                         T.C. Memo. 1995-556



                       UNITED STATES TAX COURT



            WINDSOR PRODUCTION CORPORATION, Petitioner v.
             COMMISSIONER OF INTERNAL REVENUE, Respondent



    Docket No. 27654-91.                  Filed November 21, 1995.



    Kenneth W. Gideon, Gregory P. Joseph, Sheldon S. Cohen,

Ellen K. Harrison, Mark S. Bader, B. John Williams, Jr., John F.

Coverdale, and Ruth E. Kent, for petitioner.

    Lindsey D. Stellwagen and Chalmers W. Poston, Jr., for

respondent.



                         MEMORANDUM OPINION

    COLVIN, Judge:    This matter is before the Court on

petitioner's motion for litigation costs under section 74301 and


     1
         Section references are to the Internal Revenue Code in
                                                     (continued...)
                                - 2 -


Rule 231.    Respondent concedes that petitioner meets all of the

requirements for an award of litigation costs under section 7430

except whether respondent's position in the underlying proceeding

was substantially justified.    For reasons discussed below, we

hold that respondent's position was not substantially justified.

     The parties submitted memoranda and affidavits supporting

their positions.    We decide the motion based on the memoranda and

affidavits provided by the parties.     Neither party requested a

hearing, and respondent stated that no hearing is required.

There are no significant factual disputes.     We conclude that a

hearing is not necessary to properly decide this motion.     Rule

232(a)(3).                   Background

1.   Petitioner and the Underlying Tax Case

     Petitioner was a closely held corporation the principal

place of business of which was in New York when it filed its

petition.    Petitioner was in the oil, gas, film and television

business during the years in issue.

     Petitioner's underlying case was decided at Saltzman v.

Commissioner, T.C. Memo. 1994-641.      Several consolidated cases

were decided by that opinion.    The primary issue involving

petitioner was whether it was liable for accumulated earnings

tax under section 531.



     1
      (...continued)
effect for the years in issue. Rule references are to the Tax
Court Rules of Practice and Procedure.
                               - 3 -


     Petitioner's shareholders and board of directors met on

December 1, 1987.   The minutes of that meeting show that

petitioner would probably need to plug 38 wells at a cost of

between $10,000 and $40,000 per well.   The minutes also show

that petitioner had begun negotiations to buy oil or gas projects

which required initial investments as follows:   $130,000 for

Kelso; $450,000 for Quail Creek; $375,000 for Boren; and $760,000

for Turkey Creek.   The board allocated $1 million to plug wells

and acquire new projects.

2.   Revenue Agent's Contacts with Petitioner's Representatives

     Richard Saul (Saul), respondent's revenue agent assigned to

this case, worked closely with Leonard Hochheiser (Hochheiser),

petitioner's representative.   On October 5, 1989, Saul asked

Hochheiser for a copy of petitioner's tax returns for 1986 and

1987.   Hochheiser gave those returns to Saul on November 10,

1989.   On January 3, 1991, Saul asked Hochheiser to agree to

extend the time to assess tax for petitioner's 1987 year.    Saul

received a letter on February 4, 1991, in which Hochheiser

declined.   On February 6, 1991, Saul met with Hochheiser and

discussed petitioner's business generally and the audit.    Saul

briefly mentioned section 531 as an issue to be considered.     He

did not ask petitioner's owners or Hochheiser whether petitioner

needed to accumulate earnings or had plans to expand.   Hochheiser

did not say whether petitioner had plans to expand.
                                - 4 -


    On June 13, 1991, respondent notified petitioner in writing

that petitioner was under audit for fiscal years 1987, 1988, and

1989.    On June 14, 1991, Saul sent petitioner an Information

Document Request (IDR).    In it, Saul noted that the only issue

Saul was considering was the amortization of film rights for 1987

to 1990.    The IDR led petitioner to believe that respondent would

not pursue the section 531 issue.    Saul did not consider

asserting section 531 against petitioner then because he did not

believe the section 531 issue was strong for respondent.      Saul

told Hochheiser that he leaned against pursuing the section 531

issue.    However, after meeting with a reviewer in early August

1991, Saul concluded that respondent should assert the section

531 issue against petitioner on the assumption that Windsor

had substantial liquidity and no plans to expand and because

Hochheiser did not mention expansion plans after Saul briefly

mentioned section 531.    Saul did not ask petitioner's owners

or Hochheiser about whether petitioner needed to accumulate

earnings.    Saul did not ask to see petitioner's board minutes.

