Court Opinion

ID: 9555084
Source: CourtListenerOpinion
Date Created: 2023-08-10 19:02:49.431299+00
Date Added: 2024-06-11T15:41:13.000508
License: Public Domain

United States Tax Court

                               T.C. Memo. 2023-104

             MICHAEL G. PARKER AND JULIE A. PARKER,
                           Petitioners

                                           v.

               COMMISSIONER OF INTERNAL REVENUE,
                           Respondent

                                     —————

Docket No. 16021-16.                                        Filed August 10, 2023.

                                     —————

Diana V. Lopez, Lisa J. Mendes, and Christina P. Weed, for petitioners.

Janice B. Geier, Gregory Michael Hahn, Jamie M. Powers, and Amy B.
Ulmer, for respondent.

                          MEMORANDUM OPINION

      NEGA, Judge: This deficiency case involves the tax treatment of
nonrecourse debt canceled concurrently with the sale of real property by
an S corporation wholly owned by petitioner Michael Parker. 1 After
concessions, 2 the sole issue for decision is whether income from the
cancellation of the nonrecourse debt should be included in the S
corporation’s amount realized on the sale of the real property or treated
as cancellation of debt (COD) income and thus excluded from gross
income pursuant to the section 108(a)(1)(B) insolvency exception.

        1 Unless otherwise indicated, statutory references are to the Internal Revenue

Code, Title 26 U.S.C., in effect at all relevant times, regulation references are to the
Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all relevant times, and
Rule references are to the Tax Court Rules of Practice and Procedure.
        2 Respondent has conceded several issues underlying the determined

deficiency and has conceded that petitioners are not liable for an accuracy-related
penalty under section 6662(a) or an addition to tax under section 6651(a)(1).

                                 Served 08/10/23
                                   2

[*2]                          Background

      This case was submitted fully stipulated pursuant to Rule 122.
The Stipulation of Facts and the Exhibits attached thereto and the
Stipulations of Settled Issues are incorporated herein by this reference.
When the Petition was timely filed, petitioners resided in California.

I.     The Entities

      In 2012 Exterra Realty Partners, LLC (Exterra), was an
S corporation for federal income tax purposes. Exterra was a real estate
development company operating in California. In 2012 Mr. Parker was
the 100% shareholder, president, and chief executive officer of Exterra.

       Exterra was the sole member of PLF-XIII, LLC, and PLF-XIV,
LLC (together, PLF entities), each of which was a limited liability
company (LLC) formed under Delaware state law in February 2007 and
treated as a disregarded entity for federal income tax purposes. In turn
PLF-XIII was the sole member of Montevina Phase I, LLC, while PLF-
XIV was the sole member of Montevina Phase II, LLC; both Montevina
Phase I and Montevina Phase II (together, Montevina entities) were
LLCs formed under Delaware state law in February 2007 and treated
as disregarded entities for federal income tax purposes. Separate from
this structure, Mr. Parker was individually the sole member of another
entity, PLF-XI, LLC, which, once again, was an LLC formed under
Delaware state law and treated as a disregarded entity for federal
income tax purposes. PLF-XI was a member of another LLC formed
under Delaware law, 4815 Maple Drive Pleasant Hill – IA, LLC, which
held real property in Iowa.

II.    The Real Estate Dealings

       In March 2007, through the Montevina entities, Exterra
purchased 23.6 acres of real property in Livermore, California
(Livermore property), for the purpose of commercial development. In
order to finance the purchase of the Livermore property, the following
loans were obtained from NRFC WA Holdings, LLC, an unrelated third-
party lender:
                                          3

[*3]          Description                     Parties               Amount
       Loan N709A – Phase I         Montevina Phase I       &      $20,120,000
       Senior Mortgage              NRFC WA Holdings
       Loan N709B – Phase II        Montevina Phase II &              4,230,000
       Senior Mortgage              NRFC WA Holdings
       Loan N712A – Phase I         PLF-XIII & NRFC WA                5,030,000
       Mezzanine Loan               Holdings
       Loan N712B – Phase II        PLF-XIV & NRFC WA                 2,820,000
       Mezzanine Loan               Holdings
       Loan N713      –     Iowa    PLF-XI &      NFRC    WA          2,000,000
       Mezzanine Loan               Holdings

