                        T.C. Memo. 2002-65



                      UNITED STATES TAX COURT



        HUNT & SONS, INC., Petitioner v. COMMISSIONER OF
                  INTERNAL REVENUE, Respondent



     Docket No. 5127-00.                   Filed March 8, 2002.



     Michael P. Casterton, for petitioner.

     Christian A. Speck, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     BEGHE, Judge:   On March 10, 2000, respondent issued a notice

of deficiency determining the following deficiencies and

penalties with respect to petitioner’s Federal income taxes:
                                   - 2 -

                                                Accuracy-Related
                                                    Penalty
         TYE Dec. 31          Deficiency          Sec. 6662(a)

           1996                $278,640           $16,173.60
           1997                 357,963            17,087.00

     After concessions by the parties, the only issues remaining

for determination are:       (1) Whether petitioner overstated certain

rental expense deductions on six properties, and (2) whether

petitioner is liable for accuracy-related penalties under section

6662(a)1 for overstating rental expense deductions on these

properties.

     We hold that petitioner deducted rent in excess of the fair

market rental value for two of the six properties of $30,300 for

1996 and $35,900 for 1997, and we therefore disallow $66,200 in

deductions.       We further hold that petitioner is not liable for

accuracy-related penalties under section 6662(a).

                             FINDINGS OF FACT

     Most of the facts have been stipulated and are so found.

The stipulation of facts and the related exhibits are

incorporated by this reference.

     When petitioner filed its petition in this case, its

principal place of business was in Sacramento, California.

Petitioner is a supplier of petroleum products and equipment and


     1
      Unless otherwise indicated, section references are to the
Internal Revenue Code applicable to the tax years in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
                               - 3 -

an operator of commercial cardlocks.   A commercial cardlock is an

unstaffed self-service gas station for commercial vehicles.    To

accommodate large trucks, cardlocks are usually built on larger

parcels (on the order of 1-1/2 acres) than retail gas stations.

Cardlocks are usually built in industrial areas that are easily

accessible to trucks, rather than the more expensive sites used

for retail gas stations.   Cardlocks are open 24 hours a day, 365

days a year.

     When using a cardlock, the customer must supply (and the

supplier electronically captures) customer and billing

information, including the date, time of day, vehicle odometer

reading, and other miscellaneous information, as well as product

type and gallons pumped.   The supplier bills the customer for the

gasoline and provides on the bill the detailed information

captured at the pump.   Most cardlocks have video surveillance for

added security.

     Petitioner operated the following five cardlocks in 1996 and

1997:   5750 South Watt Ave., Sacramento (Watt Avenue); 2891

Mosquito Road, Placerville (Mosquito Road); 4200 Roseville Road,

North Highlands (Roseville Road); 11341 White Rock Road, Rancho

Cordova (White Rock Road); and 4200 Mother Lode Drive, Shingle

Springs (Mother Lode Drive).   On September 1, 1997, petitioner

leased the land for a sixth cardlock located at 1201 Fee Drive,

Sacramento (Fee Drive).
                               - 4 -

     Petitioner is a closely held corporation.   Warren Hunt, Jr.,

and his wife, Anita Hunt, own 48 percent of the stock of

petitioner; Randall Dean Hunt and his wife, Cynthia Hunt, own 26

percent of the stock of petitioner; Warren Hunt III and his wife,

Rosemarie Hunt, own 26 percent of the stock of petitioner.

Randall Dean Hunt and Warren Hunt III are the sons of Warren

Hunt, Jr., and Anita Hunt.

     Petitioner paid Federal corporate income taxes of $256,863

for 1996 and $350,456 for 1997.   For each of 1996 and 1997,

petitioner paid total dividends of $24,000.

     Petitioner’s shareholders, through revocable living trusts,

own the raw land underlying all the cardlocks operated by

petitioner.2   Petitioner leases the raw land from its

shareholders’ revocable living trusts through ground leases.

Petitioner owns the improvements and operates the cardlock

businesses.

     The operation of a cardlock business, which requires the use

of underground storage tanks and pipes, entails a high degree of

financial risk because of the potential for leaks, which can

cause soil and groundwater contamination that can be very



     2
      The Watt Avenue, Mother Lode Drive, and Fee Drive land is
owned by the Warren N. Hunt III and Rosemarie A. Hunt Revocable
Living Trust and the Randall Dean Hunt and Cynthia Lynne Hunt
Revocable Living Trust. The Mosquito Road, Roseville Road, and
White Rock Road land is owned by the Warren N. Hunt, Jr., and
Anita M. Hunt Revocable Living Trust.
                                - 5 -

expensive to clean up.    In the mid-1980s, government regulators

in California imposed strict new regulations on operators of

underground storage tanks, requiring the use of double-wall

tanks, double-wall piping, tank-monitoring devices, and leakage

alarms.    Government regulators also require annual testing of the

systems to prevent or minimize soil, groundwater, and air

pollution. Petitioner spent $60,000 to clean up a leak at its

Roseville Road site and has incurred expenses of more than

$500,000 to clean up contamination at its Placerville plant.

     Petitioner paid and deducted the following amounts as rent

during 1996 and 1997 with respect to its cardlock locations:

            Property              1996             1997

           Watt Avenue          $120,000        $120,000
           Mosquito Road          55,200           53,400
           Roseville Road         48,000           54,000
           White Rock Road        54,000           55,500
           Mother Lode Drive      27,600           28,800
                                                  1
           Fee Drive                --             16,000
             Total               304,800         327,700
              1
               The Fee Drive property was leased for only
           4 months in 1997, at a rent of $4,000 per
           month.

     The annual fair market rental value for both 1996 and 1997

of Watt Avenue was $89,700 and of Mother Lode Drive was $29,900.

