                         T.C. Memo. 1999-108



                       UNITED STATES TAX COURT



         PIZZA INDUSTRIES, INC. DOMINO'S PIZZA, Petitioner v.
             COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 9942-97.                         Filed April 2, 1999.



     Paul W. Rowe and Kevin M. Bagley, for petitioner.

     Gretchen A. Kindel, for respondent.



                          MEMORANDUM OPINION



     ARMEN, Special Trial Judge:    This matter is before the Court

on petitioner's motion for an award of administrative and

litigation costs under section 7430 and Rules 230 through 233.1


     1
        Unless otherwise indicated, all sec. references are to
the Internal Revenue Code in effect for the taxable years in
     After concessions by the parties,2 the sole issue for

decision is whether respondent has established that respondent's

position was substantially justified in the administrative and

court proceedings.   We hold that respondent has not.

     Neither party requested an evidentiary hearing, and the

Court concludes that such a hearing is not necessary for the

proper disposition of petitioner's motion.   See Rule 232(a)(2).

We therefore decide the matter before us based on the record that

has been developed to date.

Background

     Petitioner is a California corporation owned 51 percent by

Pizza Park Corporation, an S corporation, (Pizza Park) and 49

percent by Michael Brown (Mr. Brown).   Pizza Park is wholly owned



issue. However, all references to sec. 7430 are to such section
in effect at the time that the petition was filed. All Rule
references are to the Tax Court Rules of Practice and Procedure.
     2
        Respondent concedes: (1) Petitioner exhausted its
administrative remedies, see sec. 7430(b)(1); (2) petitioner did
not unreasonably protract the proceedings, see sec. 7430(b)(3);
(3) petitioner substantially prevailed, see sec.
7430(c)(4)(A)(i); and (4) petitioner satisfied the applicable net
worth requirement, see sec. 7430(c)(4)(A)(ii).

      Initially, there was an issue as to the reasonableness of
the claimed costs. However, petitioner has substantiated the
expenses contested by respondent and has conceded that attorney's
fees are recoverable only to the extent of $110 per hour (plus
any allowable increases for the cost of living). See sec.
7430(c)(1)(B)(iii), (c)(2)(B). Because of petitioner's
concession regarding the rate of recovery for attorney's fees,
the claimed costs have been reduced from $12,005 to $9,477 (13.3
hours for 1997 at the rate of $110 per hour and 63.8 hours for
1998 at the rate of $120 per hour (cost of living adjusted) plus
$358 in expenses). Respondent does not contest the
reasonableness of the $9,477 amount.
                                - 3 -



by Michael Paul (Mr. Paul).

     Mr. Paul has a certain level of expertise in developing

restaurants.    Because of Mr. Paul's expertise, Domino's Pizza

Inc. (Domino's) entered into an agreement (the Area Agreement)

with Pizza Park on August 1, 1980, giving Pizza Park the

exclusive right to develop (including marketing, advertising, and

public relations) Domino's franchises3 within San Diego County,

California.    Pizza Park agreed to develop a minimum of 35

restaurants within 10 years or risk losing its territorial

protection.

     The Area Agreement provided Pizza Park with compensation for

the development of the Domino's restaurants.    During the period

of its territorial protection, Pizza Park was entitled to receive

50 percent of the royalty fees (the Compensation) that Domino's

received from each restaurant, excluding the restaurant with the

highest volume of royalty sales.    Domino's was not obligated to

pay the Compensation under certain circumstances, including if

Pizza Park violated the Area Agreement in any way.    Further, upon

termination of the Area Agreement for any reason, Pizza Park

would no longer be entitled to the Compensation for sales after

the effective termination date of the agreement.



     3
        We may interchangeably refer to a franchise as a
restaurant or a store.
                                 - 4 -



     The Area Agreement further provided that unless permitted by

Domino's, the Area Agreement would be nonassignable.     However, a

corporation actively managed and wholly owned and controlled by

Pizza Park "conducting no business other than the operation of

stores" could be allowed to operate Domino's franchises.       The

rights and responsibilities of a franchisee would be defined

under the terms of a standard franchise agreement (the Franchise

Agreements)4.    The Franchise Agreements provided that each

franchisee was required to pay Domino's a royalty fee of 5.5

percent based on the store's weekly royalty sales.

