Court Opinion

ID: 4473276
Source: CourtListenerOpinion
Date Created: 2020-01-15 06:01:27.556784+00
Date Added: 2024-06-11T12:09:17.346688
License: Public Domain

T.C. Memo. 2020-9

                   UNITED STATES TAX COURT

GLENN DAVID CUTHBERTSON a.k.a. DAVID CUTHBERTSON AND
          PAMELA CUTHBERTSON, Petitioners v.
    COMMISSIONER OF INTERNAL REVENUE, Respondent

 Docket No. 19871-15.                          Filed January 14, 2020.

        Ps were engaged in the development of a golf course and
 surrounding residential housing through several wholly owned
 entities. In 2009 and 2010, Ps’ wholly owned entities engaged in a
 series of real estate and financial transactions, involving a golf
 course, that purported to generate losses on the alleged transfer of the
 golf course property, on the alleged abandonment of the golf course’s
 improvements, and on a sale of promissory notes. In 2009 and 2010,
 Ps also transferred parcels of real estate from a limited liability
 company (LLC), which was wholly owned by P-H and P-W and was
 treated as a non-TEFRA partnership for U.S. income tax purposes, to
 another LLC that was wholly owned by P-H, via direct and indirect
 ownership, and that was also treated as a non-TEFRA partnership for
 income tax purposes. Ps caused the seller LLC to use the installment
 method of accounting, under I.R.C. sec. 453, so as to defer the
 recognition of gain on these transfers.
                                          -2-

[*2]          These losses flowed through to Ps, and Ps claimed deductions
       for these losses on their 2009 and 2010 Forms 1040. In 2009 Ps also
       filed a Form 1045, “Application for Tentative Refund”, in an attempt
       to carry back some of these losses to their 2004, 2005, 2006, 2007,
       and 2008 tax years. R issued a statutory notice of deficiency that,
       among other things, determined that Ps were not entitled to certain
       loss deductions Ps claimed under I.R.C. sec. 165 and determined that
       Ps incorrectly accounted for the income from the transfers of the real
       estate lots by causing the LLC to improperly use the installment
       method.

             Held: Ps are not entitled to deduct the losses arising out of the
       golf course transfer, property abandonment, and financial
       transactions.

              Held, further, the seller LLC adopted an impermissible method
       of accounting for the transfers of real estate parcels between the
       LLCs; therefore, Ps are not allowed to defer the gain from the
       transferred property to future tax years.

              Held, further, Ps did not have reasonable cause for their
       underpayments of income tax and therefore are liable for I.R.C.
       sec. 6662 accuracy-related penalties.

       William C. Elliott, Jr., and John J. Nail, for petitioners.

       Kimberly B. Tyson and James D. Hill, for respondent.
                                        -3-

[*3]        MEMORANDUM FINDINGS OF FACT AND OPINION

       GUSTAFSON, Judge: By statutory notice of deficiency (“SNOD”) dated

May 27, 2015, the Internal Revenue Service (“IRS”) determined deficiencies in

income tax for petitioners Glenn David Cuthbertson and Pamela Cuthbertson for

the years 2004, 2005, 2006, 2009, 2010, and 2011,1 arising from passthrough

       1
        The SNOD adjusted items for 2011 that affected liabilities for the other
years, but the SNOD did not determine a deficiency for 2011; rather, the SNOD
stated that it included that year “[f]or information purposes only”. However, the
petition ostensibly invokes our deficiency jurisdiction for all the years in the
SNOD, and after trial the Commissioner moved to dismiss the petition as to 2011
and to strike the petition’s allegations as to 2011. Under section 6213(a), we do
not have jurisdiction to redetermine a deficiency for 2011, and we will therefore
grant the Commissioner’s motion to dismiss insofar as the petition requests
redetermination of a deficiency for 2011. But the Commissioner acknowledges
that we do have jurisdiction under section 6214(b) to “consider such facts with
relation to the taxes for [2011] * * * as may be necessary correctly to redetermine
the amount of such deficiency” for the other five years in the SNOD. We will
therefore deny the Commissioner’s motion insofar as it asks us to strike
allegations as to 2011.
                                        -4-

[*4] entities owned by them,2 and section 6662(a)3 accuracy-related penalties in

the following amounts:

                                                     Penalty
                       Year        Deficiency      sec. 6662(a)
                       2004        $175,884          $35,177
                       2005         308,175           61,635
                       2006              484            -0-
                       2009       1,427,186          435,863
                       2010         517,898          103,579
                       2011            -0-              -0-

      2
         These entities were partnerships or limited liability companies (LLCs)
treated as partnerships. Each had fewer than 10 members or partners; and except
in the case of True Homes, LLC, all the partners and members of each were
individuals. Generally, we lack jurisdiction to redetermine the partnership items
of a partnership if the partnership is subject to the provisions of the Tax Equity
and Fiscal Responsibility Act of 1982, Pub. L. No. 97-248, sec. 402(a), 96 Stat. at
648. Blonien v. Commissioner, 118 T.C. 541, 551-552 (2002), supplemented by
T.C. Memo. 2003-308; see sec. 6221. However, a partnership qualifies for the
small partnership exception under section 6231(a)(1)(B) if it has fewer than 10
partners and all partners are individuals rather than “pass-thru partners” as defined
by section 6231(a)(9). As for True Homes, this case does not involve any
partnership items of that entity. Therefore, we have jurisdiction over this case and
all its issues. Neither party contends otherwise.
      3
        Unless otherwise indicated, all section references are to the Internal
Revenue Code (26 U.S.C. or “the Code”), as amended, and all Rule references are
to the Tax Court Rules of Practice and Procedure. All amounts are rounded to the
nearest dollar.
                                        -5-

[*5] The Cuthbertsons timely filed a petition in this Court pursuant to

section 6213(a) for redetermination of the deficiencies and the penalties in the

SNOD. After concessions by the parties, the issues for decision are:

      (1) whether for 2009 the Cuthbertsons are entitled to a loss deduction of

$100,137 from their wholly owned partnership, Craft Holdings, LLC, from the

purported sale of a golf course (we hold that they are not);

      (2) whether for 2009 the Cuthbertsons are entitled to a loss deduction of

$5,278,404 for the purported sale or abandonment of golf course improvements by

their other wholly owned partnership, Craft Development, LLC (we hold that they

are not);

      (3) whether for 2010 the Cuthbertsons are entitled to loss deductions under

section 165(a) in the amounts of $397,575 from Craft Development, LLC, and

$1,568,925 from Craft Holdings, LLC, on the purported sale of promissory notes

(we hold that they are not);

      (4) whether the installment method of accounting was improperly used to

report the 2008 and 2009 transfers of real estate parcels from Craft Development,

LLC, which was wholly owned by Mr. and Mrs. Cuthbertson, to True Homes,

LLC, an entity wholly owned by Mr. Cuthbertson (via his direct ownership and
                                          -6-

[*6] indirect ownership via his 100% ownership of Craft Builders, Inc.) (we hold

that it was); and

      (5) whether the Cuthbertsons are liable for section 6662(a) accuracy-related

penalties (we hold that they are).

                               FINDINGS OF FACT

I.    Petitioners and their entities

      Mr. Cuthbertson is in the real estate development business, and he is

married to petitioner Mrs. Cuthbertson. Mr. Cuthbertson incorporated Craft

Builders (“Builders”) under North Carolina law in December 1991; and he has

always been its sole equity owner. During all relevant periods, Builders was an

S corporation for Federal tax purposes.

      The Cuthbertsons organized the following LLCs under North Carolina law

in the following years: Craft Development (“Development”) in 2003; Craft

Holdings (“Holdings”) in 2006; Edgewater Golf Club (“EGC”) in 2007; and

Carolina Development Services (“CDS”) in 2008. As a land development

company, Development accounted for land purchases as inventory.

      Since at least as early as 2008, Mr. Cuthbertson has held 99% of the equity

in Development, Holdings, CDS, and EGC, and Mrs. Cuthbertson has held the

remaining 1%. As relevant to these proceedings, Development and Holdings were
                                         -7-

[*7] taxed as partnerships for Federal income tax purposes during the 2008, 2009,

and 2010 tax years. Mr. Cuthbertson’s intended purpose for Holdings was to hold

property which was not intended for developments, while Development was the

entity through which he conducted real estate development activities and sold

developed properties.

      In January 2008 Mr. Cuthbertson organized True Homes as an LLC under

Delaware law; and since its formation, he has held 100% of True Homes--59.7%

directly and 40.3% indirectly through Craft Builders (of which he is the sole

owner).

II.   Petitioners’ relatives and their entities

      Petitioners have two adult daughters: Crystal Kiker and Sandra (“Sandy”)

Russell. Sandy is married to Ben Russell, who is therefore petitioners’ son-in-law.

      Mrs. Kiker and her brother-in-law Mr. Russell formed the following LLCs

under North Carolina law: B&C4 Land Holdings (“B&C I”) in December 2008,

B&C Land Holdings II (“B&C II”) in November 2009, and B&C Land Holdings

III (“B&C III”) in November 2009. Since its formation, B&C III has had no

employees; Mr. Russell and Mrs. Kiker are managers of the entity. All three B&C

entities were formed for the purpose of investing in real estate.

      4
          We assume that “B&C” stands for “Ben [Russell] and Crystal [Kiker].”
                                         -8-

[*8] III.    Golf course property transactions

       A.    The acquisition, development, and use of Edgewater golf course
             through 2009

       Sometime in the late 1990s, Development purchased 309 acres of property

in Lancaster, South Carolina, sometimes referred to as “Edgewater Phase 1”. In

November 2003 Development purchased 1,032 acres of land in Lancaster for

$4.2 million, sometimes referred to as “Edgewater Phase 2”. In January 2005

Development purchased another 561 acres of land in Lancaster for $3.9 million,

sometimes referred to as “Edgewater Phase 3”. The borders of these three

properties met across much of their acreage.

       Approximately 154 acres of raw land within Phase 2 and Phase 3 of the

Edgewater properties was chosen to be the site of what is now the Edgewater golf

course. The golf course was intended to enhance the value of residential real

estate in the Edgewater community. The golf course and the residential properties

were developed accordingly, but in that process the intended purposes of

Mr. Cuthbertson’s entities, their actual roles, and important details of their

agreements became confused, as we show here.

       For the three years 2006 through 2008, it was Development that created the

Edgewater golf course. However, in November 2006 Development signed a deed
                                        -9-

[*9] transferring all 1,032 acres of Edgewater Phase 2 real estate to Holdings; the

deed was recorded in June 2007. In March 2007 Development signed a deed

transferring all 561 acres of Edgewater Phase 3 real estate to Holdings. Together,

these two transfers included the 154 acres that underlay the Edgewater golf course.

Development’s transfer of the Edgewater Phase 2 parcel to Holdings was recorded

in the public records of Lancaster County, South Carolina, in June 2007, and in

March 2007 the transfer of the Edgewater Phase 3 parcel was recorded in the

public records of Lancaster County, South Carolina. With respect to the 154 acres

of land that would become the golf course, Holdings recorded on its books the

basis of the portion (107 acres) of Edgewater Phase 2 as $432,740 and the basis of

the portion (47 acres) of Edgewater Phase 3 as $327,397, totaling $760,137. Thus,

for much of this three-year period (starting in November 2006), Development was

building a golf course on land to which it no longer held title, and to which no

contemporaneous agreements suggest that Development owned the improvements

it was building.