       PLF-XI used Loan N713 to contribute $1,500,000 to Montevina
Phase I and $500,000 to Montevina Phase II. Mr. Parker personally
signed a guaranty for payment of all five loans. Loans N709A, N709B,
N712A, and N712B were each nonrecourse as to Exterra. Loans N712A
and N712B were mezzanine loans, 3 which were secured by a pledge of
the PLF entities’ membership interests in the Montevina entities. Loan
N713 was a mezzanine loan, which was secured by a pledge of PLF-XI’s
membership interest in 4815 Maple Drive Pleasant Hill – IA, LLC. At
some point around or after March 2007, a separate entity, NRFC WA
Holdings II, LLC, acquired from NRFC WA Holdings all of the loans
relating to the purchase and development of the Livermore property by
Exterra or its subsidiaries.

       On October 4, 2012, Exterra entered into an agreement to sell the
Livermore property to a pair of unrelated individual third-party
purchasers (Buyers). A number of contractual agreements were
executed by the various parties, each dated October 4, 2012. In a
membership interest purchase and sale agreement, the PLF entities
agreed to sell their sole membership interests in the Montevina entities
to the Buyers in exchange for nominal consideration. In a consent and
release agreement between the Montevina entities, Mr. Parker, NRFC

        3 A mezzanine loan is a type of hybrid financing often used in commercial real

estate, where the debtor typically pledges as collateral its equity interest in another
entity. See, e.g., Gaia House Mezz LLC v. State St. Bank & Tr. Co., 720 F.3d 84, 87 n.1
(2d Cir. 2013). With respect to a mezzanine loan, the creditor thus sits in an
intermediate position to recover from the debtor, junior to any mortgage debt but
senior to equity. See Andrew R. Berman, Risks and Realities of Mezzanine Loans, 72
Mo. L. Rev. 993, 998 (2007) (“Like a theater, mezzanine debt sits in the mezzanine
section between senior debt in the more expensive orchestra, and equity sitting in the
cheaper section of the balcony.”).
                                      4

[*4] WA Holdings II, and the Buyers, the Buyers agreed to assume Mr.
Parker’s personal guaranty obligations on the Phase I Senior Mortgage
and the Phase II Senior Mortgage. The consent and release agreement
provided that the Buyers would make a partial payment of $7,400,000
on the Phase I mortgage to NRFC WA Holdings II. As part of the
consent and release agreement, Mr. Parker also agreed to deliver the
deed to the Iowa property in escrow, with release of the deed to NRFC
WA Holdings II to be made more than three years later, in January
2015. The consent and release agreement also included the following
recital: “[NRFC WA Holdings II] has agreed to consent to the Subject
Transactions, the termination of the Existing Mezzanine Loans, and the
assumption by [the Buyers] of the obligations of [Mr. Parker] . . . subject
to the terms and conditions stated below, including, without limitation,
consummation of the Subject Transaction, [NRFC WA Holdings II’s]
receipt of the [$7,400,000 payment] and the execution of the agreements
and documents . . . .”

       In a pair of loan termination agreements, NRFC WA Holdings II
agreed to cancel the unpaid balance of the mezzanine Loans N712A and
N712B owed by the PLF entities, including all accrued interest and
related fees and costs. Both loan termination agreements included the
following recital: “In connection with the proposed sale by [the PLF
entities] of all of [their] interest[s] in [the Montevina entities], [the PLF
entities] and [NRFC WA Holdings II] have agreed to terminate the Loan
Documents on the terms, and subject to the conditions, set forth herein.”