    On August 19, 1991, Saul told Hochheiser that he would

assert the section 531 issue because he believed petitioner had

no reasonable needs to accumulate earnings and the 3-year

period to assess tax was about to expire.    On August 29, 1991,

respondent issued notices to petitioner under section 534(b)

proposing to assert accumulated earnings tax for each year in

issue.    On August 30, 1991, respondent issued a notice of
                                 - 5 -


deficiency to petitioner.    The accumulated earnings tax issue

was the primary adjustment determined by respondent.     Respondent

determined that petitioner had accumulated excess taxable income

of $116,291 in 1987, $76,275 in 1988, and $143,917 in 1989 that

was taxable under section 531.

    On October 23, 1991, petitioner submitted a statement under

section 534(c) detailing its plans to expand its oil, gas, film,

and television businesses.    Petitioner attached copies of

corporate minutes to verify the amounts of accumulated earnings

needed for each of petitioner's expansion programs.     Petitioner

also stated that it needed a reserve for contingent liabilities

from an NFC Oil Co. lawsuit settled in 1988, environmental

liabilities including plugging oil wells, and breach of contract

and copyright violations.    Petitioner attached copies of

corporate minutes to verify the amounts it needed for these

reserves.

    On November 27, 1991, petitioner filed the petition in this

case.   In it, petitioner denied that it was subject to the

accumulated earnings tax and referred to the section 534(c)

statement it filed in which it stated its needs to accumulate

earnings.

    Respondent filed the answer on January 27, 1992, and an

amended answer on February 24, 1992.     Respondent alleged that

petitioner's section 534(c) statement was not sufficient.
                                - 6 -


Respondent conceded the accumulated earnings tax issue after

trial and after petitioner filed its opening brief.

                             Discussion

1.   Motion for Litigation Costs:   Introduction

     Generally, a taxpayer who has substantially prevailed in a

Tax Court proceeding may be awarded reasonable litigation costs.

Sec. 7430(a)(2).    To be entitled to an award, the taxpayer must:

     (a)   Exhaust administrative remedies.    Sec. 7430(b)(1).

Respondent concedes that petitioner meets this requirement.

     (b)    Substantially prevail with respect to the amount in

controversy.    Sec. 7430(c)(4)(A)(ii)(I).    Respondent concedes

that petitioner meets this requirement.

     (c)    Show that the position of the United States in the

action was not substantially justified.      Sec. 7430(c)(4)(A)(i)

(1988).    Respondent contends that petitioner does not meet this

requirement.    Petitioner contends and we hold that petitioner

meets this requirement.

     (d)   Be an individual whose net worth did not exceed

$2,000,000, or an owner of an unincorporated business, or any

partnership, corporation, etc., the net worth of which did

not exceed $7,000,000, when the petition was filed.      Sec.

7430(c)(4)(A)(iii); 28 U.S.C. sec. 2412(d)(2)(B).      Respondent

concedes that petitioner meets this requirement.

     (e)   Establish that the amount of costs and attorney's

fees claimed by petitioner is reasonable.      Sec. 7430(a), (c)(1).
                                 - 7 -


Respondent concedes that petitioner meets this requirement.

    A taxpayer has the burden of proving that it meets each

requirement before the Court may order an award of litigation and

administration costs under section 7430.    Rule 232(e); Estate of

Johnson v. Commissioner, 985 F.2d 1315, 1318 (5th Cir. 1993),

Gantner v. Commissioner, 92 T.C. 192, 197 (1989), affd. 905 F.2d

241 (8th Cir. 1990); Minahan v. Commissioner, 88 T.C. 492, 497

(1987).

    A taxpayer must establish that the position of the United

States in the litigation was not substantially justified to be

entitled to an award for administrative or litigation costs.

Sec. 7430(c)(4)(A)(i).   The position of the United States is the

position taken by respondent:    (a) In the court proceeding, and

(b) in the administrative proceeding as of the earlier of, (i)

the date the taxpayer receives the notice of the decision of the

Internal Revenue Service Office of Appeals, or (ii) the date of

the notice of deficiency.   Sec. 7430(c)(7).   Here, petitioner

did not receive a notice of decision from respondent's Appeals

office.   Respondent's position in the notice of deficiency,

the answer, throughout trial, and until petitioner filed its

posttrial brief, was that petitioner accumulated earnings beyond

its reasonable business needs.    Thus, respondent's position in

both the administrative and the judicial proceeding was that

taken in the notice of deficiency for purposes of section 7430.