      During those same three years, Development also constructed a building

that was used as a clubhouse for the golf course, and this clubhouse was

constructed on part of the land, outside the 154 acres that made up the golf course,

that Development had transferred to Holdings.
                                          - 10 -

[*10] In April 2008 EGC executed a lease agreement to become the tenant of the

Edgewater golf course premises. Although it was Holdings that held legal title to

the 154 acres underlying the golf course (and the rest of Phase 2 and Phase 3), the

lease agreement purported to name Development as the lessor.5 That is,

Development was ostensibly the landlord of property that in fact it did not own.

This lease charged EGC a one-time rental fee of $1 and stated that the landlord is

responsible for paying the real estate taxes associated with the leased property and

that the lessee is responsible for the costs of insurance, utilities, services, repairs,

and maintenance. The Edgewater golf course has operated without interruption

since August 2008.

      B.     The December 2009 Land Purchase Agreement between Holdings and
             B&C III for the Edgewater golf course

      Mr. Cuthbertson believed that, beginning in 2005, residential sales were

“pretty good” but that the real estate market “came to a halt” around the same time

that the Edgewater golf course opened in or around 2006 or 2007. The real estate

market experienced a severe downturn late in 2007, and the poor market continued

      5
        By April 2008 Holdings was the owner of the 154 acres of land underlying
the golf course. Mr. Cuthbertson testified that he believed at the time that
Development was the owner of the improvements on that land. We find, however,
that in fact he did not actually realize which entity owned the land or the
improvements.
                                        - 11 -

[*11] throughout the years in issue. In the midst of this downturn, several

institutions that had lent money to the Craft entities pressured Mr. Cuthbertson to

“get * * * [the golf course property] off the books”.

      In November 2009 Mr. Cuthbertson hired an appraiser to value the golf

course property. The resulting appraisal assigned a value of $660,000 to the

154-acre golf course real estate and a value of $490,000 to furniture, fixtures, and

equipment.6

      On December 29, 2009, Holdings, as “Seller”, entered into an agreement

entitled “Land Purchase Agreement (Contract for Deed)” (the “LPA”) with, as

“Buyer”, B&C III (one of the entities owned by Mrs. Kiker and Mr. Russell),

purporting to sell the Edgewater golf course to B&C III for $660,000. The LPA

was apparently never recorded in the public records.7 Before Holdings entered

      6
        This valuation allocated no “value for Business Value associated with the
operations [of the golf course]”, and the appraiser further disclaimed the accuracy
of the $490,000 valuation for the furniture, fixtures and equipment (“FF&E”)
because he was “not experienced or qualified in the valuation of equipment and
recommends to the client the use of a professional qualified in equipment and
FF&E valuation for an accurate estimate of the market value for this component of
the subject operations, if needed.”
      7
        Although the parties stipulated the recording of the deeds that evidence
Development’s sales of Phase 2 and Phase 3 to Holdings, they did not stipulate the
recording of the LPA. Those deeds bear on their first pages the stamps showing
their recording; but the copy of the LPA entered into evidence by stipulation bears
                                                                        (continued...)
                                       - 12 -

[*12] into the LPA, Mr. Cuthbertson did not seek Mr. Russell’s credit score, B&C

III’s credit score, or B&C III’s tax return. B&C III did not have any liquid assets

when it entered into the LPA. The Cuthbertsons’ real estate attorney, Wesley

Hinson, testified that the LPA was a contract for deed prepared for the conveyance

of the golf course, and was used as an alternative method for seller financing that

“fits a need where certain facts exists [sic]”. Under the LPA, B&C III was not

required to make (and did not make) a downpayment, and B&C III’s obligation to

“exercise its right to purchase the Property from Seller” would “mature and come

due on or before” December 31, 2014, when B&C III would be obligated to tender

the purchase price, along with annual interest of 6%, and Holdings would execute

the special warranty deed. On or before the closing of the purchase contemplated

by the LPA, Holdings (as “Seller”) was required to pay the amounts necessary to

release the property from three mortgages that encumbered the subject property

(totaling $10.4 million).8 From the date of the LPA (December 29, 2009) until the

      7
       (...continued)
no such stamp, nor does the settlement statement corresponding to the LPA
indicate that fees were collected for the recording of the LPA. Thus we lack this
assurance.
      8
       Thus, under the LPA, Holdings would transfer title to B&C III after
receiving B&C III’s payment but, in the meantime, would retain legal title. The
LPA provided that, before payment was made, “Seller [i.e., Holdings] may transfer
                                                                    (continued...)
                                        - 13 -

[*13] closing date, the LPA obligated the Buyer (B&C III) to, inter alia, pay the

real estate taxes, pay the utilities, pay the insurance, and maintain the property. In

the meantime, B&C III issued to Holdings a $660,000 unsecured note that was

“given for money borrowed”, which (for reasons the record does not explain)

provided for interest payable at 5.0% per annum, rather than the 6.0% interest rate

specified in the LPA. (As set out below in part V.B, Holdings subsequently sold

the B&C III note less than a year later to a third party, David Tucker, not for

$660,000 but for $95,700--14.5% of its face value.)

      The LPA provides that the property with which it is concerned is the area of

land “more particularly described on ‘Exhibit A’ attached hereto [i.e., evidently

the 154 acres of the golf course], and any improvements located thereon”. The

“improvements” consisted of the features of the golf course (tees, holes, greens,

fairways, hazards, etc.) that Development had built and that had never been

conveyed to Holdings. The property description of the LPA did not include the

clubhouse or the land on which it was built.

      8
        (...continued)
legal title to the property without Buyer’s consent. If Seller transfers legal title,
Seller will require the transferee to assume Seller’s obligations in this contract,
and the transfer and assumption of obligations by the transferee will release Seller
from all obligations to Buyer.”
                                        - 14 -

[*14] Five years after executing the LPA, Holdings transferred the golf course real

property to B&C III by deed on December 31, 2014. However, at that time B&C

III had not tendered the purchase price plus interest, as the LPA purportedly

required. Rather, Holdings had sold the note to Mr. Tucker for $95,700, and

B&C III did not begin making payments under the note until 2015. And even as

late as November 2016, B&C III had paid a total of only $68,000 under the note,

including interest.

      Mr. Cuthbertson testified that his understanding of the arrangement was

“that if there’s some upside to the land sometime down the road, that there would

be a sharing in the profits, which hasn’t come yet but that was the intent from day

one.” However, the LPA has no such provision; and Mr. Russell, in contrast,

testified that if B&C III were to sell the golf course at a profit, he would not need

to share any of that profit with Mr. Cuthbertson.

      C.     Related transactions

      In selling the golf course to B&C III, one of Mr. Cuthbertson’s expectations

was that one of his entities (such as EGC) would continue to manage the golf

course. Consistent with that expectation, on December 31, 2009 (i.e., two days

after the execution of the LPA), Mr. Cuthbertson executed, as managing member

of Development, a bill of sale purporting to sell to EGC various pieces of
                                        - 15 -

[*15] equipment used to maintain the golf course. As manager of EGC, he also

executed a note by EGC in the amount of $25,000 in favor of Development.

      Also consistent with Mr. Cuthbertson’s expectation, EGC and B&C III

entered into an agreement entitled “Edgewater Golf Lease Agreement” on

January 19, 2010 (i.e., less than a month after the LPA), by which EGC

purportedly leased the Edgewater golf course from B&C III. The lease obligated

EGC to pay rent of $1 per year, plus 25% of annual net profits over $100,000, and

50% of annual net profits over $250,000--though EGC’s records had reflected

operating losses for 2008 and 2009 (and would continue to reflect losses through

2015). The lease also obligated EGC as lessee to pay for maintenance, insurance,

utilities, and taxes9 associated with the golf course, except that maintaining

“capital improvements” was ostensibly B&C III’s obligation as lessor. That is, the

Lessee (EGC) was allegedly responsible for maintaining the premises, buildings,

and equipment that were the subject of this lease; maintaining the golf course; and

      9
        Although section 10 of the B&C III and EGC lease agreement is entitled
“Utilities; Taxes”, it makes no mention of taxes. Rather, the lessee is obligated to
pay only for utilities and “all other costs and expenses of every kind whatsoever of
or in connection with the use, operation, and maintenance of the premises and all
activities conducted thereon”, and it is not clear whether real property taxes would
fall into that category. Under the LPA the Seller (Holdings) was obliged to pay
real estate taxes through 2009. After that date, the Buyer (B&C III) was
responsible under the LPA for “all property taxes and hazard insurance on the
Property”.
                                        - 16 -

[*16] employing or contracting for the purpose of insuring adequate care of the

golf course and “all systems related thereto”. This provision conflicts with some

of the responsibilities subsequently enumerated for the Lessor (B&C III), which

was ostensibly responsible for maintenance, repair, and replacement of, among

other things, parking lots, cart paths, ponds, the drainage system, the irrigation

system, course lighting, the electrical system, and the golf course maintenance

building. Some of these items that B&C III was obliged to maintain would

apparently fall under the category of “all systems related thereto” that EGC was

obliged to maintain. In his decision to have B&C III buy the golf course, Mr.

Russell was (he testified) “absolutely” influenced by the fact that one of

Mr. Cuthbertson’s entities, as tenant of a lease agreement, rather than B&C III,

would be paying the operating expenses of the golf course.

      Under the December 2009 lease, EGC indemnified B&C III for any type of

intentional or unintentional tort liability arising from the golf course property (in

contrast to the earlier lease, which provided that “Landlord [Mr. Cuthbertson] and

Tenant [EGC] agree to hold each other harmless, and each will carry general

liability coverage.”
                                          - 17 -

[*17] D.        Payment, nonpayment, and reimbursement of expenses

          Despite the fact that the clubhouse was still owned by Holdings--i.e., had

not been purchased by B&C III and thus could not have been leased by B&C III to

EGC--the clubhouse continued to be used by golfers at the Edgewater golf course.

There is no evidence of any lease agreement for the clubhouse between EGC and

Holdings (or any other entity) nor of EGC’s paying rent for the clubhouse to any

entity.

          In 2010 and 2011, EGC paid the maintenance and repair, utilities, and

insurance expenses for the Edgewater golf course. B&C III thus did not pay those

expenses, which the lease had allocated to EGC; but B&C III also paid no capital

improvement expenses from 2009 through at least October 2012, despite its

supposed obligation to do so under the LPA and the January 2010 lease.

          In 2009, 2010, and 2011, Holdings paid property taxes for the golf course,

which it had ostensibly sold in December 2009. Only after the IRS began an audit

of these entities and raised a question about tax payments did B&C III pay

Holdings $36,923 in November of 2012, apparently to reimburse Holdings for the

property taxes that Holdings had paid after the execution of the LPA. At the same

time, EGC paid B&C III the same sum, apparently for the same reason.
                                       - 18 -

[*18] The first evidence of any payment or expenditure made by B&C III after it

entered into the December 2009 LPA appears in the form of two purchase orders

(on a letterhead that has both Development’s and EGC’s names at the top), dated

October 30, 2012, for materials and labor to install irrigation behind the number 1

tee, totaling $4,000--with a handwritten statement at the top of both invoices,

“Capital Improvement to be paid by B&C III”.

