchaser to

make payments; (5) whether the right of possession is

vested in the purchaser; (6) which party pays the

property taxes; (7) which party bears the risk of loss

or damage to the property; and (8) which party receives

the profits from the operation and sale of the

property. * * * [Citations omitted.]

An additional factor to be weighed is the presence or absence of

arm's-length dealing. Falsetti v. Commissioner, 85 T.C. 332, 348

(1985) (citing Estate of Franklin v. Commissioner, 64 T.C. 752

(1975), affd. 544 F.2d 1045 (9th Cir. 1976)).

We recognize that a number of the factors listed above favor

petitioners' contention that the sale of the Algonquin property

was not a "sham" transaction. Nevertheless, the fact remains

that petitioners continued paying the heating, electricity,

security, and maintenance expenses incurred for the property

until sometime in June 1987; i.e., over 5 months after their sale

of the property to Trust No. 234. Petitioners also paid for a

number of repairs to the property prior to its sale to a third

party in 1988. Although petitioners were ultimately reimbursed

for all or part of these expenses, it appears that such

reimbursement did not occur until proximate to the time a

contract of sale was signed between Trust No. 234 and the third
- 30 -

party. Finally, we cannot discount the fact that petitioners and

their daughter occupied the property at various times between the

time of its sale to the trust and its ultimate sale to a third

party. In the case of the daughter, this period of occupancy

lasted just over 1 year and ended shortly before the property was

sold to the third party in June of 1988. The foregoing takes on

added significance in light of the fact that petitioner was on

"both sides" of the initial sale--both as owner of the property

and as the sole shareholder of Swansons' Tool. Combined with the

questionable business purpose behind a manufacturing

corporation's purchase of a personal residence, we do not find it

unreasonable that respondent would challenge the sale as not

being at arm's-length. 

Based on the record as a whole, we cannot say that

respondent's position with respect to the house issue was

unreasonable, as a matter of either law or fact. We recognize

that petitioners have cited a number of cases supporting the

proposition that sales to close corporations by shareholders are

not "sham" transactions per se. We further note that petitioners

cited cases supporting the permissible occupancy of a residence

subsequent to its sale. A careful reading of each, however, does

not persuade us that, based on the facts of this case,

respondent's litigation position was not substantially justified.
- 31 -

20 For similar reasons, we find that it was not unreasonable as

a matter of fact or law for respondent to contend in alternative

positions that the proceeds from the sale of the Algonquin

property should be adjusted between petitioners and Swansons'

Tool. Having carefully considered petitioners' arguments, we

find that they have not met their burden of proving that

respondent was not substantially justified on this point. 

21 This requirement is set forth by implication in sec.

7430(c)(4), which states in pertinent part that:

(A) In general.--The term "prevailing party" means

any party in any proceeding to which subsection (a)

(continued...)

Accordingly, we find that petitioners have failed to meet their

burden of proof on this issue.20

Our conclusion is not diminished by the fact that respondent

ultimately conceded this matter in petitioners' favor prior to

trial. The determination of whether respondent's position was

substantially justified is based on all the facts and

circumstances surrounding a proceeding; the fact that respondent

ultimately concedes or loses a case is not determinative. See

Wasie v. Commissioner, 86 T.C. 962, 968-969 (1986); DeVenney v.

Commissioner, 85 T.C. 927, 930 (1985).

2. Net Worth

Respondent contends that petitioners have failed to

demonstrate that they satisfied the net worth requirement of

section 7430(c)(4)(A)(iii).

To qualify as a prevailing party eligible for an award of

litigation costs, a taxpayer must establish that he or she has a

net worth that did not exceed $2 million "at the time the civil

action was filed".21 In the case of a husband and wife seeking
- 32 -

21(...continued)

applies

* * * * * * *

(iii) which meets the requirements of 

* * * section 2412(d)(2)(B) of title 28,

United States Code (as in effect on October

22, 1986) * * *.

As applicable to this case, 28 U.S.C. sec. 2412(d)(2)(B)

provides that a "party" means "an individual whose net worth did

not exceed $2,000,000 at the time the civil action was filed." 

22 This statement of net worth was submitted as "attachment II"

to petitioners' amendment to motion for award of reasonable

litigation costs. As noted by petitioners, the figures presented

therein are unadjusted for depreciation. 

an award of litigation costs, the net worth test is applied to

each separately. Hong v. Commissioner, 100 T.C. 88, 91 (1993).

Although the term "net worth" is not statutorily defined,

the legislative history to the EAJA states: "In determining the

value of assets, the cost of acquisition rather than fair market

value should be used." H. Rept. 96-1418, at 15 (1980); see also

United States v. 88.88 Acres of Land, 907 F.2d 106, 107 (9th Cir.