     Exterra realized the following amounts from the Buyers’
assumption of debt:

         Entity            Description of Debt Assumed         Amount
 Montevina Phase I     Loan N709A                             $19,527,134.91
 Montevina Phase I     Deferred interest on Loan N709A          2,462,746.99
 Montevina Phase I     Funds from Mezzanine                     6,240,364.69
 Montevina Phase I     Other liabilities – lender advances      2,055,475.28
 Montevina Phase II    Loan N709B                               4,409,594.28
 Montevina Phase II    Deferred interest on Loan N709B            580,449.98
 Montevina Phase II    Funds from Mezzanine                     5,309,773.81
 Total                                                       $40,585,539.94

In addition, Exterra realized the following amounts from the debt
canceled by NRFC WA Holdings II:
                                        5

[*5]

       Entity            Description of Canceled Debt             Amount
 PLF-XIII       Loan N712A                                        $5,030,000.00
 PLF-XIII       Accrued Interest on Loan N712A                     2,879,856.79
 PLF-XIII       Loan      N712A       Outstanding       Junior       700,000.00
                Participation Interest
 PLF-XIV        Loan N712B                                         1,920,000.00
 PLF-XIV        Accrued Interest on Loan N712B                     1,768,972.00
 PLF-XIV        Loan      N712B       Outstanding       Junior       400,000.00
                Participation Interest
 Total                                                           $12,698,828.79

III.     Tax Reporting

       For tax year 2012 Exterra filed an original Form 1120S, U.S.
Income Tax Return for an S Corporation. On its original Form 1120S,
Exterra reported $53,284,369 in gross receipts, which consisted of
(1) the debt assumed by the Buyers in the sale of the Livermore property
and (2) the cancellation of the mezzanine loans. After offsetting cost of
goods sold and deductions, Exterra reported ordinary business income
of $2,741,399. Exterra subsequently filed an amended Form 1120S, in
which it reduced its gross receipts by $2,741,399 and attached Form 982,
Reduction of Tax Attributes Due to Discharge of Indebtedness (and
Section 1082 Basis Adjustment). On the Form 982 Exterra reported
$2,741,399 as a discharge of indebtedness excluded to the extent
insolvent and reduced its basis of depreciable property and net operating
loss in corresponding amounts.          The $2,741,399 related to the
cancellation of debt for Loan N712A and/or Loan N712B. As of October
4, 2012, Exterra was insolvent up to $2,741,399. This change resulted
in Exterra’s reporting zero in ordinary business income on the amended
Form 1120S. Exterra issued an amended Schedule K–1, Shareholder’s
Share of Income, Deductions, Credits, etc., to Mr. Parker to reflect the
reduction in ordinary business income. Exterra did not include in
income any amounts relating to Loan N713 on either its original or
amended Form 1120S.

      For tax year 2012 petitioners filed an original Form 1040, U.S.
Individual Income Tax Return, on which they reported $2,741,399 in
flowthrough income from Exterra. Subsequently, petitioners filed a
Form 1040X, Amended U.S. Individual Income Tax Return, for 2012,
                                           6

[*6] reflecting the amended Schedule K–1 and reporting zero in
flowthrough income from Exterra.

IV.    The Notice of Deficiency and the Petition

       On April 15, 2016, respondent issued to petitioners a notice of
deficiency for tax year 2012 determining a $3,111,363 deficiency, a
$157,224.40 section 6651(a)(1) addition to tax, and a $622,327.20 section
6662(a) accuracy-related penalty. The determined deficiency included
an upward adjustment to Exterra’s gross receipts of $2,741,399.
Petitioners timely filed a Petition disputing respondent’s deficiency
determinations.

                                     Discussion

I.     Jurisdiction and Burden of Proof

       Where a notice of deficiency issued to an S corporation
shareholder includes adjustments to both S corporation items and other
items unrelated to the S corporation, we have jurisdiction to determine
the correctness of all adjustments in the shareholder-level deficiency
proceeding. See Johnson v. Commissioner, No. 19973-18, 160 T.C., slip
op. at 11 (Jan. 25, 2023) (citing Winter v. Commissioner, 135 T.C. 238,
245–46 (2010)).      We thus have jurisdiction to redetermine the
correctness of respondent’s adjustments to petitioners’ flowthrough
share of Exterra’s income and any other determinations in the notice of
deficiency.