Accordingly, we must decide whether respondent's position was
                                  - 8 -


substantially justified when respondent issued the notice of

deficiency and when respondent filed the answer in this case.

2.   Whether Respondent's Position That Petitioner
     Accumulated Earnings Beyond Its Reasonable Business Needs
     Was Substantially Justified

     a.      Background

     The Equal Access to Justice Act's substantially justified

standard requires that the Government's position be justified

to a degree that would satisfy a reasonable person.      Pierce v.

Underwood, 487 U.S. 552, 565 (1988).      That standard applies to

motions for litigation costs under section 7430.      Nicholson v.

Commissioner, 60 F.3d 1020, 1026 (3d Cir. 1995), revg. T.C. Memo.

1994-280; Comer Family Equity Pure Trust v. Commissioner, 958

F.2d 136, 139-140 (6th Cir. 1992), affg. T.C. Memo. 1990-316;

Powers v. Commissioner, 100 T.C. 457, 470 (1993), affd. on this

issue and revd. in part and remanded on other issues 43 F.3d

172 (5th Cir. 1995).      To be substantially justified, the

Commissioner's position must have a reasonable basis in both law

and fact.2    Pierce v. Underwood, supra; Hanover Bldg. Matls.,

Inc. v. Guiffrida, 748 F.2d 1011, 1015 (5th Cir. 1984); Powers v.

Commissioner, supra at 473.      For a position to be substantially

justified, there must be "substantial evidence" to support it.


     2
       Respondent recognizes that this is the controlling
standard at issue in this case. On brief respondent states:
"To determine whether respondent acted reasonably, the Court
must consider whether respondent's position had a reasonable
basis both in law and fact. Pierce v. Underwood, 487 U.S. 552,
564 (1988); Powers v. Commissioner, 100 T.C. 457, 470 (1993)."
                               - 9 -


Pierce v. Underwood, supra at 564-565; Powers v. Commissioner,

supra at 473.

    The fact that the Commissioner eventually loses or concedes

the case does not in itself establish that a position is

unreasonable.   Wilfong v. United States, 991 F.2d 359, 364 (7th

Cir. 1993); Hanson v. Commissioner, 975 F.2d 1150, 1153 (5th Cir.

1992), revg. an unpublished Order of this Court.     However, it is

a factor to be considered.   Heasley v. Commissioner, 967 F.2d

116, 120 (5th Cir. 1992), affg. in part and revg. in part T.C.

Memo. 1991-189; Estate of Perry v. Commissioner, 931 F.2d 1044,

1046 (5th Cir. 1991); Powers v. Commissioner, supra at 471.

The taxpayer need not show bad faith to establish that the

Commissioner's position was not substantially justified for

purposes of a motion for litigation costs under section 7430.

Estate of Perry v. Commissioner, supra; Powers v. Commissioner,

supra.

    b.    Respondent's Claimed Basis in Fact

    A taxpayer is liable for accumulated earnings tax if it is

formed or availed of to avoid income tax for its shareholders by

permitting earnings and profits to accumulate instead of being

divided or distributed.   Sec. 532(a), Hughes, Inc. v.

Commissioner, 90 T.C. 1, 15 (1988).     The most important factor

in deciding if the accumulated earnings tax applies is whether

a corporation accumulated earnings and profits beyond the

reasonable needs of the business.      United States v. Donruss Co.,
                               - 10 -


393 U.S. 297, 307 (1969); Technalysis Corp. v. Commissioner,

101 T.C. 397, 403 (1993).

    Respondent contends that there was a reasonable basis in

fact for the position in the notice of deficiency and the answer

because respondent knew the following facts before issuing the

notice of deficiency:    (i) Petitioner had passive assets such

as certificates of deposit; (ii) petitioner had investments

unrelated to its oil and gas operations; (iii) petitioner had a

steady cash-flow from film rights; (iv) petitioner paid Arnold

Saltzman a $30,000 dividend in 1989; and (v) petitioner paid

management fees to Arnold Saltzman.     We do not believe that these

facts provide a reasonable basis in fact for respondent's

position.    Respondent does not state the amounts of petitioner's

liquid assets.    Respondent alleged in the answer that petitioner

had accumulated liquid assets worth more than $500,000 in each

year in issue.    Respondent might have been referring to amounts

in petitioner's Federal corporate tax returns for the years in

issue.    Petitioner reported "other investments" of $748,771 on

its tax returns for 1987, $779,913 for 1988, and $729,419 for

1989.    However, the only way to know if these amounts are

excessive is to compare them to petitioner's business plans.