1990); American Pacific Concrete Pipe Co., Inc. v. NLRB, 788 F.2d

586, 590 (9th Cir. 1986); Continental Web Press, Inc. v. NLRB,

767 F.2d 321, 322-323 (7th Cir. 1985).

To demonstrate that they each had a net worth of less than

$2,000,000 on the date their petition was filed, petitioners

submitted, on August 1, 1994, a "STATEMENT OF NET WORTH AT

ACQUISITION COST AS OF SEPTEMBER 21, 1992".22 Petitioners'

separate net worths were reported on this statement as follows:
- 33 -

23 We note that petitioners omitted the asset identified as

"Florida Bonds" from their Aug. 1, 1994, statement of net worth

in the amount of $60,000 to be allocated half to each petitioner. 

Petitioners have explained, and we accept, that this was an

(continued...)

 Asset Acq. Cost James Josephine

Cash/Checking $48,375 $24,188 $24,188

Money Fund 188,657 188,657 -

Repo Account 184,155 184,155 -

Mortgage 76,225 38,113 38,113

Mortgage 40,000 40,000 -

Contract 34,433 34,433 -

Note-1 26,815 26,815 -

Note-2 2,300 2,300 -

Note-3 80,000 80,000 -

Note-4 17,500 17,500 -

IRA-Kemper 9,000 9,000 -

IRA-Kemper 8,250 - 8,250

IRA-1st Fla. 2,500 2,500 -

IRA-1st Fla. 5,000 5,000 -

401-K Plan 45,000 45,000 -

Condo 185,000 - 185,000

Industrial Bldg. 107,500 - 107,500

Industrial Bldg. 260,000 - 260,000

Industrial Vacant 65,000 65,000 -

Stock - HSSTC 59,200 59,200 -

 Prestige 23,500 - 23,500

 Breck 25,000 25,000 -

 West Coast 25,000 25,000 -

 Sunshine 20,910 20,910 -

 FSCC 5,000 5,000 -

Sailboat 85,000 85,000 -

Motorboat 8,000 8,000 -

Auto 17,000 20,000 [sic]

Art, etc. 40,000 20,000 20,000

Totals 1,694,322 [sic] 1,010,771 683,551

With an exception for the four IRA's, the 401(k) plan, and

the stock of the six listed corporations, the parties stipulated

on May 16, 1995, to the accuracy of the preceding statement.23
- 34 -

23(...continued)

accidental omission. The stipulation of facts contains other

nonmaterial modifications and corrections. 

Pursuant to our Order of May 1, 1995, the parties submitted

simultaneous and answering memoranda of law, addressing the

proper method for determining the acquisition cost of those

assets for which there had been no stipulation. As set forth in

these memoranda, petitioners argue for an approach whereby the

amount paid for an asset, adjusted for depreciation, establishes

the acquisition cost of an asset for purposes of the net worth

computation. Respondent, on the other hand, argues that the

acquisition cost of an asset should constantly be adjusted to

reflect realized (if not recognized) income. To quote

respondent:

In summary, acquisition costs of an asset are generated

not only from external contributions but also from

realized gains, the internal reinvestment of which

acquires an increase, improvement, or enhancement in

such asset.

Having carefully considered the parties' respective arguments, we

accept petitioners' computation of their net worth under section

7430(c)(4)(A)(iii). We find no basis in this case for

disregarding the separate legal status of entities in which

petitioners hold beneficial or legal interests. See, e.g.,

Moline Properties, Inc. v. Commissioner, 319 U.S. 436, 438-439

(1943); Webb v. United States, 15 F.3d 203, 207 (1st Cir. 1994);
- 35 -

24 As noted by the Courts of Appeals for the Ninth and Seventh

Circuits, "the cost of acquisition" under GAAP is arrived at by

subtracting accumulated depreciation from the original cost of an

asset. American Pacific Concrete Pipe Co., Inc. v. NLRB, 788

F.2d 586, 590-591 (9th Cir. 1986); Continental Web Press, Inc. v.

NLRB, 767 F.2d 321, 322-323 (7th Cir. 1985). We do not here

decide whether depreciation should be used in determining net

worth for purposes of sec. 7430(c)(4)(A), as petitioners'

separate net worths, whether computed using depreciation or not,

do not exceed $2 million. 

Bertoli v. Commissioner, 103 T.C. 501, 511-512 (1994); Allen v.

Commissioner, T.C. Memo. 1988-166.