       In general, the Commissioner’s determinations set forth in a
notice of deficiency are presumed correct, and the taxpayer bears the
burden of proving them erroneous. 4 Rule 142(a)(1); Welch v. Helvering,
290 U.S. 111, 115 (1933); Rapp v. Commissioner, 774 F.2d 932, 935 (9th
Cir. 1985). The submission of this case to the Court under Rule 122 does
not change or otherwise lessen petitioners’ burden of proof. See Rule
122(b).

        4 The burden of proof may shift from the taxpayer to the Commissioner in

certain circumstances under section 7491(a), but petitioners do not allege, nor does the
evidence suggest, that the burden of proof should shift to respondent under section
7491(a) as to any issue of fact.
                                          7

[*7] II.      Tax Treatment of Debt Cancellation

       Section 61(a) broadly defines gross income as “all income from
whatever source derived.” Section 61(a)(3) specifies that gross income
includes “[g]ains derived from dealings in property,” while section
61(a)(12) does the same for “[i]ncome from discharge of indebtedness.” 5
See Gehl v. Commissioner, 102 T.C. 784, 789 (1994) (“[P]aragraphs (3)
and (12) of section 61(a) are separate, independent, and not overlapping
provisions in respect of the includability of a particular item in
income.”), aff’d, 50 F.3d 12 (8th Cir. 1995). The distinction between
these two subcategories of gross income—gain from property and COD
income—can have significant tax consequences.

       When a taxpayer sells or disposes of property, the amount
realized is equal to the amount of money plus the fair market value of
any property received. § 1001(b). When a taxpayer sells or otherwise
disposes of property encumbered by nonrecourse debt, 6 the amount of
the outstanding debt is typically included in the amount realized. 7 See
Commissioner v. Tufts, 461 U.S. 300, 317 (1983); Crane v.
Commissioner, 331 U.S. 1, 14 (1947); Milkovich v. United States, 28
F.4th 1, 8 (9th Cir. 2022); Treas. Reg. § 1.1001-2(a)(1). To the extent
that the amount realized exceeds the taxpayer’s basis in the property,
the taxpayer has gain. See § 1001(a).

       In contrast, a COD that is not part of a sale or exchange of
property generally results in COD income, which may then be subject to
certain statutory exclusions. See § 108(a)(1); see also Estate of Delman
v. Commissioner, 73 T.C. 15, 31–32 (1979). Relevantly, section
108(a)(1)(B) allows a taxpayer who is insolvent at the time of a debt
cancellation to exclude COD income from gross income. The amount of
this exclusion is limited to the amount of the taxpayer’s insolvency, i.e.,
the amount by which the taxpayer’s liabilities exceed the fair market

        5 After 2012, the year at issue, section 61(a)(12) was renumbered as section

61(a)(11).
       6   “Indebtedness is generally characterized as ‘nonrecourse’ if the creditor’s
remedies are limited to particular collateral for the debt and as ‘recourse’ if the
creditor’s remedies extend to all the debtor’s assets.” Simonsen v. Commissioner, 150
T.C. 201, 205 (2018) (quoting Great Plains Gasification Assocs. v. Commissioner, T.C.
Memo. 2006-276, 92 T.C.M. (CCH) 534, 550).
        7 If the sold or disposed-of property instead secures recourse debt, the amount

realized does not include amounts that would otherwise be COD income (i.e., debt relief
in excess of the fair market value of the underlying property). See Frazier v.
Commissioner, 111 T.C. 243, 245 (1998); Treas. Reg. § 1.1001-2(a)(2).
                                    8

[*8] value of their assets. § 108(a)(3); see White v. Commissioner, T.C.
Memo. 2023-77, at *3.