Respondent lacked a basis in fact for applying the accumulated

earnings tax because respondent had no facts about petitioner's

business plans.
                               - 11 -


    The fact that petitioner had a steady cash-flow from its

film rights, without more, does not provide a basis for

respondent's position that petitioner unreasonably accumulated

income.    The fact that petitioner paid dividends and management

fees to Arnold Saltzman, without more, does not provide a basis

for respondent's position.    Respondent does not state how much

petitioner paid to Arnold Saltzman, nor does respondent say how

an expense by a business shows that the business accumulated too

much.    We conclude that the facts known to respondent do not

provide a reasonable basis in fact for respondent's position in

the notice of deficiency.    After respondent issued the notice of

deficiency, petitioner filed its statement under section 534(c)

explaining its reasons to accumulate earnings.    Respondent does

not claim to rely on different facts for the answer than those

upon which respondent relied in the notice of deficiency.    We

conclude that the facts known to respondent do not provide a

reasonable basis for respondent's position.

    c.      Effect of Burden of Proof

    Respondent claims to be substantially justified in

determining that petitioner is liable for the accumulated

earnings tax because petitioner has the burden of proof.    We

disagree.    The fact that petitioner bears the burden of proof

does not give respondent a basis in fact or establish that

respondent's position is substantially justified.    Powers v.
                                 - 12 -


Commissioner, supra at 472-474; Williford v. Commissioner, T.C.

Memo. 1994-135.

    d.      Respondent's Lack of Diligence

    Respondent erroneously assumed that petitioner had no

reasonable business needs to accumulate earnings or plans to

expand which would justify accumulations.    Respondent did not ask

to see petitioner's records or otherwise investigate petitioner's

needs to accumulate funds before issuing the notice of

deficiency.    On July 1, 1981, Saul believed that the accumulated

earnings issue was not strong for respondent.   He told Hochheiser

that respondent would not pursue the accumulated earnings issue.

The Commissioner did not have a reasonable basis in fact and law

without diligently investigating the case.    Nicholson v.

Commissioner, 60 F.3d at 1029; Lennox v. Commissioner, 998 F.2d

244, 248 (5th Cir. 1993), revg. and remanding T.C. Memo. 1992-

382; United States v. Estridge, 797 F.2d 1454, 1458 (8th Cir.

1986); Powers v. Commissioner, 100 T.C. at 473.

    The fact that respondent issued the accumulated earnings tax

notice under section 534(b) 1 day before respondent issued the

notice of deficiency suggests that respondent was not seriously

interested in investigating the accumulated earnings tax issue.3


     3
         Sec. 534(b) provides:

     Before mailing the notice of deficiency referred to in
     subsection (a), the Secretary may send by certified
     mail or registered mail a notification informing the
                                                   (continued...)
                              - 13 -


Section 534(c) is designed to enable a taxpayer to respond to

the Commissioner's section 534(b) notification before the

Commissioner determines a deficiency.   Manson W. Corp. v.

Commissioner, 76 T.C. 1161, 1164 (1981).   In that case we said:

    [The Commissioner] admits that part of section 534's
    function is to "encourag[e] the Internal Revenue Service
    to be more deliberate than it had been in the past."
    Such deliberation can result only if respondent reads
    and considers a taxpayer's section 534(c) response
    before issuing a notice of deficiency, and we are
    confident that Congress intended for respondent to do
    just that. [Id.; fn. ref. omitted.]

    Respondent failed to request information about petitioner's

needs to accumulate earnings even though Hochheiser gave copies

of petitioner's tax returns to Saul in November of 1989 and Saul

knew in February 1991 that petitioner would not agree to extend

the time to assess tax.   We conclude that respondent did not

diligently investigate this case before issuing the notice of

deficiency or filing the answer.



     3
      (...continued)
     taxpayer that the proposed notice of deficiency
     includes an amount with respect to the accumulated
     earnings tax imposed by section 531.