The fair market rental value of Fee Drive for the 4 months of

1997 (during which the property was leased to petitioner) was

$10,400.    Respondent offered no evidence to contradict

petitioner’s and petitioner’s experts’ testimony that petitioner
                                  - 6 -

paid fair market rental value for the other properties (Mosquito

Road, Roseville Road, and White Rock Road).

                        ULTIMATE FINDINGS OF FACT

     1.   Petitioner paid the following amounts to its

shareholders in excess of the fair rental value of the

properties:

          Property             1996          1997     Total

          Watt Avenue        $30,300       $30,300   $60,600
          Fee Drive             --           5,600     5,600
            Total             30,300        35,900    66,200

Petitioner paid fair market rental value for the other cardlock

properties.

     2.   Petitioner’s payments in excess of the fair market

rental value of the properties are not deductible in computing

taxable income.

     3.   Petitioner was not negligent in deducting rent in excess

of the fair market rental value of the Watt Avenue and Fee Drive

properties.

                                 OPINION

     The parties agree that potential for abuse is inherent in

rental transactions between a corporation and its shareholders.

As we stated in Wy’East Color v. Commissioner, T.C. Memo.

1996-136:

         A taxpayer generally may deduct reasonable rents
     paid for property used in a trade or business. A
     taxpayer who rents property from a related person may
     not deduct more than he or she would have paid if the
                               - 7 -

     parties had dealt at arm’s length. A taxpayer may
     deduct only the fair rental value of premises it rents
     from related persons. We closely scrutinize whether
     rents exceed fair rental value if the lessor and lessee
     are related. Fair rental value is a question of fact.
     * * * [Citations omitted.]

See also, e.g., Limericks, Inc. v. Commissioner, 165 F.2d 483,

484 (5th Cir. 1948), affg. 7 T.C. 1129 (1946); Associated

Dentists v. Commissioner, T.C. Memo. 1998-287.   We must therefore

determine whether (and if so, to what extent) the rents paid by

petitioner to its shareholders, and deducted by petitioner, were

in excess of the fair market rental values of the properties.

I.   Burden of Proof

     Before enactment of section 7491 by the Internal Revenue

Service Restructuring and Reform Act of 1998 (RRA), Pub. L.

105-206, sec. 3001(a), 112 Stat. 726, it would have been clear

that respondent’s determinations in the notice of deficiency of

the fair market rental values of the properties were entitled to

a presumption of correctness, and petitioner would bear the

burden of proving that respondent’s determinations were

incorrect.   Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115

(1933); Wy’East Color v. Commissioner, supra.

     The Court of Appeals for the Ninth Circuit has held that the

presumption of correctness does not apply where the Commissioner

takes a position in Court that abandons the determination in the

notice of deficiency.   Morrissey v. Commissioner, 243 F.3d 1145
                                 - 8 -

(9th Cir. 2001), revg. and remanding Estate of Kaufman v.

Commissioner, T.C. Memo. 1999-119.

     In the case at hand, the notice of deficiency does not

segregate the portion of the excess rental expense disallowance

attributable to each property for each year.    We are therefore

unable to determine, on a property-by-property basis, whether the

appraisals of respondent’s expert, Mr. Harris, are consistent

with the determinations contained in the notice of deficiency.

     Section 7491 shifts the burden of proof to the Commissioner

if certain requirements are met.    However, section 7491 applies

only to court proceedings arising in connection with examinations

commenced after July 22, 1998.    RRA sec. 3001(c), 112 Stat. 727.

Neither party offered evidence to show whether the audit in the

case at hand was commenced before July 23, 1998.    However,

respondent claimed in his pretrial memorandum that the audit was

commenced before July 23, 1998, and petitioner in its opening

brief appears to accept respondent’s allegation by asserting that

it has met its burden of proof.

     Both parties introduced evidence as to the fair market

rental values of the Watt Avenue, Mother Lode Drive, and Fee

Drive properties.    The case at hand is not one of those rare

cases in which the weight of the evidence adduced by the parties

is in equipoise.    We will therefore determine the fair market

rental values of these properties on the basis of the
                               - 9 -

preponderance of the evidence rather than on an allocation of the

burden of proof.

      With respect to the White Rock Road, Roseville Road, and

Mosquito Road properties, only petitioner introduced direct

evidence regarding fair market rental value.       In lieu of offering

evidence, respondent asks us to infer that the rents on these

properties were overstated in the same overall proportion as the

rents on the other three properties.     We decline to do so.   As

discussed infra, petitioner has established by a preponderance of

the evidence that the rents paid on these properties did not

exceed their fair market rental values.

II.   Fair Market Rental Value of the Properties

      In his notice of deficiency, respondent disallowed

petitioner’s rental deductions, in the gross amounts shown on the

following table, with respect to the six properties under review:

                            1996         1997         Total
      Rent claimed       $304,800      $327,700    $632,500
      Rent disallowed
        by respondent    (203,600)     (211,620)   (415,220)
      Rent allowed by
        respondent        101,200       116,080     217,280

Respondent determined that the excess rents petitioner paid

constituted disguised dividends.     Respondent claims that

petitioner’s purpose in disguising the dividends as rental
                              - 10 -

expenses was to avoid the corporate income tax by converting

nondeductible dividends into deductible rental expenses.

     Section 162(a)(3) allows as a deduction all ordinary and

necessary expenses paid or incurred during the taxable year in

carrying on any trade or business, including “rentals or other

payments required to be made as a condition to the continued use

or possession, for purposes of the trade or business, of

property”.   In determining whether the payments here in issue

were rental payments deductible under this section, the “basic

question is * * * whether they were in fact rent instead of

something else paid under the guise of rent.”   Place v.