      E.     December 2014 “Addendum”

      We have pointed out anomalies in the foregoing transactions--i.e.,

Development’s development of a golf course on land it did not own;

Development’s purported lease to EGC in April 2008 of the golf course it did not

own; the December 2009 LPA by which Holdings agreed to convey a deed to

B&C III for the golf course, in exchange for no consideration, other than an

unsecured promissory note; and the purported January 2010 lease with terms with

which B&C III and EGC made no attempt to comply until after the Cuthbertsons

became aware of the IRS audit10--and apparently Holdings, Development, and

B&C III became aware of these anomalies. On December 15, 2014, those three

      10
       At the very latest, the Cuthbertsons were aware of the IRS audit on
March 6, 2013, the date by which they were preparing financial statements and
corresponding with IRS agents--a date only four months before the IRS issued to
the Cuthbertsons a Form 5701, “Notice of Proposed Adjustment”, dated July 2,
2013.
                                        - 19 -

[*19] entities executed an “Addendum to Land Purchase Agreement” (the

“Addendum”), apparently in an attempt to address these anomalies. The

Addendum states: “Although Development was not an original party to the LPA,

it was the Parties [sic] intent for beneficial ownership of the Improvements to

transfer to Buyer pursuant to the LPA.” Under the Addendum, B&C III agreed to

pay Development $100, and Development “acknowledge[d] and agree[d]” that it

abandoned all interests in the improvements upon the Edgewater golf course--not

as of the date of the December 2014 Addendum, but retroactively as of the date of

the December 2009 LPA. On December 31, 2014, B&C III paid Development

$100, via a check which bears the notation “Addendum related to sale of golf

course”. On the same date, Mr. Cuthbertson, as manager of Holdings, transferred

to B&C III title to the Edgewater golf course, in ostensible fulfillment of the terms

of the LPA (although B&C III had not yet paid the purchase price).

IV.   Reporting of the Edgewater land sale on 2009 tax returns

      On its 2009 Form 1065, “U.S. Return of Partnership Income”, Holdings

reported a $3.2 million total loss, which included a loss from the alleged sale of

the underlying golf course land in the amount of $100,137 (reflecting its claimed

basis of $760,137 in the land minus the $660,000 of consideration stated in the

LPA). On its 2009 Form 1065, Development reported a loss of $8.9 million,
                                       - 20 -

[*20] which included a claimed $5.3 million loss on the improvements to the

Edgewater golf course, reflected on its Form 4797, “Sales of Business Property”

(emphasis added), consistent with Development’s records, which characterized it

as a “mass sale”. On line 10 of that form, under the following terms, Development

described the land sale with the following responses: (1) “Description of

property”--“Disposals for 2009”; (2) “Date acquired”--“Various”; (3) “Date sold”-

-“December 29, 2012”; (4) “Gross sales price”--“25,000”; (5) “Depreciation

allowed or allowable since acquisition”--“$1,071,710”; (6) “Cost or other basis,

plus improvements and expense of sales”--“6,409,521”; and (7) “Gain or (loss)”--

“!5,312,811”. Holdings and Development issued Schedules K-1, “Partner’s Share

of Income, Deductions, Credits, etc.”, to the Cuthbertsons, and on Schedule E,

“Supplemental Income and Loss”, of their 2009 joint Form 1040, “U.S. Individual

Income Tax Return”, the Cuthbertsons reported nonpassive losses of $12.5 million

from these Schedules K-1. That amount includes the total reported loss of $8.9

million from Development, and the total $3.2 million loss from Holdings (which

also evidently include other losses not disputed by the Commissioner in this case).

      For 2009 the Cuthbertsons also filed with the IRS a Form 1045,

“Application for Tentative Refund”, followed by a second, superseding Form

1045. On the Forms 1045, the Cuthbertsons claimed a net operating loss (“NOL”)
                                       - 21 -

[*21] carryback of $1.89 million, which is calculated using the $2.3 million loss

reported on their 2009 return (which was derived from the losses passed through

to them by Development and Holdings). The Cuthbertsons’ Form 1045 applied

that NOL for the 2004, 2005, and 2006 tax years (three to five years before the

2009 tax year), which had the effect of decreasing the Cuthbertsons’ tax liability

for 2004 by $176,000 and for 2005 by $309,000.

V.    Bulk notes sale

      A.     The 14 notes

      In December 2010 Development, Holdings, and CDS held 14 different notes

that had been made between January 1, 2009, and April 1, 2010, by one of

Mrs. Kiker, Mr. Russell, B&C I, or B&C III. One of these was the $660,000 note

that Holdings had received from B&C III for the Edgewater golf course. The total

face amount of the 14 notes was $2,925,000; and as of December 2010, the notes

had a total outstanding principal amount, and adjusted tax basis, of $2.8 million.

All of the notes (before modification) were to mature in 2014 or early 2015. Three

notes were originally issued with a 5.00% interest rate and two others were

originally issued with a 0.75% rate, which remained unchanged at the time

Mr. Cuthbertson sold them to Mr. Tucker. The remaining nine notes had been,
                                       - 22 -

[*22] while held by Mr. Cuthbertson, modified so as to reduce their interest rate to

0.75%.

       Mr. Cuthbertson testified that he made no collection efforts on the notes

from his daughter, that banks said they did not view the notes as having “real

liquid equity”, and that the notes “basically ha[d] zero value because there’s no

income being generated on those, and I couldn’t force revenue because there was

no revenue to generate from the people I had the notes from”. As with the

Edgewater golf course, Mr. Cuthbertson testified that his lenders wanted the Craft

entities to liquidate the notes from his daughter and son-in-law and their B&C

entities.

       B.    The sale of the notes

       David Tucker has been a friend of Mr. Cuthbertson and was a business

partner with Sandy Russell (i.e., Mr. Cuthbertson’s daughter and Mr. Russell’s

wife). On December 1, 2010, Mr. Tucker agreed to buy the 14 notes (totaling

$2.8 million) in a document entitled “Bulk Note Purchase Agreement”, for a total

of $406,000. That agreement gave Mr. Tucker until December 31, 2010, to

complete any due diligence on the notes, and until March 15, 2011, to tender the

purchase price. The Bulk Note Purchase Agreement also provided: “If notice is

not given to Seller of rejection of the Agreement within this time frame this
                                        - 23 -

[*23] Agreement becomes enforceable.” However, Mr. Tucker testified that he

did not review a credit score or tax return records for any of the notes’ makers, and

that he knew the loans were unsecured. Mr. Tucker executed the agreement on his

own behalf, and Mr. Cuthbertson countersigned on behalf of Development,

Holdings, and CDS. At trial Mr. Cuthbertson was not able to articulate how he

settled on a price of $406,000. Of the $406,000 paid for the 14 notes, Mr. Tucker

and Holdings allocated $95,700 to the sale of the $660,000 note made by B&C III

for the sale of the golf course.

      On the same date that Mr. Tucker entered into the Bulk Note Purchase

Agreement, Mr. Tucker and Mr. Cuthbertson in his personal capacity entered into

another agreement that gave Mr. Cuthbertson the option to repurchase the 14 notes

from Mr. Tucker for $487,000, and the option lasted until the maturity date of each

note.11 Mr. Cuthbertson did not exercise his option to repurchase the 14 notes

(although following the modifications of January 2014, discussed below in part

V.D, none of the notes will reach maturity until December 2019, so that even by

the time of trial in this case the options appeared not to have lapsed).

      11
         The repurchase option agreement did not clarify how to reconcile the fact
that the agreement recites one price for all the notes but contemplates repurchase
of fewer than all of the notes (with no price specified for individual notes).
                                        - 24 -

[*24] C.     Simultaneous lot purchase agreement

      Also on the same date that the Bulk Note Purchase Agreement was entered

into (December 1, 2010), Mr. Tucker (along with his wife, Vada Tucker) and Mr.

Cuthbertson entered into a land sale contract entitled “Lot Purchase Agreement”.

Mr. Cuthbertson entered into the Lot Purchase Agreement in order to induce

Mr. Tucker to purchase the notes. The Lot Purchase Agreement provided that, for

the consideration of “the promises made by each party to the other, as well as the

sum of $1.00”, Mr. Cuthbertson would, on or before March 31, 2014, purchase

from Mr. Tucker a 50% tenancy in common interest in one plot of real estate, and

100% in another plot of real estate, for $412,000, but that Mr. and Mrs. Tucker

could buy the parcels back from Mr. Cuthbertson for $412,000 plus 15% of that

amount at any time on or before December 31, 2015.

      At some later date, Mr. Tucker found another buyer willing to pay cash for

the property that Mr. Cuthbertson was supposed to receive under the Lot Purchase

Agreement, and Mr. Cuthbertson agreed to allow Mr. Tucker to substitute another

parcel of real estate in lieu of both pieces originally described in that agreement.

      On March 16, 2011--one day after the purchaser’s last date to close on the

purchase specified in the Bulk Note Purchase Agreement, Mr. Tucker wired
                                        - 25 -

[*25] $406,000 to Mr. Cuthbertson, and Mr. Cuthbertson signed a bill of sale

stating that title to the 14 notes was transferred to Mr. Tucker.

      The simultaneous Bulk Note Purchase Agreement and Lot Purchase

Agreement were not symmetrical, but they do appear to have broadly offset each

other, at least for some time after they were executed: Mr. Tucker paid $406,000

to Mr. Cuthbertson under the one, and Mr. Cuthbertson paid $412,000 to

Mr. Tucker under the other. Mr. Cuthbertson had an option to undo the one, and

Mr. Tucker had an option to undo the other. And the transactions were not acted

on or enforced with any rigor.

      D.     Subsequent modification of notes

      On January 2, 2014, Mr. Tucker modified all 14 of the notes he purchased

from the three Craft entities by extending their maturity dates until either 2019 or

2020. Several of the modifications recite that the original notes had matured and

were defaulted on. Mr. Tucker testified that his consideration for extending the

loans’ maturity date was “to give him more time”, and that he received “nothing

monetarily other than if I gave him longer time, I would stand a better chance of

getting it.” In addition to postponing the maturity date of the loans, the

modifications reduced some of the interest rates: For the three loans that had
                                        - 26 -

[*26] interest rates in excess of 0.75% when Mr. Tucker purchased them, the

January 2014 modifications reduced the interest rates from 5.00% to 0.75%.

      Mr. Tucker testified that he received no payments of interest or principal

under the notes in 2011 through 2014 and that “I did receive interest’s payment in

2015 when things got a little better, but it was to catch up some of the interest

from the previous years.” When asked how he responded to interest’s not being

paid on the notes, Mr. Tucker testified: “Nothing. The world was still gone south,

you know. In other words, nobody had [any] money so there was really nothing I

could do at that time.” When asked at trial whether he would have considered

suing any of the notes’ makers for nonpayment, Mr. Tucker testified: “I figured he

will pay even if I have to modify it to give him time”, before clarifying that “he”

referred to B&C III or Mr. Russell; and he stated that he did not think Mr. Russell

would want to hurt his relationship with Mr. Tucker or Mr. Cuthbertson by failing

to pay the notes.

      E.     Reporting of bulk notes sale

      On their 2010 Forms 1065, Development, Holdings, and CDS claimed that

the 2010 bulk notes sale gave rise to a $2.4 million loss, $1.57 million of which
                                        - 27 -

[*27] was claimed by Holdings, and $400,000 of which was claimed by

Development.12 These losses, in turn, were reflected on Schedule E of the

Cuthbertsons’ 2010 Form 1040, which reflects total nonpassive losses from

Schedules K-1 of $5.5 million, and total partnership and S corporation income of

$167,000 after application of those losses.

VI.   Lot transfers and sales from Development to True Homes

      Development transferred two parcels of real estate to True Homes in 2008

and transferred a third parcel to True Homes in 2009. In January 2009

Development also sold two other parcels of real estate to Mr. Russell and Mrs.

