Trollope v. Comm'r, T.C. Memo 2009-177 (T.C. 2009).
The IRS challenged Mr. Trollope's transactions with Arrow Capital Associates, Inc. After receiving certain documents during discovery, however, the IRS conceded the issue. The Tax Court must decide if Mr. Trollope is entitled to an award of litigation costs pursuant to section 7430.
Mr. Trollope's Transactions With Arrow
Mr. Trollope and Mr. Larik each owned 1,500 shares of Arrow. Through a series of transactions, Mr. Trollope purchased Mr. Larik's 1,500 shares, or a 50% interest in Arrow. The initial transaction involved Arrow lending $1.9 million and $.7 million to Mr. Trollope and Mr. Larik respectively ($1.9 + $.7 = $2.6; keep this figure in mind). Through a stock purchase agreement, Mr. Trollope then agreed to purchase Mr. Larik's 50% interest for $2.6 million. To fund the purchase, Mr. Trollope used the $1.9 million he was lent from Arrow, and assumed Mr. Larik's $.7 million note. After becoming the sole shareholder, and owning 3,000 shares, Mr. Trollope sold 1,500 shares to Arrow in exchange for cancellation of his $1.9 million note and cancellation of the $.7 million note he had assumed on behalf of Mr. Larik.
Pre-Trial Activities
The IRS issued a 30-day letter stating that the last transaction, Arrow's purchase of 1,500 shares from Mr. Trollope, was a constructive dividend. Mr. Trollope argued in response that he "had not received a constructive dividend from Arrow, but rather had stepped in to facilitate a stock redemption as Arrow's agent." Despite Mr. Trollope's argument, the IRS issued a Notice of Deficiency (NOD). Shortly thereafter, Mr. Trollope filed a petition with the Tax Court challenging the NOD.
During the discovery process, Mr. Trollope provided additional documentation that resulted in the IRS conceding the issue. Mr. Trollope filed a motion to recover $122,402 in litigation costs under section 7430.
Section 7430 Requirements
The Tax Court provides the four-part test taxpayers must satisfy to receive an award of litigation costs under section 7430:
To qualify under section 7430, taxpayers must establish that they: (1) Were the prevailing party within the meaning of section 7430(c)(4); (2) exhausted the applicable administrative rememdies; (3) did not unreasonably protract the proceedings; and (4) have claimed costs that are reasonable.
Section 7430(c)(4) defines the term prevailing party. As is usually the case, the section provides a general rule and then states exceptions. The first exception to the term prevailing party is section 7430(c)(4)(B). Under this section, if the IRS's position is substantially justified, then the taxpayer will not be considered a prevailing party. Despite the seemingly strong language, the threshold here is quite low.
"Substantially justified" is defined as "justified to a degree that could satisfy a reasonable person" and having a "reasonable basis both in law and fact" . . . Respondent's position may be incorrect and yet be substantially justified "if a reasonable person could think it correct." Whether respondent acted reasonably ultimately turns on the available information which formed the basis for respondent's position as was as on the relevant law.
[Further] For a position to be substantially justified, "substantial evidence" must exist to support it. That phrase does not mean a large or considerable amount of evidence, but rather 'such relevant evidence as a reasonable mind might accept as adequate to support a conclusion.'
The IRS's Position was Substantially Justified
The IRS's constructive dividend argument was based on the view that the transactions between Arrow and Mr. Trollope were "independent transactions resulting in a dividend . . . under section 301(a) and 302(b)(1)." While Mr. Trollope's view, supported by the facts, showed the transactions were a "single integrated transaction resulting in exchange treatment under section 302(a).
The Tax Court holds for the IRS because Mr. Trollope did not provide "all of the relevant information under his control" prior to the issuance of the NOD. Mr. Trollope provided only the stock purchase agreement to the IRS prior to the formal discovery process. Despite a "multiyear dialogue" between the IRS and Mr. Trollope prior to issuing the NOD, Mr. Trollope never provided the loan documents, corporate minutes, or any other documentation to support the "integrated transaction" argument. All of which were under his control. Thus, relying solely on the stock purchase agreement, it was reasonable for the IRS to take the legal position that the transaction in question was a constructive dividend.
Analysis
I often wonder what is the "real story" behind these types of facts. Why, for example, wouldn't Mr. Trollope provide any and all necessary documentation to support his position? Particularly since this was supposedly a "multiyear" dialogue. Did Mr. Trollope simply become frustrated during the audit process and refuse to cooperate?
Also, the Court's opinion does not discuss what specific documents were provided to the IRS during discovery that caused the IRS to concede the issue. These facts might help illuminate the real story here.
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