Commissioner, 17 T.C. 199, 203 (1951), affd. per curiam 199 F.2d

373 (6th Cir. 1952).   In connection with a lease between related

parties, the inquiry “requires a careful examination of the

circumstances surrounding the rental of the property to determine

the intentions of the parties in agreeing upon * * * [the] lease

and in fixing the terms thereof.”   Davis v. Commissioner, 26 T.C.

49, 56 (1956).   The question whether payments are rental payments

within the meaning of the statute is a question of fact to be

resolved on the basis of all the facts and circumstances.     Thomas

v. Commissioner, 31 T.C. 1009, 1012 (1959); S. Ford Tractor Corp.

v. Commissioner, 29 T.C. 833, 842 (1958).
                              - 11 -

     A.   The Fair Market Rental Value of Watt Avenue, Mother
          Lode Drive, and Fee Drive

     Both parties submitted substantial evidence concerning the

fair market rental value of three of the properties petitioner

leased:   Watt Avenue, Mother Lode Drive, and Fee Drive.

     Respondent submitted separate appraisal reports on each of

the three properties prepared by Kenneth R. Harris, MAI, of

Hopkins Appraisal Services, Inc., a national appraisal firm

specializing in the appraisal of petroleum properties.     Mr.

Harris used the same basic methodology for all three properties.

First, Mr. Harris determined the fair market value of the land

using only the cost approach to value, because he found both the

market and income approaches to be irrelevant to the appraisal of

raw land.   Under the cost approach, Mr. Harris determined the

sale prices of four or five comparable properties and computed a

sale price per square foot for each of the comparable properties.

He then used his judgment to adjust the sale price per square

foot of each of the comparable properties for perceived

differences between the comparable properties and the subject.

Very significant adjustments were made, leading us to question

whether these properties were true “comparables”. Adjustments on

the Fee Drive property ranged from 20 to 60 percent and on the

Mother Lode Drive property ranged from 15 to 40 percent.     One of

the four “comparables” on the Watt Avenue property was adjusted

by 65 percent.   It would be very easy to justify much higher or
                               - 12 -

lower values by making smaller or larger adjustments to the sale

prices per square foot used in adjusting the comparable

properties.   Because the “comparables” used by Mr. Harris were so

different from the subject properties, and thus required such

significant discretionary adjustments in order to provide a basis

for comparison, we are left with some doubt about the reliability

of Mr. Harris’s conclusions.   Presumably, these were the most

“comparable” properties that Mr. Harris was able to find.

     Next, Mr. Harris used the adjusted per-square-foot values

for the “comparable” properties to determine the value of the

subject properties.   For two of the properties (Watt Avenue and

Fee Drive), Mr. Harris computed an average adjusted price per

square foot for the “comparable” properties, which was rounded up

to the nearest whole dollar amount per square foot.   For the

remaining property (Mother Lode Drive), Mr. Harris eliminated the

high and low comparable values and used a whole dollar amount in

the range of the remaining three values.

     Mr. Harris then computed a fair market value for the subject

properties by multiplying the per-square-foot values he

determined from his average or median adjusted “comparable”

properties by the number of square feet of each of the subject

properties.

     After deriving a current fair market value for the subject

properties, Mr. Harris computed the annual fair market rental
                              - 13 -

value of the properties by applying a flat 10-percent

“capitalization” rate to the fair market value.3   Mr. Harris

based his “capitalization” rate on conversations with several

people who had experience with ground leases with major oil

companies, all of whom indicated that annual ground lease rates

were a flat 10 percent of the current fair market value of the

land.4   Mr. Harris made no adjustment in the rental


     3
      The parties’ experts referred to the rate applied to the
fair market value to compute the first year’s annual rent as a
“capitalization rate”. A true capitalization rate is a rate used
to convert a perpetual stream of income into a discounted present
value. Narver v. Commissioner, 75 T.C. 53, 91 n.17 (1980), affd.
670 F.2d 855 (9th Cir. 1982); Lanier v. Commissioner, T.C. Memo.
1998-7. We nevertheless recognize that it is common practice to
refer to both the capitalization rate and its inverse as the “cap
rate”.
     4
      Mr. Harris’s appraisal (and the appraisals of the other
experts) did not take into account that these properties were
subject to existing ground leases, some of which were made in
earlier years. For example, the Watt Avenue lease was entered
into in 1990 and provided for annual escalations based on
increases in the consumer price index, none of which were
apparently made. Instead of determining the rent for the years
in issue on the basis of market conditions existing at the time
the leases were entered into, Mr. Harris determined the current
fair market lease rate for a new lease. The parties should have
taken into consideration any change in market conditions. “[A]
transaction must not be disregarded simply because it was not at
arm’s length.” Sun Props., Inc. v. United States, 220 F.2d 171,
174 (5th Cir. 1955). Our role is merely to limit deductions to
the amount that would have been paid if the parties had entered
into the transactions at arms length. “In the absence of arm’s
length negotiations ‘an inquiry into what constitutes reasonable
rental is necessary to determine whether the sum paid is in
excess of what the lessee would have been required to pay had he
dealt at arm's length with a stranger.’” Sparks Nugget, Inc. v.
Commissioner, 458 F.2d 631, 635 (9th Cir. 1972) (quoting Place v.
Commissioner, 17 T.C. 199, 203 (1951), affd. 199 F.2d 373 (6th
                                                   (continued...)
                                - 14 -

“capitalization” rate for the greater risks involved in leasing

property for use as a cardlock operation to a small independent

operator, such as petitioner, rather than to a major oil

company.5

     Using this methodology, Mr. Harris determined the fair

market value and fair market rental value for the three

properties to be as follows:

                    Fair Market    Capitalization   Fair Market
     Property          Value            Rate        Rental Value

   Watt Avenue       $690,000            10%         $69,000
   Fee Drive          240,000            10           24,000
   Mother Lode        230,000            10           23,000
     Drive

     Petitioner’s experts criticized Mr. Harris for failing to

account for the significant risks a landlord undertakes when

leasing property to an independent cardlock operator.   According

to their uncontradicted testimony, underground petroleum storage

tanks have a history of leaking, causing soil and groundwater

contamination that must be remediated at significant cost.     While



     4
      (...continued)
Cir. 1952)), affg. T.C. Memo. 1970-74. The validity and amount
of allowed deductions should not depend on changes in market
conditions occurring after the parties’ contractual arrangements
were set. Because neither party offered evidence of changes in
market conditions, we will assume that market conditions did not
change between the lease date and the years in issue.
     5
      Petitioner’s witnesses made a strong showing that leasing
property for use as a gas station carries with it significant
risks for the lessor, risks not taken into account in Mr.
Harris’s analysis.
                                - 15 -

current double-hull tanks provide much greater protection against

leaks, significant risks still exist.    Both the owner of the land

and the tenant are liable under California law for the cost of

cleanup, even through the tenant whose tanks leak generally is

liable under the terms of the lease or under California’s

equitable indemnity laws to reimburse cleanup costs paid by the

landlord.   See, e.g., Meghrig v. KFC Western, 516 U.S. 479 (1996)

(reciting that owner ordered by California regulatory authorities

to clean up prior owner’s petroleum contamination); First San

Diego Properties v. Exxon Co., 859 F. Supp. 1313 (S.D. Cal. 1994)

(innocent current owner seeking indemnity from prior owner and

operator who caused contamination is not liable to prior operator

for contribution); Zands v. Nelson, 797 F. Supp. 805 (S.D. Cal.

1992) (owner and operator jointly and severally liable to clean

up petroleum contamination); Mangini v. Aerojet-Gen. Corp., 227

Cal. App. 3d 1248, 1273-1274 (1991) (doctrine of equitable

indemnity under California law).    Because of the substantial cost

of cleaning up soil and groundwater contamination, the landlord

assumes significant risk when the tenant does not have the

financial wherewithal to respond in damages for the cost of

cleaning up a petroleum leak.

     In addition, property containing underground petroleum

storage tanks may become stigmatized because of concern of

potential buyers about soil and groundwater contamination.
                              - 16 -

Stigmatization can cause a reduction in the value of the property

even when the environmental hazards have been remediated or

mitigated.   See In re Custom Distribution Servs., Inc., 216

Bankr. 136, 154-155 (Bankr. N.J. 1997) (reducing fair market

value of property by 20 percent to account for environmental

stigma); Inmar Associates Inc. v. Borough of Carlstadt, 549 A.2d

38, 45 (N.J. 1988) (“not reasonable to conclude that contaminated

property is unmarketable, but stigma of contamination and other

factors suggest that capitalization rate may have to be altered

to reflect condition” (citing Patchin, “Valuation of Contaminated

Properties”, The Appraisal Journal 7 (Jan. 1988))).

     A landlord takes on much greater risk when leasing property

to an independent operator of cardlocks (such as petitioner) than

when leasing the same property to a major oil company, because of

the difference in the lessee’s financial strength.    An

independent operator may not have the financial wherewithal to

respond to a significant environmental problem, which would leave

the landlord primarily liable for the cost of the cleanup.     A

landlord would thus likely require a greater return (by requiring

the payment of more rent) when leasing property to a small

independent operator of underground storage tanks than when

leasing the same property to a major oil company.

     The additional credit risk assumed by a landlord leasing

property to an independent cardlock operator rather than a major
                              - 17 -

oil company should be reflected in the “capitalization” rate, or

otherwise accounted for in determining the fair market value and

fair market rental value of the property.   Cf. In re Custom

Distribution Servs., supra at 155 n.17 (“The New Jersey Supreme

Court appears to favor an approach that accounts for the stigma

of environmental contamination via an adjustment to the

capitalization rate”.); Inmar Associates, Inc. v. Borough of

Carlstadt, supra at 45 (suggesting that environmental stigma

should be reflected in higher capitalization rate).

     Mr. Harris improperly used a flat 10-percent

“capitalization” rate, relying on information concerning the

“capitalization” rates used in leases between landowners and

major oil companies.   We disagree with Mr. Harris’s use of a flat

10-percent “capitalization” rate in light of the special risks

borne by the lessor when leasing property to an independent

cardlock operator.   We also have greater uncertainty about Mr.

Harris’s conclusions than we would if the “comparable” properties

were more similar to the subject properties.   Despite these

misgivings, we give substantial weight to Mr. Harris’s

conclusions of value because his report is professionally

prepared, he is well qualified to make adjustments to equate the

comparable properties, and he fully disclosed his methodology and

analysis.
                              - 18 -

     We cannot say the same of the reports submitted by

petitioner’s experts.   Petitioner submitted reports from two

experts:   Patrick D. McIntosh, a licensed appraiser for McIntosh

& Associates, and Skip Vanderbundt, a real estate agent and

senior vice president of Cornish & Carey Commercial.   Mr.

McIntosh supported his testimony with two reports:    A “narrative

summary restricted report” (restricted report) in which Mr.

McIntosh had appraised, for estate-planning purposes, the land

both raw and improved, and a “summary consulting report”

(consulting report) in which Mr. McIntosh determined the fair

market rental value of the properties leased by petitioner.     Both

reports reach conclusions of value without providing any support

or analysis for the conclusions.   The restricted report describes

the real property and states a conclusion of value.    Nothing is

expressed in the report to support Mr. McIntosh’s conclusion of

value.   In the consulting report, Mr. McIntosh concludes that

petitioner’s leases are all within the range of fair market

rental values on the basis of one identified lease, known as the

Nella Oil lease, and Mr. McIntosh’s knowledge of other lease

transactions, the specific terms of which, Mr. McIntosh says in

the report, he cannot disclose.