Kiker (jointly, in their individual capacities). Development deferred a portion of

the income from the transfer of five parcels13 of real estate in 2008 and 2009. For

income tax purposes, Development reported for 2008 the non-deferred portion of

income (i.e., $684,000) of the two 2008 transfers valued at $1.27 million; and

reported for 2009 the non-deferred portion (i.e., $1.84 million) of the 2009 transfer

valued at $3.6 million. However, Development did not report installment sale

      12
       The remaining amount of the $2.4 million loss, reported on CDS’s return,
was not disallowed by the IRS in its SNOD.
      13
        In the SNOD the IRS disallowed the deferral of the revenue from all five
of these sales. As to the parcels transferred to Mr. Russell and Mrs. Kiker,
because the Cuthbertsons did not raise this issue at trial or on brief, we treat this
issue, with respect to these parcels, as conceded.
                                         - 28 -

[*28] treatment for any of these transactions, nor did it file a Form 6252,

“Installment Sale Income”, with its returns.14 Development’s 2009 Schedules K-1

issued to Mr. Cuthbertson and Mrs. Cuthbertson indicate that neither received

distributions from Development during that year.

      Consistent with its 2008 and 2009 tax returns, Development’s 2009 and

2010 audited financial statements report that deferred revenue of $2.8 million and

$1.8 million, respectively. Mrs. Privette, the chief financial officer for Mr.

Cuthbertson’s real estate entities, entered the difference between the properties’

book values or bases (that is, their historic costs) and their fair market values at the

time of transfer in Development’s accounting records as “deferred revenue”.15

      14
        The 2008 return is not in evidence; but the 2009 return lacked the
Form 6252, and the Cuthbertsons do not allege that the 2008 return included Form
6252. Mr. Cuthbertson’s accountant, return preparer, and auditor, Thomas Moyer,
explained that they did not elect installment sale treatment for these transfers
because “it was simply a capital distribution and a re-contribution to another entity
owned in the same manner.” To the extent, if any, that his reasoning behind the
non-election is relevant, we are not at all convinced that the proffered reason was
actually involved in the decision. If the transfers were “simply a capital
distribution and a re-contribution to another entity”, then presumably none of the
proceeds should have been reported as income.
      15
         The record does not reflect when, if ever, True Homes disposed of the
three tracts of real estate that Development transferred to it in 2008 and 2009;
however, Mr. Moyer and Mrs. Privette testified that whenever that happened, they
would have reported any gain on such dispositions at that time as gain to
Development.
                                        - 29 -

[*29] VII.   Return preparation

      The Cuthbertsons engaged Mr. Moyer’s accounting firm, Moyer, Smith, and

Roller, to prepare their personal tax returns as well as those of their business

entities for the years in issue. After hearing Mr. Moyer’s testimony, we are unable

to find facts as to what information he asked for and what the Cuthbertson’s

provided for the reporting of the transactions giving rise to the disputed

adjustments in this case.

VIII. Notice of deficiency

      The IRS audited the Cuthbertsons’ entities’ 2009, 2010, and 2011 tax

returns. As part of that process, the immediate supervisor of the IRS’s examining

agent signed a penalty approval form on August 30, 2013. Having determined

deficiencies, on May 27, 2015, pursuant to section 6212(a), the IRS mailed an

SNOD to the Cuthbertsons. The SNOD determined deficiencies for 2009 and

2010, and made correlative adjustments for losses that the Cuthbertsons carried

back to their 2004, 2005, and 2006 tax years. The SNOD indicates an adjustment

by the Commissioner of $9 million to the Cuthbertsons’ Schedule E for 2009;

$1.4 million to their Schedule E for 2010; and $96,000 for 2011.
                                       - 30 -

[*30] With respect to Holdings, the SNOD specified that an adjustment of

$100,137 was necessary for the Golf Course Transaction for the 2009 tax year, and

an adjustment of $1,568,925 was necessary for the Note Sale.

      With respect to Development, the SNOD specified that for the 2009 tax

year, an adjustment to Development’s income of $5,278,404 was necessary to

correct for the treatment of the golf course transaction on Development’s Form

4797. The SNOD also indicated that an adjustment for Development’s 2010 tax

year of $397,575 was necessary for the Note Sale, and it determined that

correction of the use of the installment sale treatment to defer income during the

2009, 2010, and 2011 tax years required adjustments to income of $2,803,411,

$975,299, and $78,289, respectively.

      The SNOD also determined that the Cuthbertsons are liable for

accuracy-related penalties for both 2009 and 2010. (The SNOD also made other

adjustments that were subsequently conceded by the parties and therefore are no

longer at issue in this case.)

      The Cuthbertsons timely mailed their petition to this Court on August 5,

2015. At the time they filed their petition, the Cuthbertsons lived in North

Carolina.
                                         - 31 -

[*31]                                 OPINION

I.      Burden of proof

        In general, the IRS’s statutory notice of deficiency is presumed correct, “and

the petitioner has the burden of proving it to be wrong”. Welch v. Helvering, 290
U.S. 111, 115 (1933); see also Rule 142(a). Section 7491(a) provides

circumstances in which that burden may shift, but the Cuthbertsons do not invoke

that provision. Rather, they argue that the Commissioner bears the burden of

proof in this case because the SNOD does not provide the legal or factual basis for

its adjustments. Their argument is that, because the SNOD was not sufficiently

particular as to the factual or legal basis for the Commissioner’s determination,

“the Cuthbertsons were required to present differing evidence at trial to argue

against every possible ground for disallowance.”

        Section 7522(a) requires that a notice of deficiency “describe the basis

for * * * tax due”. Rule 142(a) provides that the Commissioner bears the burden

of proof with respect to “any new matter”. “[W]here a notice of deficiency fails to

describe the basis on which the Commissioner relies to support a deficiency

determination and that basis requires the presentation of evidence that is different

than that which would be necessary to resolve the determinations that were
                                        - 32 -

[*32] described in the notice of deficiency”, the Commissioner bears the burden of

proof. Shea v. Commissioner, 112 T.C. 183, 197 (1999).

      A new theory that “merely clarifies or develops the original determination is

not a new matter”. See Wayne Bolt & Nut Co. v. Commissioner, 93 T.C. 500, 507

(1989). But a new theory that either “alters the original deficiency or requires the

presentation of different evidence” is a new matter. Id. The Cuthbertsons have

failed to explain how the Commissioner’s arguments in this case do more than

clarify or develop the determinations in the SNOD, and they have not explained

how any evidence they would have needed to counter the Commissioner’s

contentions here differed from what would have been necessary to resolve the

determinations described in the SNOD. The Cuthbertsons therefore bear the

burden of proof.

II.   General legal principles

      A.     Reporting partnership tax items

      Sections 702 and 1366 provide that partners of partnerships (or, as here,

LLCs taxed as partnerships under subchapter K) and shareholders of

S corporations (such as Builders) are taxed on the tax items realized initially by

the entities in which they hold equity interests. Because the Cuthbertsons filed

joint tax returns for 2009 and 2010, and Development, Holdings, and CDS were
                                       - 33 -

[*33] owned entirely by them, the tax items initially reported by those entities

ultimately were taken into account by the Cuthbertsons on their personal returns.

      B.     Loss deductions

      Section 165(a) provides: “There shall be allowed as a deduction any loss

sustained during the taxable year and not compensated for by insurance or

otherwise.” Regulations provide that for a loss to be deductible under section 165,

“a loss must be evidenced by closed and completed transactions, fixed by

identifiable events, and * * * actually sustained during the taxable year. Only a

bona fide loss is allowable. Substance and not mere form shall govern in

determining a deductible loss.” 26 C.F.R. sec. 1.165-1(b), Income Tax Regs.

(emphasis added).

      “[F]amily tax planning is permissible. However, an intra-family transaction

will be closely scrutinized”. Royster v. Commissioner, T.C. Memo. 1985-258, 49
T.C.M. 1594, 1605 (1985), aff’d, 820 F.2d 1156 (11th Cir. 1987); see

Barnes Grp., Inc. v. Commissioner, T.C. Memo. 2013-109, at *51 (the transaction

“was executed between related parties and therefore deserves extra scrutiny”),

aff’d, 593 F. App’x 7 (2d Cir. 2014). If that scrutiny reveals that family members

did not actually govern their affairs in accord with agreements that they purported

to enter into, then we will not respect those agreements more than they did.
                                        - 34 -

[*34] The parties’ legal arguments in this case can largely be characterized as

pertaining either to the rules governing whether a taxpayer is entitled to a loss

deduction upon disposing of an asset,16 or to the Code’s tax accounting rules

governing when a tax item is properly taken into account. We address each in turn

below.

III.   Deductibility of losses from the Edgewater golf club transfer and
       the bulk notes sale

       A.    Holdings’ claimed loss on the 2009 sale of the golf course

       In 2009 Holdings held title to the 154 acres underlying the golf course, for

which its claimed basis was $760,137. It purported to sell that land to B&C III for

$660,000 (the value at which it had been appraised) and therefore claimed a loss

deduction of approximately $100,000. While the parties do not dispute that the

LPA did not convey legal title to B&C III in 2009, the Cuthbertsons contend that

the sale nonetheless closed in the 2009 tax year because the benefits and burdens

of owning the golf course land passed to B&C III. We hold, however, that

Holdings is not entitled to deduct this claimed loss for two factually related and

overlapping reasons: First, B&C III did not actually assume the benefits and

       16
       The Commissioner has not invoked application of section 267 or section
707(a)(2)(B) to the intrafamily transactions at issue.
                                       - 35 -

[*35] burdens of ownership of the land; and second, the purported sale lacked

economic reality.

             1.     Development’s assumed ownership of the golf course
                    improvements

      To address two of the issues in this case--Holdings’ claimed loss on the sale

of the golf course (discussed here in part III.A), and Development’s claimed

abandonment loss from the golf course improvements (discussed below in

part III.B)--we must inquire who owned the golf course improvements.

      Necessary to the Cuthbertsons’ litigating position that Development

abandoned the improvements (and necessary to its reporting position that it sold

them) is the proposition that Development owned the improvements, and the

Cuthbertsons contend that it did. However, it is undisputed that Development

passed to Holdings legal title to the golf course in 2006 and 2007 without any

express retention of the improvements that it had built thereon and without any

documented understanding about ownership of the improvements that

Development continued to make on the property thereafter. But the Cuthbertsons

contend that, under State law, Development became a “tenant at will” of Holdings

on the golf course property after it transferred the golf course land to Holdings and
                                       - 36 -

[*36] that as a tenant Development could and did therefore own the improvements

it made on the property.

      The Commissioner urges the general proposition that “[r]eal property

improvements run with the land” and disputes Development’s status as a “tenant at

will”. To resolve this dispute would require us to determine whether the facts

about these transactions and dealings among related entities support the existence

of an undocumented tenancy and whether State law does, as the Cuthbertsons

contend, give to the tenant ownership of improvements that he builds.

      However, we conclude that we do not need to definitively resolve this

question. As we show below, even if we assume that the Cuthbertsons’ position is

correct and that Development did own the golf course improvements, we must

hold in favor of the Commissioner on both Holdings’ claimed loss on the sale and

Development’s claimed abandonment loss. We therefore proceed on the

assumption that Development did own the golf course improvements--but this

assumption in favor of the Cuthbertsons creates insuperable difficulties for them

on the issue of Holdings’ claimed loss on the sale, which we now address.
                                         - 37 -

[*37]         2.     Benefits and burdens

        Caselaw guides our analysis with regard to when a sale is complete for tax

purposes. In the context of real property, “a sale and transfer of ownership is

complete upon the earlier of the passage of legal title or the practical assumption

of the benefits and burdens of ownership.” Keith v. Commissioner, 115 T.C. 605,

611 (2000). While Holdings claimed a loss on the sale of the land underlying the

Edgewater golf course in 2009, Holdings did not actually transfer legal title to the

property to B&C III until December 2014, so we must decide whether these

instruments confer upon B&C III the benefits and burdens of ownership.

Consequently, in order for Holdings to have incurred a taxable loss in 2009,

B&C III must have practically assumed the benefits and burdens of ownership of

the Edgewater golf course land.