       In deciding whether debt relief results in gain or COD income, we
focus on the facts and circumstances surrounding how the taxpayer-
debtor satisfied or extinguished the underlying debt. See Danenberg v.
Commissioner, 73 T.C. 370, 381 (1979); Peninsula Props. Co. v.
Commissioner, 47 B.T.A. 84, 91–92 (1942). If nonrecourse debt relief is
conditioned upon a sale or exchange of property or is otherwise a part of
that underlying sale or exchange, the amount of debt relief is properly
included in the amount realized and is not COD income. See Simonsen,
150 T.C. at 211 (focusing on fact that lender’s willingness to cancel
mortgage debt was completely dependent on debtor’s willingness to
convey proceeds from sale of residence); Sands v. Commissioner, T.C.
Memo. 1997-146, 73 T.C.M. (CCH) 2398, 2403 (rejecting taxpayer’s
contention that COD was “separate and distinct” from transfer of
ownership in property), aff’d without published opinion sub nom.
Murphy v. Commissioner, 164 F.3d 618 (2d Cir. 1998); Treas. Reg.
§ 1.1001-2(a)(1) (“[T]he amount realized from a sale or other disposition
of property includes the amount of liabilities from which the transferor
is discharged as a result of the sale or disposition.” (Emphasis added.));
see also 2925 Briarpark, Ltd. v. Commissioner, 163 F.3d 313, 319 (5th
Cir. 1999) (concluding that debt relief “was closely intertwined” with
underlying sale of property and thus included in amount realized on
sale), aff’g T.C. Memo. 1997-298. In such an instance, it is immaterial
whether debt relief takes the form of an assumption of debt by a
purchaser or a cancellation by a lender. See 2925 Briarpark, Ltd. v.
Commissioner, 163 F.3d at 319; Simonsen, 150 T.C. at 212–13.

      Respondent contends that the $2,741,399 relating to the
cancellation of Loans N712A and N712B is taxable to Exterra as gain
derived from the sale of the Livermore property. See § 61(a)(3).
Respondent emphasizes that Loans N712A and N712B were
nonrecourse to Exterra and were canceled as part of the sale of the
Livermore property.

       Petitioners take a rather different approach. In their briefing
petitioners sidestep the threshold inquiry—whether the debt
cancellation was part of the sale of the Livermore property and thus
gave rise to gain—and focus on their contentions that either Exterra or
petitioners themselves were insolvent at the time the debt was
discharged. Cf. Gehl, 102 T.C. at 789 (“Only after it is determined that
[section 61(a)(12)] applies does one reach the question of the impact of
                                     9

[*9] insolvency and therefore the applicability of section 108.”);
Danenberg, 73 T.C. at 384 (rejecting taxpayers’ argument that their
insolvency precluded inclusion of debt relief in amount realized). As best
we can tell, much of petitioners’ briefing is premised on a misconception
that facts relating to Mr. Parker in his personal capacity are relevant to
the question of whether there was income to Exterra in 2012 (and only
then, flowthrough income to Mr. Parker as its 100% S corporation
shareholder). In determining whether to sustain respondent’s upward
adjustment to Exterra’s gross receipts (and thus the corresponding
deficiency with respect to petitioners), we respect Exterra’s separate
corporate existence. See Durando v. United States, 70 F.3d 548, 552 (9th
Cir. 1995) (“[I]t [is] improper to treat income earned by [an S]
corporation through its trade or business as though it were earned
directly by its shareholders . . . .”); Crook v. Commissioner, 80 T.C. 27,
33 (1983) (“The separate existence of corporations is firmly established
under the tax law, and this Court has recognized that the business of a
subchapter S corporation is separate and distinct from that of its
shareholders.” (internal citation omitted)), aff’d, 747 F.2d 1463 (5th Cir.
1984). Accordingly, petitioners’ observation, for instance, that Loans
N712A and N712B were recourse as to Mr. Parker personally, is simply
irrelevant to the issue before us.

      We agree with respondent that the issue in this case is the
threshold question of whether the cancellation of Loans N712A and
N712B gave rise to gain or COD income for Exterra. We ultimately
resolve that question in respondent’s favor.