     In cross-examination and through the testimony of Mr.

Harris, respondent established that the Nella Oil property is

superior in every way to petitioner’s properties.    It is a highly
                               - 19 -

visible property in a prime location and is used as a retail gas

station, convenience store, and cardlock operation.    Mr. McIntosh

discloses no analysis to adjust for the superiority of the Nella

Oil lease.    He simply attempts to justify petitioner’s lease

rates by pointing out that the rent per square foot paid by Nella

Oil is higher than the rent per square foot paid by petitioner.

     Mr. McIntosh criticized Mr. Harris’s report, arguing that it

is not appropriate to apply a capitalization rate to the fair

market value of the property to derive the fair market rental

value of the property.    Yet in a letter to petitioner dated

December 8, 1999, criticizing an Internal Revenue Service

engineer’s report in a prior dispute,6 Mr. McIntosh stated that


     6
      Petitioner provided a copy of Mr. McIntosh’s letter to the
Internal Revenue Service. Respondent used this letter at trial
for impeachment purposes. Mr. McIntosh testified at trial that
he reviewed Mr. Vanderbundt’s report and found it to be a sound
basis for determining the fair rental value of the subject
properties. Mr. Vanderbundt relied entirely on a single
“comparable” lease for property in Lodi, California, which is 23
miles south of Sacramento, California, near Stockton, California.
Mr. McIntosh was asked at trial whether the Modesto and Stockton
areas are comparable to Sacramento:

     A:   Some of the areas around Modesto and Stockton, and
          I’m familiar with those areas, because I do
          appraising in that area, would be familiar
          [similar] with many of the areas around the
          Sacramento metropolitan area.

             *     *     *     *     *     *     *

     Q:   Mr. McIntosh, would you ever attempt to use a
          comparable from areas like Modesto or Stockton for a
          property in Sacramento?
                                                   (continued...)
                             - 20 -



     6
      (...continued)
     A:   It would depend on the kind of property. I think of
          some times when they would be very comparable.

Yet in his December 8, 1999, letter criticizing respondent’s
engineer’s report, Mr. McIntosh stated:

     The IRS appraiser appears to feel that the Modesto/
     Stockton areas are equal to the Sacramento area. He is
     either unaware or does not mention that the former
     areas have been economically depressed for some time,
     while the Sacramento area has been rebounding. I
     regularly appraise stations and mini marts in all of
     these cities. I do not consider them equivalent, nor
     would I ever attempt to use comparables from areas like
     Modesto or Stockton for a property in Sacramento.”
     [Emphasis added.]

     At trial, Mr. McIntosh also sought to justify the
conclusions reached by Mr. Vanderbundt in his report by stating
that he thought the Vanderbundt report was well prepared and
would meet the requirements for a professional appraisal if Mr.
Vanderbundt were licensed as an appraiser. As discussed in more
detail below, Mr. Vanderbundt used as a “comparable” a single
lease transaction between related parties, not an arm’s-length
transaction. Mr. McIntosh testified that it is appropriate for
an appraiser to use a related-party lease as a comparable if he
could “verify the information, and see that it’s factual, and
that it is pretty much parallel with the rest of the market data
that you’ve got.”

     While it may be acceptable to mention a related-party
transaction as additional support for an appraisal, it is clearly
improper for an appraiser to rely solely on a related-party lease
in determining the fair market value of another property. The
purpose of an appraisal is to determine fair market value of the
subject property. Fair market value is the price a willing buyer
would pay to a willing seller in an arm’s-length transaction,
with neither party being under compulsion to buy or sell, and
both having reasonable knowledge of the facts. United States v.
Cartwright, 411 U.S. 546, 551 (1973); Morris v. Commissioner, 70
T.C. 959, 988 (1978). A related-party transaction is, by
definition, not an arm’s-length transaction and thus does not
provide reliable evidence of the fair market value of the
“comparable” property. Mr. McIntosh’s inconsistent positions
                                                   (continued...)
                              - 21 -

“the recent lease negotiated with the Nella Oil Company in West

Sacramento * * * gives a Cap Rate of 13%, a 13% range is deemed

reasonable and meaningful for comparable purposes.”   Mr. McIntosh

also testified at trial that the Nella Oil lease would result in

a capitalization rate of “someplace in the neighborhood of 12 to

13 percent.”

     Mr. McIntosh faced a difficult problem in attempting to

justify petitioner’s rental rates because he had previously

valued the properties for estate-planning purposes at low

values.7   Mr. McIntosh’s fair market value determinations in his

estate-planning appraisal were even lower than respondent’s fair

market value determinations, as shown in the following chart:




     6
      (...continued)
regarding the comparability of property in Modesto or Stockton
with Sacramento, depending on whether the analysis supports or
contradicts his client’s position, and his suggestion that it
would be proper for an appraiser to rely solely on a single
related-party comparable in determining the fair market value of
the subject property, call into question the independence of his
analysis.
     7
      Presumably, petitioner and its shareholders wanted
conservative values for estate-planning purposes, so as to
minimize gift and estate taxes. Mr. McIntosh was already bound
by the conservative fair market value determinations he used in
his estate-planning appraisal. It is, of course, easier to
justify higher rental rates with higher property values.
                                - 22 -

                                               Petitioner’s
                         Respondent’s       “Estate-Planning”
       Property           Appraisal             Appraisal
                         (Mr. Harris)         (Mr. McIntosh)
   Watt Avenue             $690,000              $674,000
   Fee Drive                240,000               225,000
   Mother Lode Drive        230,000                60,000
     Total                1,160,000               959,000

     Mr. McIntosh did not attempt to apply a “capitalization”

rate to his estate-planning values in order to justify

petitioner’s rental rates because such a high “capitalization”

rate could not be supported.    Instead, Mr. McIntosh testified

that there is no consistent relationship between the value of

land and the rental value of land, and that “the use of a

hypothetical cap rate * * * can only do one thing, and that’s get

you an inaccurate, unrealistic conclusion.”    This is because, Mr.