        In similar cases, we have considered the following factors as “indicative of

the benefits and burdens of ownership”:

        A right to possession; an obligation to pay taxes, assessments, and
        charges against the property; a responsibility for insuring the
        property; a duty to maintain the property; a right to improve the
        property without the seller’s consent; a bearing of the risk of loss; and
        a right to obtain legal title at any time by paying the balance of the
        full purchase price. * * *
                                        - 38 -

[*38] Id. at 611-612. In determining whether the benefits and burdens of

ownership practically shifted to B&C III, we consider all of the relevant facts and

circumstances. See Clodfelter v. Commissioner, 426 F.2d 1391, 1393 (9th Cir.

1970) (“The transaction should be regarded in its entirety”), aff’g 48 T.C. 694

(1967).

      Application of these factors in the instant case is complicated by the fact

that the LPA purports to transfer from Holdings to B&C III both the land and the

“improvements” thereon, whereas Holdings could not transfer title, or contract to

convey title, to B&C III for the improvements, which (the Cuthbertsons contend

and we assume) Holdings did not own. If B&C III somehow obtained the benefits

and burdens of the improvements, it did not obtain them through the LPA. For

several of the benefits and burdens it is difficult to distinguish the land underlying

the golf course from the golf course and to decide whether (for example) B&C III

obtained from Holdings the right to possess the golf course land but not the

improvements, the responsibility to maintain the land but not the improvements,

and to bear the risk of loss from the land but not from the improvements.

Consequently, even if we found that some benefits and burdens passed to B&C III

under the LPA, B&C III did not obtain the benefits and burdens of the
                                        - 39 -

[*39] “improvements” (assumed to have been owned by Development) that were

an ostensible subject of the LPA, since Development was not a party to the LPA.

      Under the transactions among these related parties taken as a whole,

B&C III ultimately lacked the “benefits and burdens” as measured by the Keith

factors: Under the terms of the January 19, 2010, lease with EGC, B&C III

contracted away some of the responsibilities that it bore under the LPA. The new

lease with B&C III as the landlord, required that EGC as lessee have the

“responsibility for insuring the property”. EGC (rather than Development and

B&C III) was obligated under both leases to maintain the property, other than

“capital improvements”, even after the purported sale. The lease between EGC

and B&C III allocated to EGC the “risk of loss”, at least by way of tort liability

and property damage.

      We assume that, when a purchaser of property is dealing at arm’s length

with unrelated parties, he may be seen as obtaining and bearing the burdens of

ownership even if his manner of bearing those burdens is to find a lessee who will

contract to bear them for him.17 In this case, however, B&C III stepped into a

      17
        In Frank Lyon Co. v. United States, 435 U.S. 561, 575 (1978), the
Supreme Court respected the parties’ sale and leaseback arrangement, holding that
“the transaction, as it ultimately developed, was not a familial one”; rather it was a
genuine multiple-party transaction with economic substance which is compelled or
                                                                        (continued...)
                                         - 40 -

[*40] prearranged agreement in which it acquired ostensible property rights from a

related party for no money down and became the lessor to a party related to the

seller that had already been operating the property and that had borne and would

continue to bear the burdens of ownership. Practically speaking, B&C III took on

no burdens.

      Moreover, the lease between B&C III and EGC also set forth the

requirement that all insurance policies “shall be written in a form satisfactory to

and approved by Lessor” (i.e., by B&C III) and the policies “shall be issued by

insurance companies satisfactory to Lessor.” There is no evidence in the record

that EGC obtained and maintained the types of insurance policies required by the

lease; and more importantly, as it concerns the benefits and burdens analysis, the

record lacks any evidence that B&C III undertook its duties to approve the

insurance policies and insurance companies that underwrote the policies.

Additionally, because B&C III had not paid any money under the LPA and had not

yet accepted legal title, if something catastrophic occurred, then B&C III stood to

lose very little if anything, since it was thinly capitalized, and its promissory note

      17
         (...continued)
encouraged by business or regulatory realities. Here, we find the opposite. The
substance and form of the transaction between Holdings and B&C III make clear
that the parties were not dealing with each other at arm’s length, and the
transaction was very much a “familial one”.
                                         - 41 -

[*41] to Holdings for the purchase of the property was not secured by collateral or

by personal guaranties by B&C III’s members.

        Like the parties’ agreements concerning the insurance of the property, the

parties’ agreements concerning property taxes further detract from the

Cuthbertsons’ position. Contrary to the provisions in the LPA and the EGC

lease,18 Holdings evidently retained the “obligation to pay taxes” for years after

2009, since Holdings, rather than B&C III or EGC, was in fact the party that paid

them.

        For the most part, B&C III did not acquire the benefits and burdens of

owning the golf course, so Holdings did not actually sell the property to B&C III.

Holdings is therefore not entitled to claim any loss on the sale of the property.

              3.    “Economic reality”

        Focusing on the substance of the Cuthbertsons’ dealings with their daughter

and son-in-law’s entity, rather than the form the Cuthbertsons nominally followed,

we find almost no evidence that a true sale occurred between Holdings and

B&C III. This would be true even without the heightened scrutiny we apply to

intrafamily transactions, and it is especially true in light of that standard.

        18
        EGC’s lease had no explicit provision about taxes but did require EGC to
transfer into its name “all other costs and expenses of every kind whatsoever”.
                                        - 42 -

[*42] Generally, taxpayers are free to arrange their affairs to minimize their tax

liabilities, and a taxpayer does not have even a patriotic duty to increase his or her

own tax liability. Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934), aff’d,

293 U.S. 465, 469 (1935). On the other hand, “[w]hile it is true that a taxpayer

can structure a transaction to minimize tax liability under the Internal Revenue

Code, that transaction must nevertheless have economic substance in order to be

‘the thing which the statute intended.’” Kirchman v. Commissioner, 862 F.2d
1486, 1491 (11th Cir. 1989) (quoting Gregory v. Helvering, 293 U.S. at 469), aff’g

Glass v. Commissioner, 87 T.C. 1087 (1986). Holdings’ purported sale of the

Edgewater golf course land to B&C III was not a legitimate arm’s-length

transaction that they simply arranged in a tax-favorable manner. Rather, “it is

patent that there was nothing of substance to be realized by [the taxpayers] * * *

from this transaction beyond a tax deduction.” Knetsch v. United States, 364 U.S.
361, 366 (1960).

      The caselaw of the Fourth Circuit, in which an appeal would lie in this case,

applies a test to which it refers as “a two-pronged ‘economic reality’ test”, which

looks to two factors: (1) the intent of the parties, and (2) the economic substance

of the transaction.” United States v. Bergbauer, 602 F.3d 569, 577-578 (4th Cir.

2010) (quoting Gen. Ins. Agency, Inc. v. Commissioner, 401 F.2d 324, 330
                                         - 43 -

[*43] (4th Cir. 1968), aff’g T.C. Memo. 1967-143). Both determinations “are

questions of fact, with the taxpayer bearing the burden of proof.” Id. at 578.

                    a.     The intent of the parties

      In examining the parties’ intent, the Court of Appeals in Bergbauer first

examined the plain language of the transaction documents before turning to

extrinsic evidence, and we will do the same. The distinctive terms of the LPA lead

us to conclude that it is not the instrument that it purports to be--an arm’s-length

contract for deed. Contracts for deed are often used in certain circumstances:

      If an institutional loan is not available or is insufficient to permit the
      purchaser to complete the transaction, the seller is sometimes willing
      to finance a portion of the purchase price on the property. This
      financing arrangement may take the form of a purchase money
      mortgage. Alternatively, the seller may prefer a long-term installment
      purchase contract, often called a “contract for deed” or a uniform real
      estate contract. * * * [Emphasis added.]

14 Powell on Real Property, sec. 81.01[3][e] (M. Wolf ed. 2019). But in this case

the purported “contract for deed” financed not a portion but all of the purchase

price and provided not for installments but for a balloon payment after five years.

A contract for deed (also referred to as an “installment land contract”) operates

similarly to a traditional mortgage (i.e., giving the lender an interest in the

property and requiring payment before the buyer has an unencumbered interest)

but is sometimes used for higher-risk borrowers, see 15 Powell on Real Property,
                                         - 44 -

[*44] supra, sec. 84D.01[2], in which case we would expect to see terms less

favorable for the borrower than a traditional mortgage. That is, for an arm’s-

length contract for deed, we would expect to see a higher interest rate (rather than

the 6.0% rate stated in the LPA or the 5.0% rate (inexplicably 1% lower) in the

corresponding promissory note), or increased required amounts of collateral

(rather than the unsecured arrangement in the LPA), or personal guaranties (also

lacking in the LPA). This is the scenario about which Mr. Hinson, the

Cuthbertsons’ real estate attorney, testified--that contracts for deed are used for

seller-financing when buyers are unable to obtain third-party-lender financing.

The biggest difference between an installment land contract and a mortgage

financed real estate transaction is that normally under an installment land contract,

“the vendor retains legal title to the property until all of the purchase price has

been paid”. Id. sec. 84D.01[1]. That feature is present in the LPA, but the other

features typical in contracts for deeds are lacking from the LPA between Holdings

and B&C III.

      We find instead that the attributes of the LPA that are different from those

in normal contracts for deed reveal the parties’ intent. The transaction as they

carried it out got the golf course property nominally “off the books” of

Mr. Cuthbertson’s entities, as his lenders required, but left the ostensible purchaser
                                         - 45 -

[*45] with no obligation to make any payment, and left Mr. Cuthbertson free to

exploit the golf course’s value for his residential developments. From the eight

corners of the LPA and the promissory note executed by B&C III, and even from

Mr. Cuthbertson’s own testimony, the parties’ intent is clear: Get the golf course

nominally “off the books” to satisfy the lenders. Therefore, Mr. Cuthbertson and

his family members undertook the transactions necessary to get it off the books,

without causing any of them to incur any additional liabilities.

      With respect to the Cuthbertsons’ intent, the record contains no evidence of

serious negotiations. Rather, Holdings sought no collateral, no credit report, no

tax returns, no demonstrated liquidity, and no personal liability from the

property’s “purchaser”, and they charged no premium over the appraised value to

compensate them for the high-risk manner of financing of the purchase or the time

value of money. These remarkable terms make the parties’ intent clear:

Mr. Cuthbertson never really intended to impose actual obligations or

consequences upon Ben and Crystal’s entity, B&C III, if it defaulted on the LPA.

In reality, all of the parties intended to leave their situations unchanged.

                    b.     The requirement of economic substance

      The economic substance of this transaction also undermines the

Cuthbertsons’ claimed tax treatment of the transaction as a sale of the golf course
                                        - 46 -

[*46] by Holdings to B&C III. There was no substance; the “sale” from Holdings

to B&C III altered nothing.

      As is discussed above, a contract for deed is similar to a mortgage, but when

instead a buyer enters into a contract for deed (such as the LPA at issue here),19 the

seller retains title; and, except where State law requires that the property be sold in

a foreclosure sale, upon default that title-holding seller can simply seize the

property without foreclosure under the contract’s forfeiture clause. See 15 Powell

on Real Property, supra, sec. 84D.03[1]. “Under state recording acts, an

installment purchaser is unprotected against a subsequent taker of the property

who acquires an interest without notice of the installment land contract.” Id. sec.