     Pursuant to the Area Agreement, Mr. Paul initiated the

development of the Domino's franchise in the San Diego area,

developing 31 franchise stores.     Pizza Park owned 20 such

franchises.     Petitioner, although not a wholly owned subsidiary

of Pizza Park, was allowed to own 11 franchise stores.

Petitioner's shareholders, Mr. Brown and Mr. Paul (as the sole

shareholder of Pizza Park) executed the franchise agreements for

the stores owned by petitioner.

     During the years in issue, petitioner operated the franchise

store with the highest volume in royalty sales within the San

Diego area.     For that store, petitioner paid 100 percent of the


     4
        There are no pertinent differences between the Franchise
Agreements here at issue. We therefore refer to the Franchise
Agreements in the collective.
                               - 5 -



royalty fees directly to Domino's.     As for the other stores,

petitioner paid 50 percent of the royalty fees due (or 2.75

percent of the royalty sales) to Domino's and the other 50

percent of the royalty fees due (or the other 2.75 percent of the

royalty sales) to Mr. Paul as the sole owner of Pizza Park.       The

royalty payments to Mr. Paul were reported by petitioner on Forms

1099.

     On each of petitioner's corporate income tax returns for

1992 through 1994 taxable years, petitioner claimed a royalty

expense deduction equivalent to the royalty fees paid to Domino's

and Mr. Paul, or 5.5 percent of petitioner's royalty sales.

     Respondent conducted an examination of petitioner's 1992

through 1994 taxable years.   During the administrative audit,

petitioner was represented by Paul W. Rowe (Mr. Rowe).     Mr. Rowe

provided respondent with copies of the Area Agreement and the

Franchise Agreements.   Further, Mr. Rowe provided respondent with

a letter from Domino's explaining the reason why payments had

been made to both Mr. Paul and Domino's.     The purpose of this

practice was to ease the administrative burden on Domino's by

eliminating the need for it to issue checks--in effect

eliminating the "middleman" with respect to those payments.

     After considering the Area Agreement, the Franchise

Agreements, and the letter of explanation from Domino's,
                               - 6 -



respondent determined that petitioner was not entitled to a

royalty expense deduction for the portion of the royalty fees

paid to Mr. Paul (the Contested Payments).5   At the time,

respondent's theory for disallowing the deduction was not clear.

Respondent issued a notice of deficiency for the taxable years

1992 through 1994 on February 25, 1997.

     Petitioner filed its petition in this case on May 16, 1997.

Subsequently, on December 9, 1997, the Court served notice that

this case would be called for trial in San Diego, California, on

May 11, 1998.   Shortly before that date, on May 4, 1998, Kevin M.

Bagley entered his appearance as petitioner's co-counsel.    Two

days later, on May 6, 1998, the parties placed a telephone

conference call to Domino's counsel.   During this call, Mr.

Bagley asked Domino's counsel regarding the consequences if

petitioner failed to make the Contested Payments to Mr. Paul.

Domino's counsel advised the parties that Domino's would be

entitled to sue petitioner to recover the unpaid royalty.

Pursuant to this conversation, respondent conceded the

deductibility of the Contested Payments on May 7, 1998, by

executing a stipulated decision, which was entered by the Court

on May 14, 1998.   Thereafter, on August 10, 1998, petitioner


     5
        Respondent made certain other adjustments that are only
computational that result from the disallowance of the royalty
expense deduction for the Contested Payments.
                               - 7 -



submitted its motion for an award of administrative and

litigation costs.   Two days later, on August 12, 1998, the Court

vacated its Decision, recharacterized the form of decision as a

stipulation of settlement, and filed petitioner's motion for an

award of costs.

Discussion

     We apply section 7430 as amended by the Taxpayer Bill of

Rights 2 (TBOR 2), Pub. L. 104-168, secs. 701-704, 110 Stat.