McIntosh claims, a tenant will pay more than the fair market rent

determined through the application of a “capitalization” rate

applied to the fair market value of the property if the tenant

can earn a profit at the higher rent.

     We do not find Mr. McIntosh’s testimony credible in this

respect.   The fair market value of the land reflects the highest

and best use of the property.    The “capitalization” rate reflects

the rate of return that the owner would require from, and that a

tenant would pay to lease, the land.     The “capitalization” rate

reflects prevailing market interest rates for risk-free

investments, together with a risk premium that takes into account
                              - 23 -

the risks of the transaction, including the risks involved in the

particular real estate activities in which the tenant proposes to

engage.   See Narver v. Commissioner, 75 T.C. 53, 91 n.17 (1980),

affd. 670 F.2d 855 (9th Cir. 1982); Lanier v. Commissioner, T.C.

Memo. 1998-7 (“The “capitalization” rate * * * Although basically

related to the rate of interest * * * includes risk and liquidity

factors”).   A properly computed fair market value and

“capitalization” rate reflect competitive market conditions.    Mr.

McIntosh’s suggestion that a “capitalization” rate is properly

used to determine fair market value from known rental rates but

not the other way around is inconsistent with basic mathematical

and appraisal principles.8   Mr. McIntosh’s testimony is also

inconsistent with the methodology he used in his December 8,

1999, letter criticizing respondent’s methodology.

     We have previously recognized the appropriateness of using

“capitalization” rates to determine the fair market rental value

of real estate.   For example, in Clairton Slag, Inc. v.

Commissioner, T.C. Memo. 1979-485, we stated:

     inasmuch as no comparable leases were available from
     which to extrapolate the fair rental value of the
     Property, the next best method for determining the fair
     rental value of the Property is the “comparable sales”
     method (CSM). The CSM requires the identification of
     two relevant figures: (1) the rate of return on


     8
      If the present value of the property equals the rental
value divided by the “capitalization” rate, then, as a matter of
algebra, the rental value must equal the present value multiplied
by the “capitalization” rate.
                              - 24 -

     investment an unrelated lessor of comparable property
     would require; and (2) the fair market value of the
     subject property at the beginning of each lease year.
     * * *

Similarly, in Osterlund, Inc. v. Commissioner, T.C. Memo.

1987-40, we stated:

     All three of these experts used essentially the same
     method to derive their estimates of the Property's fair
     rental value. They first estimated the Property's fair
     market value using comparable sales of property. They
     then multiplied their estimates of the Property's fair
     market value by a rate of return they believed a lessor
     of property similar to the Property would have required
     during the years in question upon leasing such property
     in an arm's-length transaction. We agree with the
     parties that this is a reasonable method for
     determining the fair rental value of the Property.

     We are not bound by the opinion of any expert witness and

may accept or reject expert testimony in the exercise of sound

judgment.   Helvering v. Natl. Grocery Co., 304 U.S. 282, 295

(1938); Estate of Hall v. Commissioner, 92 T.C. 312, 338 (1989).

     We give very little weight to Mr. McIntosh’s testimony

because his reports contain no analysis and little reliable data

to aid us in determining the fair market rental value of the

subject properties, and because his testimony on a number of

matters was simply not credible.

     We also give little weight to Mr. Vanderbundt’s report.    Mr.

Vanderbundt’s report was based on a single “comparable” to

support his rental rate conclusions.   His “comparable” was a

lease between related parties for a property in Lodi, California,

which had been supplied to him by petitioner.   This single
                             - 25 -

related-party lease does not provide reliable information

concerning fair market values.

     However, we do agree with Mr. McIntosh’s and Mr.

Vanderbundt’s testimony that the “capitalization” rate used in

determining the fair market rental value of property should

reflect the additional risks incurred by a landlord in leasing

land to an independent cardlock operator such as petitioner,

rather than a major oil company.   We find that a 13-percent

“capitalization” rate is an accurate assessment of the rate of

return that an arm’s-length lessor would have required from

petitioner during 1996 and 1997.   A “capitalization” rate of 13

percent is in the range of rates suggested by Mr. McIntosh in his

December 8, 1999, letter, and is in the upper range of rates that

Mr. McIntosh claims would be derived from the Nella Oil lease,

which was entered into in the same general timeframe as

petitioner’s leases and was to a similar independent operator.

      Mr. Harris credibly testified that a flat 10-percent rate

would be appropriate for leases to major oil company tenants.

However, the 10-percent rate fails to take into account the

environmental credit risks borne by a landlord when leasing

property to an independent cardlock operator.   A 3-percent risk

premium seems appropriate to us, in light of the substantial

additional risks a landlord incurs when leasing property to an

independent operator of underground storage tanks.   Therefore, we
                                 - 26 -

will apply a 13-percent “capitalization” rate in determining the

fair rental value of the properties.