84D.02[1]. Thus, the “purchaser [using a contract for deed] is well advised to

record either the contract or some summary or other evidence of the contract that

is sufficient to provide notice to third parties.” Id. We do not say that a contract

for deed can never have economic substance; but in the context of the transactions

at issue here, the contract for deed--the atypical terms of which we discussed

      19
         The LPA references a supposed “mortgage” that was executed on the same
date; but if the parties to the LPA prepared and executed such an instrument, then
the Cuthbertsons failed to enter it into the record. If, as seems more likely, the
LPA’s reference to the mortgage is in fact an inaccurate reference to the unsecured
promissory note, which lacks the fundamental characteristic of a mortgage, then
this careless reference in the LPA (or the parties’ failure to carry through by
executing a mortgage) further underscores the unseriousness of the transaction.
                                        - 47 -

[*47] above in part III.A.3.a--is truly insubstantial. The month before the end of

the 2009 tax year, Mr. Cuthbertson paid an appraiser to value the Edgewater golf

course. That same month, the Cuthbertsons’ daughter and son-in-law organized--

and did not capitalize--an LLC; and in the final days of that year, their LLC

“bought” the land underlying the Edgewater golf course with an unsecured, low-

interest, nonrecourse promissory note promising a balloon payment five years later

in the exact amount of the appraiser’s valuation. There is no evidence that the

LLC recorded the LPA in the county land records. Five years later, the

Cuthbertson’s entity (Holdings) no longer held the note, and no payments of any

kind had been made under it. (Rather, not quite a year after the note had been

executed, it was sold for 15% of its face value (i.e., for $95,700 rather than

$660,000).)

      In the meantime, EGC (another entity owned by the Cuthbertsons)

continued to operate the Edgewater golf course as it always had. EGC had the

option to extend its existing lease with Development in six-month increments for

no additional consideration, and there is no evidence that it ever terminated that

lease. But on January 1, 2010 (a date on which its old lease would not have

expired, if EGC had been exercising its option), EGC entered into the new lease

with B&C III, giving to EGC the right to possess property that it already
                                        - 48 -

[*48] possessed. EGC’s new terms with B&C III were less favorable, as EGC

would now purportedly owe to its new landlord, in addition to its $1 rent (in

perpetuity), additional rent consisting of a percentage of its net profits; and EGC

would continue to hold virtually every benefit and burden of the Edgewater golf

course property. So unserious was the December 2009 transaction that, in the

LPA, Holdings purported to sell improvements that the Cuthbertsons contend (and

we assume) Holdings did not own; and the parties behaved--without any warrant

in the documents--as if the clubhouse went along with the deal as well.

      The minimal amount of actual consideration paid at the time the LPA was

executed and the deferred future transfer of title are characteristics more aptly

associated with an “option to purchase”, which “unilaterally binds the seller to

keep an offer of sale open at a specified price and on designated terms for a

specified period of time.” 14 Powell on Real Property, supra, sec. 81.01[2][b]. An

option to purchase, which does not transfer ownership of the property, is a

characterization that the Cuthbertsons resist, since they argue that B&C III was

“obligated * * * to pay the purchase price of $660,000 on or before December 31,

2014”--but this “obligat[ion]” was an unsecured note to an entity owned by the

father of B&C III’s principals; the note was promptly sold at a steep discount to a
                                         - 49 -

[*49] friendly party; and the note was essentially ignored by the parties until the

IRS took an interest in the situation.

       Admittedly, the transaction between Holdings and B&C III lacked some

characteristics of an option. In consideration for executing an actual option, a

“seller also generally receives a non-refundable payment from the purchaser as

consideration for the option”; that is, “[t]o be bound by an option, the seller must

receive valuable consideration.” Id. (emphasis added). That feature was lacking

in this case.

       Consequently, the instrument and the underlying promissory note at issue

here lack some of the characteristics of either a “contract for deed” or of an

“option”. It was instead a unique hybrid transaction, conceived by

Mr. Cuthbertson, the critical feature of which was that it allowed him to present

the financial records of Holdings to his lenders without inclusion of the golf

course. Additionally, as we observed in the discussion of the benefits and

burdens, in part III.A.2, the payments by Holdings of the insurance and taxes on

the property illustrate the true economic substance of the transaction.

       The Court of Appeals in Bergbauer found that the “economic reality test

was met because the terms of the transaction were grounded in ‘business reality

such that reasonable men, genuinely concerned with their economic future, might
                                       - 50 -

[*50] bargain for such an agreement.’” Bergbauer, 602 F.3d at 580 (quoting Gen.

Ins. Agency, Inc. v. Commissioner, 401 F.2d at 330). However, in this case, we

find the opposite. No person “genuinely concerned with their economic future”

would bargain for an agreement like the one entered into by Holdings. We hold

that the purported sale of the golf course by Holdings to B&C III lacked economic

reality.

       B.    Development’s claimed loss on the 2009 sale or abandonment of the
             Edgewater golf course improvements

       As we explained above in part III.A.1, we assume, consistent with the

Cuthbertsons’ contention, that Development owned the golf course improvements

in 2009. Although the Cuthbertsons initially reported on their tax return that

Development sold the improvements to the Edgewater golf course at a $5.3

million loss,20 consistent with Development’s records,21 there is no evidence of any

such sale; and the Cuthbertsons now argue instead that Development abandoned

the improvements in the final days of 2009, at the same time that Holdings

       20
       This loss flows through from Development’s Form 1065, reflected on the
Form 4797, reporting the transaction under Part II, “Ordinary Gains and Losses”.
       21
        Mr. Moyer, petitioner’s accountant, testified that the abandonment of the
improvements was characterized on the accounting records as a “mass sale”. We
did not find credible his testimony that this was simply the result of his computer’s
accounting software not having “abandonment” as an option.
                                       - 51 -

[*51] purportedly sold the underlying land. We now address that claimed

abandonment loss.

      The Court of Appeals for the Fourth Circuit (to which an appeal of this case

would lie) has noted “the general rule that a taxpayer cannot recharacterize a

transaction to avoid the tax consequences of the form of the transaction actually

chosen,” Snowa v. Commissioner, 123 F.3d 190, 198 n.11 (4th Cir. 1997), rev’g

on other grounds T.C. Memo. 1995-336, and has held that, “[g]enerally, taxpayers

are liable for the tax consequences of the transaction they actually execute and

may not reap the benefit of recasting the transaction into another one substantially

different in economic effect that they might have made”, Estate of Leavitt v.

Commissioner, 875 F.2d 420, 423 (4th Cir. 1989), aff’g 90 T.C. 206 (1988). Here

again, we follow the economic reality test recently re-affirmed by the Court of

Appeals in Bergbauer, 602 F.3d at 580, and the burden of proof remains with the

Cuthbertsons.

      On brief the Cuthbertsons assert that two actions demonstrate the

abandonment of the Edgewater golf course improvements: (1) that Development

sold the golf course maintenance equipment to EGC and (2) that Development

wrote off, in its accounting and financial statements, its costs of the improvements.
                                         - 52 -

[*52] The Cuthbertsons argue in support of abandonment treatment that the sale

of equipment used at an immovable facility has, in at least one other case, been

found sufficient to prove abandonment of intangible improvement costs. See A.J.

Indus., Inc. v. United States, 503 F.2d 660, 663-664 (9th Cir. 1974). That

statement is true, but the Cuthbertsons ignore several critical differences that

distinguish that case from their own supposed “abandonment”--namely, that in

A.J. Indus., Inc. there was no question of ownership of legal title to the land

involved, that the taxpayer’s sale of equipment used at a mining facility was to an

unrelated third party, and that the mining facility ceased all operations after the

sale of the equipment (and it had periodically ceased operations, before the sale).

Id. The Court of Appeals explained that the asset for which the loss was claimed

“is not the mine or the real estate, and no question of legal title to the land is

involved. It is an amount separable and identifiable from the land itself.” Id.

at 663 (emphasis added). The Cuthbertsons’ equipment sale, by contrast, was

from one entity whose equity was owned 99% and 1% by Mr. and Mrs.

Cuthbertson to another entity identical in ownership. Finally, the Edgewater golf

course continued its operations, completely unaffected by this “abandonment”,

using the improvements that had been “abandoned”. The act of abandonment

must constitute “some step that irrevocably cuts ties to the asset” and must be
                                        - 53 -

[*53] “visible to outside observers”. Corra Res., Ltd. v. Commissioner, 945 F.2d
224, 226 (7th Cir. 1991), aff’g T.C. Memo. 1990-133. The “owner” of the

lawnmowers and equipment (formerly Development) had changed (now EGC); but

before and after, it was EGC that kept cutting the grass, and thus the abandonment

of the golf course improvements was not perceptible to anyone. (These facts also

distinguish this case from A.J. Indus., Inc.)

      We are unpersuaded that Development abandoned the Edgewater golf

course improvements. The evidence that Development wrote off the

improvements on its internal records could just as well be invoked to try to prove

that the Cuthbertsons thought they had sold the improvements--and such a

conclusion would be more consistent with the manner in which the Cuthbertsons

reported the “loss” by Development (i.e., as a loss from the sale of business

property). And the fact that the Cuthbertsons sold a relatively small amount of

maintenance equipment to another of their own identically held entities, which

continued to operate and maintain the golf course, hardly indicates that they had a

real desire to abandon anything.

      An asset is abandoned when it “is permanently retired from use in the trade

or business”. See 26 C.F.R. sec. 1.167(a)-8(a)(3), Income Tax Regs. One does

not abandon an asset when he makes it available to his own entity for continued
                                         - 54 -

[*54] use in the business for which it was created. It is quite clear that

Mr. Cuthbertson was not indifferent to the fate of the golf course property, in

which Development had invested millions of dollars. He did not leave it to go to

seed. On the contrary, his entities picked it right up and continued to maintain and

operate it for the benefit of enhancing the sale value of residential lots in the

Edgewater development.

      The 2014 “addendum” to the LPA by B&C III and Development further

demonstrates that the golf course improvements were not abandoned. When those

three entities purported to agree in that addendum that Development would take

$100 to “abandon” the golf course improvements, they made it crystal clear that all

the parties had understood and intended that the golf course improvements would

be a part of the ongoing Edgewater development.

      The Cuthbertsons’ claim of an abandonment loss also fails to meet the

economic reality test applied by the Court of Appeals for the Fourth Circuit. The

evidence shows that the Cuthbertsons and their entities did not intend to abandon

the Edgewater golf course improvements, and the economic substance of the

transaction is that the same entity (the Cuthbertsons’ EGC) was operating the golf

course before and after the supposed “abandonment”.
                                        - 55 -

[*55] C.     Bulk notes sale

      Our analysis of the bulk notes sale to Mr. Tucker in 2010 is governed by the

same authority as our analysis of Holdings’ “sale” of the Edgewater golf course

land. Section 165 provides for the deductibility of losses from the sale of

property. Under 26 C.F.R. section 1.165-1(b), Income Tax Regs., again, “a loss

must be evidenced by closed and completed transactions, fixed by identifiable

events, and * * * actually sustained during the taxable year. Only a bona fide loss

is allowable. Substance and not mere form shall govern in determining a

deductible loss.” (Emphasis added.) See also Du Pont v. Commissioner, 118 F.2d
544, 545 (3d Cir. 1941) (noting that a “controlled or sympathetic vendee” can

“divest a sale of its fundamental incident of finality”), aff’g 37 B.T.A. 1198

(1938), and aff’g Raskob v. Commissioner, 37 B.T.A. 1283 (1938). Like the

taxpayer in Du Pont, the Cuthbertsons “attempt to give verisimilitude to their

transactions by reliance upon their own protestations and upon their construction

of * * * [these] circumstances, all of which may be said to be open to two

interpretations, one favorable and the other dubious.” Id. at 547.

      Even if Mr. Tucker was an unrelated party, the structure and treatment of

the transaction would also preclude the Cuthbertsons’ deduction of the losses

arising from it. As with the sale of the Edgewater golf course land, the unserious
                                        - 56 -

[*56] manner of the parties’ dealings makes it unclear which precise transaction

could or should be examined. If one views the December 2010 transfer of notes

from Mr. Cuthbertson to Mr. Tucker in exchange for Mr. Tucker’s March 2011

transfer of $406,000 to Mr. Cuthbertson, standing alone, then it is difficult to

respect that transaction, which neither Mr. Cuthbertson nor Mr. Tucker respected.