Respondent argues that even if Congress originally intended

acquisition cost as the proper measure of net worth, relatively

recent trends in generally accepted accounting principles (GAAP)

require that such a measure be abandoned. We have considered

respondent's arguments on this point and find them off the mark. 

While there has been a change in the rules regarding the method

by which individuals prepare their financial statements, there

has been no change in the definition of acquisition cost under

GAAP, and as that was the standard set forth in the legislative

history, it is the measure of net worth we apply to this case.24

After careful review of the record, we find that petitioners

have adequately set forth a statement of their net worth pursuant

to Rule 231(b)(5) and have met the burden of proving that their

separate net worths did not exceed $2 million on the date they

filed their petition.

We have considered all other arguments raised by respondent

regarding the net worth requirement and, to the extent not
- 36 -

discussed above, find them to be without merit. Before

continuing, however, we find it necessary to comment on some of

the arguments raised by respondent in her memoranda.

While there was colorable merit to some of the contentions

raised by respondent in her memoranda regarding the question of

net worth, others border on being frivolous and vexatious. As an

illustration, respondent set forth the following proposition in

arguing that additional amounts should be added to petitioner

Josephine Swanson's calculation of net worth: 

Florida provides for the equitable distribution of

property between spouses upon divorce. Fla. Stat. ch.

61.075 (1994). * * * 

Respondent notes that the record provides no indication

of marital disharmony between the petitioners and

presumes that Florida's equitable distribution statute

does not expressly apply to this case. However, this

significant expectancy to receive an equitable

distribution in the event of divorce may itself

constitute an asset of a spouse entitled to recognition

for purposes of the net worth computation.

Such transparent sophistry speaks for itself and comes perilously

close to meriting an award of fees to petitioners under section

6673(a)(2).

3. Exhaustion of Administrative Remedies

Notwithstanding our conclusion that respondent was not

substantially justified with respect to the DISC issue,

petitioners are not entitled to an award of litigation costs if

it is found that they failed to exhaust their administrative

remedies.
- 37 -

25 Sec. 301.7430-1(b)(2), Proced. & Admin. Regs., provides

that:

a party or qualified representative of the party * * *

participates in an Appeals office conference if the

party or qualified representative discloses to the

Appeals office all relevant information regarding the

party's tax matter to the extent such information and

its relevance were known or should have been known to

the party or qualified representative at the time of

such conference.

No "30-day letter" was issued to petitioners prior to the

issuance of the statutory notice of deficiency. Respondent

contends, however, that petitioners failed to exhaust their

administrative remedies by not seeking an Appeals Office

conference prior to the filing of their motion for summary

judgment. In support, respondent maintains that:

After commencing litigation, * * * [petitioners']

attorneys forged quickly ahead by filing a motion for

partial summary judgment without attempting to confer

with either Appeals or District Counsel to seek a

possible settlement--a conference which likely would

have eliminated the need for the parties to prepare a

prosecution and defense of the motion and its extensive

exhibits and attachments, perhaps resulting in reduced

litigation activities, saving time for the parties and

the Court.

In opposition, petitioners state that, pursuant to section

301.7430-1(e)(2), Proced. & Admin. Regs., they have per se

exhausted their administrative remedies.

In pertinent part, section 301.7430-1(e), Proced. & Admin.

Regs., sets forth the following exception to the general rule

that a party must participate25 in an Appeals Office conference

in order to exhaust its administrative remedies:
- 38 -

(e) Exception to requirement that party pursue

administrative remedies. If the conditions set forth

in paragraphs (e)(1), (e)(2), (e)(3), or (e)(4) of this

section are satisfied, a party's administrative

remedies within the Internal Revenue Service shall be

deemed to have been exhausted for purposes of section

7430.

* * * * * * *

(2) In the case of a petition in the Tax 

Court--

(i) The party did not receive a notice

of proposed deficiency (30-day letter) prior

to the issuance of the statutory notice and

the failure to receive such notice was not

due to actions of the party (such as failure

to supply requested information or a current

mailing address to the district director or

service center having jurisdiction over the

tax matter); and

(ii) The party does not refuse to

participate in an Appeals office conference

while the case is in docketed status. 

[Emphasis added.]

Section 301.7430-1, Proced. & Admin. Regs., fails to define the

phrase "does not refuse to participate". 

Respondent's arguments suggest that section 301.7430-

1(e)(2), Proced. & Admin. Regs., is to be interpreted as

requiring an affirmative act by petitioners; i.e., a request for

an Appeals Office conference. Petitioners, on the other hand,

contend that the proper interpretation is one that puts the

burden on respondent, requiring that she act affirmatively. 