      The parties have stipulated that Loans N712A and N712B were
nonrecourse as to the PLF entities and Exterra. While the original loan
agreements for Loans N712A and N712B are not part of the stipulated
record, the parties further stipulated that Loans N712A and N712B
were each mezzanine loans. The record establishes that Loan N712A
and N712B were each secured by the PLF entities’ pledge of their
respective membership interests in the Montevina entities. Because the
PLF entities and the Montevina entities were disregarded entities for
federal income tax purposes, we treat Exterra as owning the underlying
assets (i.e., the Livermore property), subject to the nonrecourse
mezzanine Loans N712A and N712B, before the sale. 8 See Treas. Reg.

      8 For federal income tax purposes, we characterize the mezzanine Loans

N712A and N712B, which were secured by pledges of equity in the disregarded
Montevina entities, as nonrecourse debt encumbering the underlying Livermore
                                         10

[*10] § 301.7701-2(a) (“[I]f the entity is disregarded, its activities are
treated in the same manner as a sole proprietorship, branch, or division
of the owner.”); see also Pierre v. Commissioner, 133 T.C. 24, 42 (2009)
(Halpern, J., dissenting) (“A sole proprietorship is generally understood
to have no legal identity apart from the proprietor.”), supplemented by
T.C. Memo. 2010-106. In turn the sale of the PLF entities’ membership
interests in the Montevina entities is characterized for federal income
tax purposes as a sale of the encumbered Livermore property by Exterra.
See DAF Charters, LLC v. Commissioner, 152 T.C. 250, 260 (2019)
(“[A]ny items of income and loss generated by the [disregarded] entity
are directly attributable to and reported by the entity’s owner for
Federal tax purposes . . . .”); see also Carter G. Bishop & Daniel S.
Kleinberger, Limited Liability Companies § 2:83 Westlaw (database
updated June 2023) (“The transfer of the interest in a disregarded entity
is not treated as a transfer of the interest for federal tax purposes, but
rather as a transfer of the assets of the disregarded entity.”).

       The record is further clear that the cancellation of Loans N712A
and N712B was part of the sale by Exterra (through the disregarded
entities) of the Livermore property to the Buyers. As the relevant loan
termination agreements between the PLF entities and NRFC WA
Holdings II represented, the loan cancellation was made “[i]n connection
with the proposed sale.” Further, the loan termination agreements were
executed on October 4, 2012—the same date that the various other
agreements effecting the sale of the Livermore property, including the
consent and release agreement to which NRFC WA Holdings II was a
party, were executed. The COD was part and parcel of the global
agreement to convey the Livermore property, with NRFC WA Holdings
II accepting new personal guaranties, a partial payment by the Buyers,
and the escrowed deed to the Iowa property in consideration of that
cancellation.

      We conclude that NRFC WA Holdings II’s cancellation of Loans
N712A and N712B was dependent on Exterra’s sale of the Livermore
property to the Buyers and was a part of the same sale transaction. See
Simonsen, 150 T.C. at 211. Accordingly, given that Loans N712A and
N712B were nonrecourse as to Exterra, the amount of debt relief was
properly includible in Exterra’s amount realized on the sale of the

property in the hands of Exterra, the regarded entity; we note that the Commissioner
has previously adopted a similar view in subregulatory guidance in a related context.
See Rev. Proc. 2014-20, 2014-9 I.R.B. 614; I.R.S. Priv. Ltr. Rul. 09-53-005 (Dec. 31,
2009).
                                   11

[*11] Livermore property and gave rise to gain to the extent in excess of
Exterra’s basis in the property. See Treas. Reg. § 1.1001-2(a)(1). In
turn, that gain flowed through to petitioners’ personal income tax
returns via Mr. Parker’s 100% shareholder interest in Exterra.

III.   Conclusion

      We hold that the $2,741,399 was properly includible in Exterra’s
amount realized on the sale of the Livermore property. We will sustain
respondent’s determination of a deficiency with respect to this issue.

       To reflect the foregoing,

       Decision will be entered under Rule 155.