First we examine what was sold: the 14 notes. Both men testified that they never

made any collection efforts under the 14 notes, even as the notes matured and their

makers made no payments toward the balance; and both men reduced the initial

interest rates of various notes to three-quarters of a percent. Serious lenders would

generally seek more security than the borrowers’ fear of reputational damage in

the event of default. Mr. Tucker admitted he would never have sued to enforce the

notes, and Mr. Cuthbertson retained an option to buy the notes back (by which he

could have protected his family and its entities if Mr. Tucker had become active in

collection). Additionally, Mr. Tucker responded to defaults on the notes by

extending the maturity dates and lowering the interest rates on the loans so that

they were still outstanding years later--the opposite actions that one might expect

from a party lending at arm’s length. Consequently, if we view the note sale in

isolation, the evidence shows that it was not bona fide.
                                        - 57 -

[*57] The better approach--more consistent with the evidence, the structure of the

transaction, and the economic reality surrounding it--is to view the note sale and

the Lot Purchase Agreement together as a notes-for-land exchange. This

conclusion is supported by Mr. Cuthbertson’s testimony that his purchase of the

land was intended to incentivize Mr. Tucker to buy the notes from him and by the

fact that the cash consideration nominally changing hands was $406,000 for the

notes and $412,000 under the Lot Purchase Agreement. Meanwhile, Mr.

Cuthbertson and Mr. Tucker agreed to allow Mr. Tucker to swap a different piece

of real estate well after the close of the 2010 tax year without adjusting the cash

consideration. The Cuthbertsons, who bear the burden of proof, failed to offer any

evidence as to the timing of the transaction and the value of this substituted

property. Accordingly, even assuming arguendo that the notes were bona fide and

that Mr. Tucker intended to enforce them, the evidence of the offsetting notes-for-

land arrangement and the failure to convey the property that had been “bargained”

for under the Lot Purchase Agreement make it clear that the bulk notes sale was

not a “closed and completed transaction”.

      The Cuthbertsons thus failed to prove that the transaction between

Mr. Cuthbertson and Mr. Tucker at the end of 2010 was closed and completed.
                                         - 58 -

[*58] The Cuthbertsons are therefore entitled to no deduction under section 165

for that transaction for 2010.

IV.   Lot transfers

      Development used the installment method to account for income it realized

on the sales to True Homes during the 2008 and 2009 tax years. However,

Development is a dealer selling real property in the ordinary course of its trade or

business; accordingly, such installment sale treatment would, as the Cuthbertsons

now admit, be inappropriate because the installment method of accounting is not

available for “dealer disposition[s]”, sec. 453(b)(2)(A), which are defined to

include “[a]ny disposition of real property which is held by the taxpayer for sale to

customers in the ordinary course of the taxpayer’s trade or business”,

sec. 453(l)(1)(B). The SNOD holds Development to the “sale” characterization of

these transfers but corrects for the improper accounting method by recognizing all

of the income in the year of the transaction rather than deferring a portion of it.

The Cuthbertsons resist the IRS’s adjustments for two reasons: (1) that the

adjustments have no basis in law and (2) that the property transfers were simply

transfers of equity (i.e., they ask us to apply the substance-over-form doctrine, and

in effect to recast the property transfers as a different type of transaction).
                                        - 59 -

[*59] A.     Development’s contemporaneous characterization of the sales

      Development reported these transactions as “sales” in its audited financial

statements for 2009 and 2010 and on its tax returns for 2008 (we infer) and for

2009 (in evidence); but on those tax returns it reported only a portion of the

proceeds as income (i.e., as “sales” and not, the 2009 return shows, as

distributions); and it failed to file with those tax returns a Form 6252, which

would have reported the installment sale treatment.

      Development, True Homes, and their principals and employees had the

opportunity and responsibility to characterize these transactions in the manner that

they thought most accurate--and at the first branch in their decision tree, before

selecting an accounting method, they chose to characterize the transfer of these

properties as “sales”. There is no evidence that they contemporaneously

characterized them as distributions to the Cuthbertsons followed by contributions

to True Homes.

      B.     Changes in accounting methods

      Section 446(a) requires a taxpayer to compute taxable income under the

method of accounting it regularly uses in keeping its books. Once the

Commissioner determines that a taxpayer’s method of accounting

does not clearly reflect income, he has broad discretion to select a method of
                                        - 60 -

[*60] accounting that, in his opinion, does clearly reflect the income of the

taxpayer.22 Sec. 446(b). The Commissioner’s determination may be challenged

only upon a showing of abuse of discretion. RACMP Enters. v. Commissioner,

114 T.C. 211, 218-219 (2000). Whether an abuse of discretion occurred depends

upon whether the Commissioner’s determination is without sound basis in fact or

law. Id.; see also Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 532

(1979).

      The Cuthbertsons concede that their choice of bookkeeping labels was poor,

but they argue that “the entities intended for the transfers to be equity

contributions by Mr. Cuthbertson to True Homes”. That is to say, rather than

attempting to overcome the heavier-than-normal burden of showing that the

Commissioner abused his discretion in changing the method for reporting sales,

the Cuthbertsons now argue substance over form, attempting to recast the

      22
          The Commissioner proposes for 2009 adjustments to the Cuthbertsons
income based on changes in the accounting method for transactions that occurred
in 2008, an apparently closed year for which year there are no adjustments
proposed. The Cuthbertsons dispute this 2009 adjustment, but they do not dispute
that, if an adjustment is called for, it may be made for 2009. Following a change
of accounting method, the Commissioner may make any necessary adjustments to
prevent taxable income from being duplicated or omitted as a result of the change
under section 481(a). For purposes of section 481(a) adjustments, once there has
been a change in the method of accounting, no statute of limitations applies to the
Commissioner’s authority to correct errors on old tax returns. See Mingo v.
Commissioner, 773 F.3d 629, 636 (5th Cir. 2014), aff’g T.C. Memo. 2013-149.
                                        - 61 -

[*61] transactions as not sales at all but rather a form different from what they

originally reported as deferred income in Development’s 2009 and 2010 Audited

Financial Statements and on its 2008 and 2009 tax returns, i.e., recasting the

transactions as changes in equity, rather than as sales.

      C.     Substance over form

      Courts have established strict standards for a taxpayer who elects “a specific

course of action and then when finding himself in an adverse situation [seeks to]

extricate himself by applying the age-old theory of substance over form.”

Bergbauer, 602 F.3d at 576 (quoting Cornelius v. Commissioner, 494 F.2d 465,

471 (5th Cir. 1974), aff’g 58 T.C. 417 (1972)). “We have recognized that

‘[g]enerally, taxpayers are liable for the tax consequences of the transaction they

actually execute and may not reap the benefit of recasting the transaction into

another one substantially different in economic effect that they might have made.’”

Id. (quoting Estate of Leavitt v. Commissioner, 875 F.2d at 423). The

Cuthbertsons resist this application of Bergbauer, and instead argue that they

should be excused from their initial characterization because they ask for only a

change in bookkeeping labels.
                                        - 62 -

[*62]         1.    Changing labels vs. recasting a transaction

        In support of this argument they cite Sitterding v. Commissioner, 80 F.2d
939, 941 (4th Cir. 1936), rev’g 32 B.T.A. 506 (1935), for the proposition that

“[w]here there is no question of bad faith with regard to the bookkeeping entries,

the rights of the parties can neither be established nor impaired by the

bookkeeping methods employed.” However, in determining in Sitterding that the

distribution was in fact a distribution of corpus, the Court of Appeals observed

that the IRS’s adjustment at issue was “based largely upon the fact that the

distribution made to the taxpayer was from an income account kept by the

executors” (i.e., they were paid from the wrong account). Id. at 940-941.

        The issue presented by the Cuthbertsons’ argument is not from which bank

account Development paid Mr. Cuthbertson or True Homes; rather, the issue is

whether the Cuthbertsons can use the substance-over-form doctrine to recast the

transaction in a manner quite different from what they had previously described

and reported--which, we observe, is not the same thing as a “mere bookkeeping

entry”. This proposed recasting is undercut by two facts about Development’s

financial reporting: First, Development recorded its equivalent transactions with

Mr. Russell and Ms. Kiker--plainly not equity contributions--as sales, using the

same impermissible accounting method. (The Cuthbertsons no longer dispute the
                                       - 63 -

[*63] adjustments as to those sales.) Second, when Development did engage in

equity distributions, it knew how to report them. Development did in fact record

accounting entries for distributions of equity in the “Statement of Cash Flows” in

its 2009 financial statement. The transactions involving these parcels were not

among those recorded distributions.

            2.     Comparison to contemporaneous sale transactions

      The Cuthbertsons attempt to bolster their substance-over-form argument by

contrasting Development’s property transfers to True Homes with Development’s

sale of property to Mr. Russell and Ms. Kiker. In comparing the transfers to True

Homes with those to Mr. Russell and Ms. Kiker (which the Cuthbertsons evidently

concede are sales), the Cuthbertsons allege that “Development did not execute any

sale documents for the transfers to True Homes”; but they allege that in the other

transactions “Development required the purchasers to execute standard sale

documents, including purchase agreements and promissory notes.”23 This attempt

to factually distinguish the transfers from Development to True Homes fails for

several reasons. First and foremost, the Cuthbertsons failed to offer any

      23
        Mr. Moyer, the accountant, testified that the only evidence of which he
was aware for the transfer of the three properties to True Homes was the
respective deeds, which he contrasted to the sales to Mr. Russell and Mrs. Kiker,
for which he said he recalled receiving other “sales documents”. In the absence of
corroborating documentation, his testimony was not convincing.
                                        - 64 -

[*64] documentary evidence that would support their claims. Rather, they cite

only the testimony of Mr. Cuthbertson and his accountant Mr. Moyer, who both

testified that the transactions were documented in different manners. On the issue

of the contract for deed for the golf course (discussed above), the Cuthbertsons’

real estate attorney, Mr. Hinson, testified that “a standard transaction would be

a deed filed that would convey clear and fee simple, absolute title.” Evidently,

that is, a deed would suffice. Mr. Cuthbertson’s and Mr. Moyer’s testimony (that

the transfers from Development to True Homes were substantiated by a deed) and

Mr. Hinson’s testimony (that a deed is sufficient) undercut the Cuthbertsons’

argument that the lack of other “sales” documents besides the deed is an indicium

of a transfer of equity rather than a sale. And, finally, in light of the anomalies

discussed above in connection with the Cuthbertsons’ other transactions, we have

serious doubts about how “standard” the other sales documents are.

             3.     Contrasting the 2009 and 2010 financial statements

      The Cuthbertsons attempt to bolster their substance-over-form argument by

pointing out supposed differences between Development’s 2009 and 2010

financial statements. They point to the disclosure of “Related party transactions”

in Development’s 2010 financial statement, and they argue that the lack of any
                                        - 65 -

[*65] such disclosures in the 200924 financial statement shows that they intended

to treat the 2009 transfer from Development to True Homes, as distributions and

contributions. That is, the Cuthbertsons ask us to take the silence about “Related

party transactions” in the 2009 financial statements as evidence that no such

transactions took place--in particular, that no sale transaction between

Development and True Homes took place--in 2009, since (they say) they did

report such transactions when they did take place, e.g., in 2010.