1452, 1463-1464 (1996).   The amendments made by TBOR2 apply in

the case of proceedings commenced after July 30, 1996.    See TBOR2

secs. 701(d), 702(b), 703(b), and 704(b), 110 Stat. 1463-1464.

Inasmuch as the petition herein was filed on May 16, 1997, the

amendments made by TBOR2 apply in the present case.6

     A. Requirements for a Judgment Under Section 7430

     A judgment for administrative costs incurred in connection



     6
        Congress has amended sec. 7430 twice since the Taxpayer
Bill of Rights 2, Pub. L. 104-168, 110 Stat. 1452 (1996). First,
Congress amended sec. 7430 in the Taxpayer Relief Act of 1997
(TRA), Pub. L. 105-34, secs. 1285, 1453, 111 Stat. 788, 1038-
1039, 1055. Second, Congress amended sec. 7430 in the IRS
Restructuring and Reform Act of 1998 (RRA 1988), Pub. L. 105-206,
sec. 3101, 112 Stat. 685, 727-730. However, the amendments made
by TRA do not apply in the case of proceedings commenced before
Aug. 5, 1997, and the amendments made by RRA 1998 apply only to
costs incurred more than 180 days after July 22, 1998. The
petition herein was filed on May 16, 1997, and petitioner has not
claimed costs incurred more than 180 days after July 22, 1998.
The amendments made by TRA and RRA 1998 therefore do not apply in
the present case.
                                 - 8 -



with an administrative proceeding may only be awarded under

section 7430(a) if a taxpayer:    (1) Is the "prevailing party";

and (2) did not unreasonably protract the administrative

proceeding.   See sec. 7430(a) and (b)(3).    Similarly, a judgment

for litigation costs incurred in connection with a court

proceeding may only be awarded if a taxpayer: (1) Is the

"prevailing party"; (2) has exhausted his or her administrative

remedies within the IRS; and (3) did not unreasonably protract

the court proceeding.    See sec. 7430(a), (b)(1), (3).

     A taxpayer must satisfy each of the respective requirements

in order to be entitled to an award of litigation or

administrative costs under section 7430.     See Rule 232(e).   Upon

satisfaction of these requirements, a taxpayer may be entitled to

reasonable costs incurred in connection with the administrative

or court proceeding.    See sec. 7430(a)(2) and (c)(1).

     To be a prevailing party, the taxpayer must substantially

prevail with respect to either the amount in controversy or the

most significant issue or set of issues presented and satisfy the

applicable net worth requirement.    See sec. 7430(c)(4)(A).

Respondent concedes that petitioner has satisfied the

requirements of section 7430(c)(4)(A).    Petitioner will

nevertheless fail to qualify as the prevailing party if

respondent can establish that respondent's position in the court
                                 - 9 -



and administrative proceedings was substantially justified.    See

sec. 7430(c)(4)(B).

     B.   Substantial Justification

     The Commissioner may establish that a position is

substantially justified if, based on all of the facts and

circumstances and the legal precedents relating to the case, the

Commissioner acted reasonably.    See Pierce v. Underwood, 487 U.S.

552 (1988); Sher v. Commissioner, 89 T.C. 79, 84 (1987), affd.

861 F.2d 131 (5th Cir. 1988).    A position is substantially

justified if the position is "justified to a degree that could

satisfy a reasonable person".    Pierce v. Underwood, supra at 565

(construing similar language in EAJA).    Thus, the Commissioner's

position may even be incorrect but substantially justified "if a

reasonable person could think it correct".    Maggie Management Co.

v. Commissioner, 108 T.C. 430, 443 (1997).

     The relevant inquiry is "whether * * * [the Commissioner]

knew or should have known that [his] position was invalid at the

onset".   Nalle v. Commissioner, 55 F.3d 189, 191 (5th Cir. 1995),

affg. T.C. Memo. 1994-182.   We look to whether the Commissioner's

position was reasonable given the available facts and

circumstances at the time that the Commissioner takes his

position.   See Maggie Management Co. v. Commissioner, supra at

443; DeVenney v. Commissioner, 85 T.C. 927, 930 (1985).
                               - 10 -



     The fact that the Commissioner eventually loses or concedes

a case does not establish an unreasonable position.      See Bouterie

v. Commissioner, 36 F.3d 1361, 1367 (5th Cir. 1994), revg. on

other grounds T.C. Memo. 1993-510; Estate of Perry v.