Petitioners reason that they cannot "refuse to participate" in an
- 39 -

26 As we have not found any prior cases addressing this issue,

it appears that the correct interpretation of the meaning of the

regulation is one of first impression.

Appeals Office conference unless and until respondent makes an

offer of such a conference.26

We conclude that petitioners' reading of section 301.7430-

1(e)(2), Proced. & Admin. Regs., is correct. Section

601.106(d)(3), Statement of Procedural Rules, states that with

respect to cases docketed in the Tax Court:

(iii) If the deficiency notice in a case docketed in

the Tax Court was not issued by the Appeals office and no

recommendation for criminal prosecution is pending, the case

will be referred by the district counsel to the Appeals

office for settlement as soon as it is at issue in the Tax

Court. The settlement procedure shall be governed by the

following rules:

(a) The Appeals office will have exclusive

settlement jurisdiction for a period of 4 months over

certain cases docketed in the Tax Court. The 4 month

period will commence at the time Appeals receives the

case from Counsel, which will be after the case is at

issue. Appeals will arrange settlement conferences in

such cases within 45 days of receipt of the case. * * *

[Emphasis added.]

The notice of deficiency in this matter was issued by the

District Director for Jacksonville, Florida. There is no

suggestion that a recommendation for criminal prosecution was

ever pending against petitioners. Accordingly, pursuant to the

procedural rules, respondent's Appeals Office gained settlement

jurisdiction over petitioners' case after it was docketed in 

this Court and maintained such jurisdiction for a period of 
- 40 -

4 months. Contrary to the language of section

601.106(d)(3)(iii)(a), Statement of Procedural Rules, however,

Appeals in this case did not arrange a settlement conference

within 45 days of receipt of petitioners' case. Petitioners

could not, therefore, have refused to participate in an Appeals

Office conference, as none was ever offered.

We note that when a 30-day letter has been issued, the

procedural rules provide that, in general, the taxpayer is

entitled, as a matter of right, to an Appeals Office conference. 

See sec. 601.106(b), Statement of Procedural Rules. No such

right exists, however, once the taxpayer's case is docketed in

the Tax Court. Furthermore, once the case is docketed, there is

no provision in the procedural rules for a taxpayer request for

an Appeals Office conference.

Based on the foregoing, we find that petitioners have

exhausted their administrative remedies within the meaning of

section 7430 and the regulations thereunder.

4. Whether Petitioners Unreasonably Protracted the

Proceedings

Based upon the record, we find that petitioners did not

protract the proceedings. 

5. Whether the Fees Sought in This Matter Are Reasonable

As discussed below, we find that the amount sought by

petitioners in this matter for litigation costs is not reasonable

and must be adjusted to comport with the record.
- 41 -

27 Petitioners are seeking an award of fees based solely upon

the statutorily provided rate of $75 an hour, as adjusted by the

COLA. Sec. 7430(c)(1)(B)(iii). Petitioners have not argued that

there are "special factors" which would justify a higher rate in

this case. Id.

C. Award of Litigation Costs

As an initial matter, we note that the parties disagree as

to whether the cost of living adjustment (COLA), which applies to

an award of attorney's fees under section 7430, should be

computed from October 1, 1981, or from January 1, 1986.27

Respectively, these are the two dates on which COLA's were first

provided under the EAJA and section 7430.

Our position on this issue was addressed in Bayer v.

Commissioner, 98 T.C. 19 (1992), where we concluded that 

Congress, in providing for cost of living adjustments in section

7430, intended the computation to start on the same date the

COLA's were started under the EAJA; i.e., October 1, 1981. Id.

at 23. Citing Lawrence v. Commissioner, 27 T.C. 713 (1957),

revd. on other grounds 258 F.2d 562 (9th Cir. 1958), we stated

that we would continue to use 1981 as the correct year for making

the COLA calculation, unless, of course, the Court of Appeals to

which appeal lay had held otherwise. Golsen v. Commissioner, 54

T.C. 742, 756-757 (1970), affd. 445 F.2d 985 (10th Cir. 1971).

This case is appealable to the Court of Appeals for the 11th

Circuit, which has not addressed the question of whether 1981 or

1986 is the correct date for purposes of computing the COLA
- 42 -

28 We find that to the extent of the $16,588 paid by Swansons'

Tool, petitioners did not "pay or incur" fees within the meaning

of sec. 7430. Although the nature of the agreement under which

(continued...)

adjustment under section 7430. Accordingly, we will follow our

holding in Bayer, and we find October 1, 1981, to be the

applicable date from which to make the adjustment.