      In our view, this does not establish a factual basis for the Cuthbertsons’

argument; rather, it seems just as likely to be simply another example of the

recurring inconsistencies in the documentation of their transactions and of their

nonobservance of the formalities required by their transactions. If the

Cuthbertsons had kept their records in good order other than in this one instance,

then perhaps we would find this argument plausible; but in light of the other

abnormalities we have noted herein, the fact that there is in one year a reporting of

      24
        Two of the three sales at issue were in 2008; but because the Cuthbertsons
did not offer 2008 financial statements into evidence, we do not know how
Development’s 2010 financial statements compare to its 2008 financial statements.
                                         - 66 -

[*66] “Related party transactions” and no reporting of the same transactions in the

prior year proves little about the nature of the transfers at issue here.25

      Moreover, this argument is contradicted in the instance of Development’s

2009 sale of the golf course maintenance equipment to EGC--apparently a

“Related party transaction[]” that took place in 2009. The bill of sale, which

purports to transfer title to the golf course maintenance equipment listed thereon,

states: “This Bill of Sale shall be effective as to the transfer of all property listed

in it as of December 31, 2009.” Development’s 2009 “Audited Financial

Statements For Year Ending December 31, 2009” lists EGC as a related party.

Mr. Moyer testified:

      25
         Questions about the accuracy of Development’s 2009 audited financial
statement also arise when we compare representations made therein to the parties’
stipulations in this case. The Cuthbertsons here stipulated that Development
transferred the 1,032 acres of Edgewater Phase 2 and the 561 acres of Edgewater
Phase 3 to Holdings by the end of 2007. However, in Development’s “Notes to
Financial Statements” for the year ending December 31, 2009, the last note states:
“The Edgewater Project--Phases I & II * * * [are] a portion of the larger overall
Edgewater project which totals approximately 1,900 acres. * * * At December 31,
2009, Craft Development, LLC is the primary property owner.” (Emphasis
added.) The disclosure goes on to explain: “Property taxes and assessments due
January 15, 2010 total approximately $2,600,000”, and “[s]ubsequent to December
31, 2009, * * * [Development] had paid approximately $364,000 of the
$2,600,000 due.” This is to say that in their own audited financial reports,
prepared on March 19, 2010, for the year ending December 31, 2009, the
Cuthbertsons represented to their investors and lenders that Development, rather
than Holdings, was the “primary property owner”--thus incorrectly representing
the ownership of the property.
                                        - 67 -

[*67] Under accounting standards, auditing standards, if you have actual
      sales between related entities, you have to disclose those sales.
      Obviously you could be misreporting total consolidated sales by
      showing sales between entities like this. So this is just simply stating
      those sales between the companies.

But Development’s 2009 financial statement is no more silent about

Development’s lot sale to True Homes than it is about Development’s equipment

sale to EGC--which we know did take place. Silence about a related-party sale in

Development’s financial statements is not reliable evidence that no related party

sale occurred.

      D.     The basis for the IRS’s adjustments

      Finally, circling back to the Cuthbertsons’ first argument (i.e., that “the

Commissioner’s determination is arbitrary and has no basis in law”), the

Commissioner’s adjustment to the Cuthbertsons’ income is clearly supported by

statute and precedent on this topic. Even if the Cuthbertsons had produced

documents that reliably showed substantial differences in the manner in which

Development documented its transactions with True Homes, the record lacks any

evidence that the Cuthbertsons actually intended to treat Development’s transfers

to True Homes as capital distributions to the Cuthbertsons followed by capital

contributions by the Cuthbertsons to True Homes, rather than intending to treat

them as sales. “To put it plainly, we have bound taxpayers to ‘the “form” of their
                                          - 68 -

[*68] transaction’ when they attempt to recharacterize an otherwise valid

agreement bargained for in good faith. We have also refused to entertain

arguments ‘that the “substance” of their transaction triggers different tax

consequences.’” Bergbauer, 602 F.3d at 576 (quoting Estate of Leavitt v.

Commissioner, 875 F.2d at 423). The Cuthbertsons and their company must treat

these transactions as they themselves characterized them (i.e., as “sales”) and must

use a proper method of accounting to do so (i.e., not by the installment method

inappropriate for “dealer disposition[s]”, sec. 453(b)(2)(A), (l)(1)(B)).

V.    Accuracy-related penalties

      A.       Substantial understatement

      Section 6662(a) and (b)(2) imposes a 20% accuracy-related penalty on an

underpayment of tax attributable to a substantial understatement of income tax.

An understatement is “substantial” if it exceeds the greater of 10% of the tax

required to be shown on the return or $5,000. Sec. 6662(d)(1)(A). By this

measure, the Cuthbertsons’ understatements of income tax for 2009 and 2010 were

substantial.

      B.       Supervisory approval

      Under section 7491(c) the Commissioner has the burden of production as to

liability for penalties; and after the trial of this case, this Court issued its opinion
                                         - 69 -

[*69] in Graev v. Commissioner (“Graev III”), 149 T.C. 485 (2017),

supplementing and overruling in part 147 T.C. 460 (2016), holding that the burden

of production includes showing that the immediate supervisor of the individual

IRS employee who made the “initial determination” of the penalty approved that

penalty in compliance with section 6751(b)(1). We therefore ordered the parties

in this case to address the issue of compliance with section 6751(b)(1) and to file

“any motions they deem appropriate in light of” Graev III. The Commissioner

asserted that he had fulfilled that burden by offering into evidence at trial the civil

penalty approval form that had been signed by the immediate supervisor in

August 2013, 21 months before the SNOD was issued.

      The only dispute about supervisory approval that the Cuthbertsons then

raised was the contention26 that on July 11, 2013--before the penalty approval

form was signed--the IRS issued to the Cuthbertsons a “30-day letter” to which

was attached a Form 5701 that included accuracy-related penalties asserted against

the Cuthbertsons. A 30-day letter may indeed constitute an “initial determination”

      26
        The Cuthbertsons did not offer into evidence the 30-day letter that they
describe in their brief. Even after we solicited “any motions they [the parties]
deem appropriate”, the Cuthbertsons did not move for leave to reopen or
supplement the trial record. Consequently, the evidence in this case consists only
of a penalty approval form--authenticated by the parties’ stipulation--that was duly
signed by the immediate supervisor 21 months before the SNOD was issued.
                                       - 70 -

[*70] that fails to comply with section 6751(b)(1) if it lacks supervisory approval.

See Clay v. Commissioner, 152 T.C. 223 (2019). However, the Cuthbertsons are

unable to make that case because they acknowledge that their 30-day letter was

signed by the immediate supervisor. Consequently, to the extent the 30-day letter

included a penalty determination, that determination was approved--by the signing

of the 30-day letter--before the letter was issued to them. The approval is not

rendered invalid because it was not given on a specific form. Rather, “the IRS’s

use of a form other than the one prescribed by internal administrative regulations

does not preclude a finding that the supervisory approval requirement has been

satisfied.” Palmolive Bldg. Inv’rs, LLC v. Commissioner, 152 T.C. 75, 85 (2019)

(citing PBBM-Rose Hill, Ltd. v. Commissioner, 900 F.3d 193, 213 (5th Cir. 2018)

(“The plain language of § 6751(b) mandates only that the approval of the penalty

assessment be ‘in writing’ and by a manager”)). As in Frost v. Commissioner,

154 T.C. ___, ___ (slip op. at 23) (Jan. 7, 2020), “petitioner has not claimed * * *

that respondent formally communicated his initial penalty determination to

petitioner before the date that the examining agent’s manager” approved the

penalty--approved in this case (the Cuthbertsons effectively admit) by signing the

30-day letter itself.
                                        - 71 -

[*71] C.     Reasonable cause

      Under section 6664(c)(1), the underpayment penalty does not apply to any

portion of an underpayment if a taxpayer had reasonable cause and acted in good

faith with respect to that portion; this reasonableness analysis takes into account

the taxpayer’s experience, knowledge, and education. 26 C.F.R. sec. 1.6664-

4(b)(1), Income Tax Regs. Reliance on the advice of a tax adviser may constitute

reasonable cause and good faith if such reliance was itself reasonable and in good

faith. Id. The Cuthbertsons allege that they relied on their accountant, Mr. Moyer.

      To show reliance on an adviser, a taxpayer must prove that: (1) the adviser

was a competent professional who had sufficient expertise to justify reliance,

(2) the taxpayer gave the adviser the necessary and accurate information, and

(3) the taxpayer actually relied in good faith on the adviser’s judgment.

Neonatology Assocs. P.A. v. Commissioner, 115 T.C. 43, 99 (2000), aff’d, 299
F.3d 221 (3d Cir. 2002). While the Commissioner bears the initial burden of

production to show a substantial understatement of income tax, sec. 7491(c), once

that burden is satisfied, the taxpayer bears the burden of proving defenses to

penalties, Higbee v. Commissioner, 116 T.C. 438, 446 (2001).

      The Cuthbertsons failed to show reliance on an adviser, and their principal

failing was that they did not show that they gave Mr. Moyer the necessary and
                                        - 72 -

[*72] accurate information. We do not know (i.e., they did not prove) what they

showed him. Mr. Moyer gave testimony about his supposed general practices but

gave little declarative testimony about the Cuthbertsons. He testified that,

generally, he reviews most items on his clients’ tax returns, although subordinate

employees prepare the details, and that, generally, if he could not determine how

to deal with a financial or tax item, he would ask the client for further information.

He testified that Mr. Cuthbertson has typically been forthcoming with information

when Mr. Moyer has made requests of him.

      However, much of Mr. Moyer’s testimony was stated in the subjunctive--

i.e., when he was asked how he acted, or what he did in a certain situation, he

answered what he “would have” done. For example, Mr. Moyer testified that he

“would have” received various documents relating to the transaction between

B&C III and Holdings, and Development’s sale of golf course maintenance

equipment to EGC.

      As to the bulk notes sale, Mr. Moyer testified that in general he would have

asked for and received whatever information was necessary to prepare a return for

the Cuthbertsons and their entities, but also that he was not aware of the related

Lot Purchase Agreement that, we found, was critically related to the notes sale.
                                        - 73 -

[*73] Similarly, as to the issue of Development’s use of the installment method of

accounting to defer income on the transfer of property to True Homes, when asked

whether he had “ask[ed] for any additional information or other documents that

you did not receive with respect to these transfers”, he testified: “I would have

received everything that I would have asked for, yes.” The Court finds Mr.

Moyer’s testimony--to the extent that it was subjunctive--unpersuasive at best,

since it was not informative as to what actually happened, and evasive at worst.

Mr. Moyer was not aware that the bulk notes sale by three of the Cuthbertsons’

entities was only the first half of a notes-for-land exchange. Accordingly, the

Cuthbertsons have failed to prove that they gave their adviser the necessary and

accurate information.

      Lastly, while we think it probable that the Cuthbertsons relied on Mr.

Moyer’s advice, they have not proved that such reliance was in good faith. As to

the Edgewater golf course transfer to B&C III, the entire transaction seems to have

lacked a good-faith business purpose. The Cuthbertsons knew that they did not

abandon the golf course, that they entered into transactions that did not reflect

arm’s-length dealings or have arm’s-length terms, that the transactions were

funded by near-worthless (if not completely worthless) notes, and that they did not

even respect the terms of their own non-arm’s-length transactions.
                                      - 74 -

[*74] Consequently, the Cuthbertsons are liable for the accuracy-related penalty

under section 6662(a) and (b)(2) for the substantial understatement of income tax

attributable to the loss deductions claimed in connection with the Edgewater golf

course transaction with B&C III, the supposed abandonment of the golf course

improvements, and the bulk notes sale to Mr. Tucker.

      To reflect the foregoing,

                                                     An appropriate order will be

                                               issued, and decision will be entered

                                               under Rule 155.