     Sec. 534(c) provides:

     Within such time (but not less than 30 days) after the
     mailing of the notification described in subsection (b)
     as the Secretary may prescribe by regulations, the
     taxpayer may submit a statement of the grounds
     (together with facts sufficient to show the basis
     thereof) on which the taxpayer relies to establish that
     all or any part of the earnings and profits have not
     been permitted to accumulate beyond the reasonable
     needs of the business.
                               - 14 -


    e.      Whether Respondent's Desire to Have a Trial Bars an
            Award of Litigation Fees

    Respondent contends that trial was needed so respondent

could assess the probative value, admissibility of testimony and

documents offered by petitioner to prove its business needs.

For example, respondent wanted to assess Arnold Saltzman's

credibility at trial.    Respondent argues that until respondent

conceded the accumulated earnings tax issues, respondent's

litigating position was substantially justified because this case

could only be resolved by examining the facts and circumstances,

including assessing the credibility of the witnesses.      We

disagree.    The Government is not automatically excused from

having a reasonable basis in fact in cases where facts and

witnesses' credibility are in dispute.

    Respondent cites Richman v. Commissioner, T.C. Memo. 1994-

140 for the proposition that respondent's position is

substantially justified where the issues are factual and depend

on a determination of credibility.      This is not what we held

in Richman.    In Richman, the Commissioner determined that the

taxpayer fraudulently omitted interest income.      We held that

the Commissioner had a reasonable basis in fact because, when

respondent issued the notice of deficiency, respondent knew that

the taxpayer used an incorrect Social Security number on his

account statements, and the account statements contained a notice
                               - 15 -


that the amount of interest would be reported to the Internal

Revenue Service.    Id.

    Respondent contends that respondent was substantially

justified in asserting the accumulated earnings issue because

petitioner did not provide documents relevant to that issue in

its protest letter dated May 15, 1991.   We disagree.    Respondent

first proposed to assert the accumulated earnings issue in August

1991.   It is unreasonable to fault petitioner for not

anticipating that respondent would raise the accumulated earnings

issue later.

    Respondent contends that petitioner acknowledged the need

for trial in its motion to shift the burden of proof to

respondent.    We disagree; petitioner's motion to shift the burden

of proof did not state that trial was needed.   Rather, petitioner

asserted that respondent should bear the burden of proof if the

matter went to trial.

    Respondent contends that petitioner admitted that trial

was needed by proposing 65 findings of fact after trial.    We

disagree.   Petitioner properly proposed findings of fact in its

posttrial brief.   This has no bearing on whether respondent's

position was substantially justified.

    Respondent argues that respondent's position was

substantially justified because

    In response to discovery, petitioners represented
    that they had produced all documents establishing the
    allegations in their petition; but in fact not all of
                               - 16 -


    the documents were produced and identified until after
    respondent filed her response to Petitioner's Motion
    For An Order To Show Cause Pursuant to Rule 91(f).

Respondent points out that respondent had objected to

petitioner's motion under Rule 91(f) to compel stipulation in

part because respondent had not seen many of the documents that

petitioner proposed to be stipulated.    These facts could not

provide a basis in fact for respondent's position when the notice

of deficiency was issued or the answer was filed.    We conclude

that the documents that petitioner sought to include in a

proposed stipulation do not show that trial was needed or

otherwise substantially justify respondent's position.

    f.     Whether Petitioner Must Show That Respondent Had
           Neither a Basis In Fact Nor a Basis in Law

    Respondent contends that to establish that the position of

the United States was not substantially justified, petitioner

must show that legal precedent does not substantially support

respondent's position given the facts reasonably available to

respondent.   Respondent contends that petitioner has failed to

do this.   We disagree.   As discussed above, facts about

petitioner's need to accumulate earnings were reasonably

available to respondent if respondent had investigated the issue.

Respondent failed to make such an investigation.    In the

circumstances, we conclude that respondent had insufficient

knowledge of the facts of the case to render respondent's
                                 - 17 -


position substantially justified.     Pierce v. Underwood, 487 U.S.

552 (1988); Powers v. Commissioner, 100 T.C. 457, 472 (1993).

3.   Conclusion

     We conclude that respondent's position was not substantially

justified when respondent issued the notice of deficiency or

filed the answer.

     To reflect the foregoing,


                                           An order will be

                                     issued granting petitioner's

                                     motion for an award of

                                     litigation costs.