1. Amount of Litigation Costs

Petitioners seek an award of litigation fees and expenses in

the total amount of $140,580.46. Petitioners have also asked

that they be awarded any additional costs incurred since March 1,

1994, to recover such fees and expenses. However, as explained

in the affidavit of petitioners' counsel filed as a supplement to

motion for litigation costs:

with counsel's acquiescence, Petitioners have paid to

date only $56,588 of the fees incurred on their behalf. 

As a result of Baker & McKenzie's advisery role with

regard to the DISC Issue, Petitioners agreed after

Respondent fully conceded the case to pay only $40,000

of the unbilled fees incurred from December 1992 on

their behalf. The $40,000 amount was paid by the

Swansons from their Joint checking account. H.& S.

Swansons' Tool Co., Mr. Swanson's closely held

corporation and the client of record for bookkeeping

purposes, had previously paid $16,588 for services

rendered on petitioners' behalf between September and

November, 1992.

Petitioners agreed to allow Baker & McKenzie to recover

any remaining unbilled fees in excess of the $56,588

Petitioners have paid to date to the extent that

Petitioners prevail on * * * [their Motion for

Reasonable Litigation Costs.] [Emphasis added.]

Thus, beyond the $40,000 agreed to, there is no legal obligation

of petitioners to pay fees incurred on their behalf in the

judicial proceeding.28 Furthermore, based on the agreement
- 43 -

28(...continued)

such payment was made is unclear, the ultimate effect was to

diminish the deterrent effect of the expense involved in seeking

review of, or defending against, unreasonable Government action. 

See, e.g., SEC v. Comserv Corp., 908 F.2d 1407, 1413-1415 (8th

Cir. 1990). 

detailed in the affidavits of petitioners' counsel, they incurred

no fees with respect to the preparation of their motion. 

Petitioners did not, therefore, incur fees in this matter in an

amount greater than $40,000. See Marre v. United States, 38 F.3d

823, 828-829 (5th Cir. 1994); United States v. 122.00 Acres of

Land, 856 F.2d 56 (8th Cir. 1988) (applying sec. 304(a)(2) of the

Uniform Relocation Assistance and Real Property Acquisition

Policies Act of 1970, 42 U.S.C. sec. 4654(a); fees were not

actually "incurred" because the taxpayer had no legal obligation

to pay his attorney's fees); accord SEC v. Comserv Corp., 908

F.2d 1407, 1414 (8th Cir. 1990) (construing the EAJA, which

language the Court did not find to be significantly different

from that in United States v. 122.00 Acres of Land, supra); see

also Frisch v. Commissioner, 87 T.C. 858, 846 (1986) (lawyer

representing himself pro se was not entitled to fees for his own

services because such fees were not paid or incurred).

Because there is no mention in the affidavits of counsel

regarding the liability of petitioners for costs other than fees

incurred after December 1992, we find that petitioners are not

similarly restricted with respect to an award of "reasonable

court costs" under section 7430(c)(1)(A) or those items listed in

section 7430(c)(1)(B)(i) and (ii). 
- 44 -

29 Pursuant to petitioners' agreement with counsel, December

1992 was the month from which they agreed to pay $40,000 of

unbilled fees incurred on their behalf. According to the

affidavits of counsel, September 1993 was the last month in which

fees were incurred to defend the DISC issue. Thus, this is the

only period for which petitioners may recover fees in this

matter. 

30 We reach this figure based upon 158.8 hours devoted to the

DISC issue and 7.6 of general case management apportioned to the

DISC issue ((158.8 / (158.8 + 139.8) x 14.3 = 7.6). 

We must apportion the award of fees sought by petitioners

between the DISC issue, for which respondent was not

substantially justified, and the Algonquin property issue, for

which respondent was substantially justified. Based on the

record, we find that for the period December 1992 until September

1993,29 a total of 312.9 hours was spent by counsel in connection

with the Court proceedings. Of this amount, 158.8 hours were

devoted to the DISC issue, 139.8 hours to the Algonquin property

issue, and 14.3 hours to general case management. Based upon the

$75-per-hour statutory rate, as adjusted by the COLA computed

from 1981, we find that petitioners are entitled to an award for

166.4 hours of fees paid to counsel.30

As for expenses other than fees, petitioners have asked for

total miscellaneous litigation costs in the amount of $6,512.33. 

Based upon our evaluation of the total time spent on the DISC

issue, and our need to exclude miscellaneous expenses incurred

with respect to the Algonquin property issue, we find that
- 45 -

petitioners are entitled to an award of miscellaneous expenses in

the amount of $3,300.

To reflect the foregoing,

An appropriate order will be

 issued and decision will be entered

 pursuant to Rule 155.