     Using the market values determined by Mr. Harris (values

that petitioner’s expert, Mr. McIntosh, conceded were, if

anything, on the high side), and using a “capitalization” rate of

13 percent, we conclude that the fair market rental values of the

properties were as follows:

                      Fair Market     Capitalization    Fair Market
    Property             Value             Rate         Rental Value
 Watt Avenue              $690,000          13%             $89,700
 Mother Lode Drive         230,000          13               29,900
 Fee Drive                 240,000          13               31,200

     Petitioner is not entitled to deduct the amounts paid as

rent in excess of the fair market rental value of the property.

The excess amounts paid as rent were in the following amounts:

  Property           Rent Paid         Fair Market Rent        Excess
                 1996        1997       1996        1997
Watt Avenue    $120,000    $120,000   $89,700     $89,700     $60,600
Mother Lode
Drive            27,600      28,800    29,900      29,900        ---
                             1                    2
Fee Drive         ---        16,000      ---       10,400       5,600
  Total         147,600     164,800    119,600    119,602      66,200
     1
      The Fee Drive property was leased for only 4 months in
1997, at a rent of $4,000 per month.
     2
      Inasmuch as the Fee Drive property was leased for only 4
months, we have used four-twelfths of the annual fair market
rental value.
                               - 27 -

     B.    Fair Market Rental Value of Remaining Properties

     To show that the rents petitioner paid on the remaining

properties were fair market rents, petitioner offered the

testimony of its president and shareholder, Randall Dean Hunt,

and the opinions of Messrs. McIntosh and Vanderbundt.      Respondent

offered no evidence to contradict petitioner’s position or the

testimony of its expert witnesses.      At trial, respondent’s

expert, Mr. Harris, testified that he had appraised all six

properties.    When the Court asked respondent how it was to

determine the fair market rental values of the remaining three

properties when respondent had not filed Mr. Harris’s appraisal

reports with respect to these properties, respondent’s counsel

replied:

         Your Honor, to be perfectly honest with you,
     respondent was prepared to concede that the other three
     properties’ rental rates were reasonable.

         However, upon receiving Mr. McIntosh’s reports, we
     kind of concluded that perhaps looking at just Mr.
     McIntosh’s reports, and Mr. Vanderbundt’s report, that
     maybe they weren’t so reasonable. And that’s why we’re
     not willing to concede that point at this point.

         But I think Mr. Harris concluded that they were
     reasonable, and we didn’t feel that there was any need
     to submit his reports to the Court.

Respondent offered no evidence to suggest that the rents paid by

petitioner on the remaining three properties exceeded their fair

market rental values.    Respondent asks us to infer that

petitioner must also have paid excess rents on the other three
                              - 28 -

properties because petitioner paid rents in excess of fair market

rental value on two of the three properties for which respondent

submitted evidence.9   We do not draw the inference respondent

asks for.

     Petitioner is entitled to prevail if a preponderance of the

evidence shows that the rents paid were not in excess of the

respective fair market rental values of the remaining properties.

Petitioner has come forward with evidence to show that the rental

rates it paid represented fair market rental values for the

remaining three properties.   Petitioner submitted testimony from

its president and two expert witnesses to support its rental

values.   Because respondent failed to submit any contrary direct

evidence, a preponderance of the evidence supports petitioner’s

position.

     While the preponderance of the evidence supports

petitioner’s rental rates, we are not entirely satisfied by the

evidence presented by the parties.     Petitioner’s evidence was

subject to all the infirmities noted above with respect to the

expert testimony of Messrs. McIntosh and Vanderbundt.     We refer

specifically to the fair market values of the remaining

properties found by Mr. McIntosh in his original report for

estate planning purposes, which, we have no doubt, were


     9
      Of course, respondent asserted at trial and on brief,
without submitting any evidence to support his assertion, that
the rents for the three remaining properties were excessive.
                             - 29 -

substantially understated, and to the complete lack of data and

analysis contained in the expert reports offered by petitioner.

Using Mr. McIntosh’s “estate-planning” appraisal values, as

respondent requests, and our 13-percent “capitalization” rate

would have resulted in very substantial excessive rents.10    We

believe this is attributable to Mr. McIntosh’s undervaluing of

the properties for estate-planning purposes rather than to

petitioner’s overstating of the rents.

     While we would have preferred to base our decision on a

record containing expert testimony supported by complete data and

thorough, unbiased analysis, we must to do the best we can with

the evidence presented by the parties.   We are comforted in the

correctness of our conclusion that petitioner paid fair market

rents for the remaining three properties by respondent’s

admission that Mr. Harris, respondent’s expert, had concluded

that the rents for these three properties were not excessive.11


     10
      Applying a 13-percent “capitalization” rate to Mr.
McIntosh’s fair market values would have resulted in fair market
rent of $18,200 per year for Mosquito Road, $32,500 for Roseville
Road, and $33,800 for White Rock Road. Using these fair market
rental values, petitioner would have overstated the fair market
rents for these three properties for the 2 years in issue by
$151,100.
     11
      Because respondent’s appraiser used a flat 10-percent
“capitalization” rate to determine fair market rental value,
respondent’s expert must have determined fair market values
exceeding $530,000 for Mosquito Road, $540,000 for Roseville
Road, and $550,500 for White Rock Road--many times the values
determined by Mr. McIntosh (who valued the properties at
                                                   (continued...)
                              - 30 -

We therefore find that the rents petitioner paid on the remaining

properties did not exceed the fair market rental values of the

properties.

III. Penalties

     Respondent argues that petitioner should be liable for a 20-

percent accuracy-related penalty by reason of petitioner’s

negligence under section 6662(a)(1).   Respondent claims that the

magnitude of the discrepancy between the rent paid and the fair

market rental value of the properties establishes negligence.