Commissioner, 931 F.2d 1044, 1046 (5th Cir. 1991); Sokol v.

Commissioner, 92 T.C. 760, 767 (1989).    However, the

Commissioner's concession does remain a factor to be considered.

See Powers v. Commissioner, 100 T.C. 457, 471 (1993), affd. in

part, revd. in part and remanded on another issue 43 F.3d 172

(5th Cir. 1995).

     As relevant herein, the position of the United States that

must be examined against the substantial justification standard

with respect to the recovery of administrative costs is the

position taken by respondent as of the date of the notice of

deficiency.   See sec. 7430(c)(7)(B).   The position of the United

States that must be examined against the substantial

justification standard with respect to the recovery of litigation

costs is the position taken by respondent in the answer to the

petition.   See Bertolino v. Commissioner, 930 F.2d 759, 761 (9th

Cir. 1991), affg. an unpublished decision of the Tax Court; Sher

v. Commissioner, 861 F.2d 131, 134-135 (5th Cir. 1988), affg. 89

T.C. 79 (1987).    Ordinarily, we consider the reasonableness of

each of these positions separately.     See Huffman v. Commissioner,
                              - 11 -



978 F.2d 1139, 1144-1147 (9th Cir. 1992), affg. in part, revg. in

part and remanding on other issues T.C. Memo. 1991-144.    In the

present case, however, we need not consider two separate

positions because there is no indication that respondent's

position changed or that respondent became aware of any

additional facts that rendered his position any more or less

justified between the issuance of the notice of deficiency and

the filing of the answer to the petition.

     Respondent determined in the notice of deficiency that

petitioner was not entitled to a royalty expense deduction for

the Contested Payments.   As we understand respondent's position,

respondent would not have disallowed the deduction if petitioner

had directly paid the Contested Payments to Domino's.   Respondent

disallowed the royalty expense deduction based on "the conduct of

the parties"; i.e., the fact that petitioner made the Contested

payments to Mr. Paul, and respondent's interpretation of the Area

Agreement.   The deduction was disallowed because respondent

determined that petitioner was the implied assignee of the Area

Agreement and therefore possessed a fixed and unconditional right

to reimbursement for the Contested Payments under that agreement.

Finally, respondent concluded that any payments made to Mr. Paul

were simply constructive dividends.

     Even in light of the fact that petitioner made the Contested
                              - 12 -



payments to Mr. Paul, we are not convinced that respondent

reasonably interpreted the Area Agreement to deny petitioner a

deduction for the Contested Payments.   In arriving at this

conclusion we have considered the rights and obligations of the

parties as set forth in the Area Agreement and the Franchise

Agreements, including:   (1) Under the Area Agreement Pizza Park

was the party with the right to receive the Compensation; (2)

petitioner was not a party to the Area Agreement; (3) petitioner

was not wholly owned by Pizza Park or Mr. Paul, but was 49

percent owned by another individual; (4) even Pizza Park's right

to receive the Compensation was conditional; (5) petitioner's

obligation to pay 5.5 percent of its royalty sales as a royalty

fee was unconditional; and, finally, (6) petitioner in fact

satisfied this obligation.

     Petitioner's obligation to Domino's for the royalty fees

arose under the Franchise Agreements.   Pursuant to the Franchise

Agreements, each store operated by petitioner was unconditionally

required to pay 5.5 percent of its royalty sales proceeds to

Domino's as a royalty.   Respondent did not have any indication

that petitioner was relieved of this obligation.   Although

petitioner did not pay the entire 5.5 percent royalty fee to

Domino's, respondent was provided with a letter from Domino's

counsel explaining the reason for this (albeit informal)
                              - 13 -



arrangement.   A Corporation is not precluded from deducting an

otherwise deductible royalty expense because the fee is paid to a

shareholder as opposed to a third party.   Cf. Podd v.