Respondent offers no other evidence of negligence than the

magnitude of the discrepancy.12

     Respondent argues that a negligence penalty is mandated

where the taxpayer fails to offer credible independent evidence




     11
      (...continued)
$140,000, $250,000, and $260,000, respectively). Even using a
13-percent “capitalization” rate would result in values of
$410,769, $415,384, and $426,923 for Mosquito Road, Roseville
Road and White Rock, respectively. Under any scenario, Mr.
McIntosh’s “estate-planning” appraisal substantially undervalued
the properties.
     12
      In connection with additions to tax and penalties, sec.
7491(c) places a burden of production on the Commissioner in
cases involving examinations commenced after July 22, 1998.
Internal Revenue Service Restructuring and Reform Act of 1998,
Pub. L. 105-206, sec. 3001, 112 Stat. 726. Neither party offered
evidence to show when the audit was commenced. However,
respondent claimed in his pretrial memorandum that the audit was
commenced before July 23, 1998, and petitioner in its opening
brief appeared to accept the burden of proof. Whether sec.
7491(c) applies here is irrelevant because petitioner is entitled
to prevail on a preponderance of the evidence.
                              - 31 -

to show how the lease rents were determined, citing Duplicating

Supply Co. v. Commissioner, T.C. Memo. 1993-451.

     In Duplicating Supply, the Court recognized that the

taxpayer had the burden of establishing that it was not negligent

in setting the rent for the property, as the Commissioner had

determined in the notice of deficiency.   The taxpayer had

substantially overstated rent (charging for 1 year’s rent 44

percent of the fair market value of the property), had made no

investigation of the market before setting the rent, and offered

no explanation to show how the rental figure had been determined.

     The case at hand is easily distinguished from Duplicating

Supply.   The uncontradicted evidence indicates that petitioner

made efforts to determine the correct rents by contacting real

estate agents before setting the rents.   Petitioner’s president

and shareholder, Randall Dean Hunt, testified that before

entering into each of the leases, he (or his father before him)

asked several different brokers whether the rental rate was

reasonable.

     Respondent argues that even though Mr. Hunt named the

brokers he and his father spoke with, Mr. Hunt’s testimony was

self-serving and should be disregarded because petitioner did not

call the brokers as witnesses.   Respondent asks us to disregard

Mr. Hunt’s testimony because it is self-serving and

uncorroborated by any independent witnesses, citing Wichita
                             - 32 -

Terminal Elevator Co. v. Commissioner, 6 T.C. 1158, 1165 (1946),

affd. on other grounds 162 F.2d 513 (10th Cir. 1947).

     In Wichita Terminal, we recognized that the Commissioner has

no obligation to introduce evidence to rebut an allegation by the

taxpayer where the taxpayer failed to introduce “one scintilla of

evidence” to support its allegation.    In that case, we stated:

“The rule is well established that the failure of a party to

introduce evidence within his possession and which, if true,

would be favorable to him, gives rise to the presumption that if

produced it would be unfavorable.”     Id.   However, as we stated in

Sisson v. Commissioner, T.C. Memo. 1994-545:

     This rule originates in Lord Mansfield’s observation
     that “all evidence is to be weighed according to the
     proof which it was in the power of one side to have
     produced, and in the power of the other to have
     contradicted.” Mammoth Oil Co. v. United States, 275
     U.S. 13, 51 (1927) (quoting Blatch v. Archer, 1 Cowper
     63, 65 (1774)); Kirby v. Tallmadge, 160 U.S. 379, 383
     (1895). What Lord Mansfield did not say, but what the
     Supreme Court added, is that the rule is to be applied
     cautiously, and only in cases where the evidence is
     possessed by one party and not accessible to the other
     party. Mammoth Oil Co. v. United States, supra at 51.
     This qualification mitigates the rigor with which the
     rule might otherwise restrict the ability of the
     parties to present their cases as they choose; the
     qualification makes clear that, in our judicial system,
     the trial court’s role is to decide cases on the
     evidence presented, not on imaginable “evidence” not
     presented. Fuller, The Problems of Jurisprudence 706
     (Temp. ed. 1949) (“the moral force of a judgment of
     decision will be at a maximum when * * * The judge
     decides the case solely on the basis of the evidence
     and arguments presented to him”).
                               - 33 -

In the case at hand, the witnesses to the conversations were

equally available to petitioner and respondent.    Petitioner was

not required to call witnesses to corroborate the testimony it

offered.   If respondent did not believe the testimony, he should

have called witnesses or taken other discovery to impeach Mr.

Hunt’s testimony.   Respondent offered no evidence to call into

question the truth of Mr. Hunt’s testimony.

     In addition, the magnitude of the discrepancy is not nearly

as significant as it was in Duplicating Supply Co. v.

Commissioner, supra.   We have found that petitioner overstated

rent on only two of the six properties and charged as total

annual rent less than 20 percent of what we have found (and what

respondent’s expert claimed) to be the fair market value of these

properties.13   Petitioner’s rental payments exceeded the fair

market rental value of the Watt Avenue property by approximately

33 percent and the Fee Drive property by approximately 53

percent.   While petitioner did overstate rental deductions on

these two properties, we do not find that the overstatements were

of sufficient magnitude to mandate a determination that

petitioner was negligent in setting the rents.    We therefore



     13
      In 1996, petitioner charged rent of $120,000 for Watt
Avenue on a value of $690,000, resulting in a rental rate of 17
percent of value. In 1997, petitioner charged $120,000 in rent
for Watt Avenue and annualized rent of $48,000 on Fee Avenue, for
total rent of $168,000 on a value of $930,000 or approximately 18
percent of value.
                             - 34 -

conclude that petitioner is not liable for an accuracy-related

penalty on the grounds of negligence under section 6662(a)(1).

     After giving effect to the parties’ concessions,



                                        Decision will be entered

                                   under Rule 155.