Commissioner, T.C. Memo. 1998-231 (taxpayer entitled to deduct a

royalty fee paid to a shareholder to the extent the royalty fee

was reasonable), supplemented by T.C. Memo. 1998-418.

     Respondent contends that it was reasonable for respondent to

treat petitioner as the implied assignee of the Area Agreement

because Domino's ignored the separate identity of petitioner from

Pizza Park for certain purposes.   (Specifically, respondent

refers to the fact that in determining the store with the highest

volume in sales, all stores owned by both petitioner and Pizza

Park were pooled.)   Respondent surmised therefore that for the

stores owned by petitioner, petitioner was entitled to receive

the Contested Payments as reimbursement.   Because a taxpayer is

not entitled to deduct an expense for which there is a fixed and

unconditional right to reimbursement, respondent disallowed the

loss.   However, respondent's position ignores the terms of the

parties' agreements.

     First, we are not persuaded that respondent reasonably

determined petitioner to be the implied assignee of the Area

Agreement and therefore entitled to the Compensation.    Petitioner

was never a party to the Area Agreement that provided for the
                              - 14 -



Compensation.   Petitioner was only a party to the 11 franchise

agreements under which petitioner operated its stores and was

required to pay a 5.5-percent royalty fee.   It is not clear that

the fact that Domino's, a third party, chose to treat petitioner

and Pizza Park as members of one "group"--the "Paul Group"--for

one purpose otherwise affected the rights and obligations of

petitioner (and its shareholders) and Pizza Park (and its

shareholder) for other purposes.

     Petitioner was a separate corporate entity possessing a

different identity from Pizza Park and Mr. Paul.    Petitioner was

not solely owned by Pizza Park or Mr. Paul but was also owned by

Mr. Brown, a 49 percent shareholder.   There was no reason for

respondent to conclude that Mr. Brown would be willing to allow

petitioner to pay dividends to Mr. Paul without making

appropriate adjustments on its corporate books.    Nor was there

any indication that petitioner's corporate identity was in any

manner ignored.   Finally, petitioner appropriately filed Forms

1099 reporting the payments made to Mr. Paul.   Therefore,

respondent has failed to establish that respondent reasonably

determined petitioner to be the implied assignee of the Area

Agreement.

     Second, even if petitioner impliedly become an assignee of

the Area Agreement, the right to receive the Compensation was not
                              - 15 -



a "fixed" or "unconditional" right to receive reimbursement.

Whereas under the Area Agreement the right to receive the

Compensation was conditional and revokable, the obligation of a

franchise owner, such as petitioner, under a franchise agreement

to pay the 5.5-percent royalty fee was unconditional.   Therefore,

there appears to be no fixed or unconditional right to receive

reimbursement for the Contested Payments.

     Based on the forgoing, we are not convinced that respondent

reasonably determined that petitioner was entitled to a fixed or

unconditional right to receive reimbursement as an implied

assignee of the Area Agreement.

     Finally, we have considered that respondent conceded this

case based on a single telephone conversation with Domino's

counsel.   Upon being informed by Domino's counsel that Domino's

would be entitled to sue petitioner for recovery if petitioner

failed to make the Contested Payments to Mr. Paul, respondent

immediately conceded the deficiencies.   We do not understand why

respondent did not seek to make this inquiry before issuing a

notice of deficiency.   Respondent was not precluded from

contacting Domino's, a third party, to confirm respondent's

theory before issuing a notice of deficiency.   Respondent was

aware of the basis for disallowing the deduction and should have

taken minimal steps to confirm or negate respondent's theory
                             - 16 -



before issuing a notice of deficiency.

     Respondent claims that it was petitioner's burden to prove

that it was entitled to the deduction.    However, petitioner

provided respondent with copies of the agreements at issue.

Respondent's determination was simply based on respondent's

interpretation of those agreements.    At the time, respondent's

theory for disallowing the deduction was not completely clear,

and hence petitioner could do nothing further to substantiate the

claimed deduction.

     In light of the foregoing, respondent has failed to

establish that respondent's position in the administrative and

court proceedings was substantially justified.

     To reflect our disposition of the disputed issues and the

parties' concessions,



                                           An appropriate order and

                                      decision will be entered.
