                  T.C. Summary Opinion 2001-34



                     UNITED STATES TAX COURT



      STEPHEN J. ROLING AND PEGGY A. ROLING, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 15224-99S.                   Filed March 20, 2001.


     Stephen J. Roling and Peggy A. Roling, pro sese.

     George W. Bezold, for respondent.




     DEAN, Special Trial Judge:   This case is before the Court on

petitioners' Motion for Litigation and Administrative Costs filed

pursuant to section 7430 and Rule 231.   This case was filed

pursuant to the provisions of section 7463 of the Internal

Revenue Code as in effect at the time the petition was filed.

Unless otherwise indicated, all other section references are to

the Internal Revenue Code in effect for the year at issue, and
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all Rule references are to the Tax Court Rules of Practice and

Procedure.   The decision to be entered is not reviewable by any

other court, and this opinion should not be cited as authority.

                              Background

     Respondent filed a response to petitioners’ motion in which

he agrees that petitioners:    (a) Have substantially prevailed

with respect to the amount in controversy; and (b) meet the net

worth requirements as provided by law.

     Respondent does not agree that petitioners:    (1) Have

substantially prevailed on the most significant issue in the

case; (2) have exhausted their administrative remedies; (3) have

not unreasonably protracted the administrative or Court

proceedings; or (4) have claimed a reasonable amount of costs.

     More importantly, respondent argues that his positions in

the administrative and Court proceedings were substantially

justified.

     The parties have not requested a hearing in this case and

the Court concludes that a hearing is not necessary to decide

this motion.   See Rule 232(a)(2).   Accordingly, the Court decides

the motion after consideration of the petition, the stipulation

of settlement, petitioners' motion for litigation and

administrative costs, respondent's response to the motion, and

petitioners' response to respondent's response to the motion.
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     Petitioners resided in Bellevue, Iowa, at the time they

filed their petition.

The Examination

     Timber Expenditures

     Stephen Roling (petitioner) operates a logging business as a

sole proprietor.   As part of his business petitioner enters into

"right to cut" contracts with landowners.   The contracts allow

petitioner to enter onto the land to cut specifically identified

trees within a certain time frame, usually from 12 to 15 months.

Petitioner does not actually cut the timber until he has a buyer

for it.   The buyer, a lumber mill, picks up the cut trees from

the landowner's property.

     Typically, petitioner makes a payment of 20 percent of the

contract price (downpayment) at the time the contract is signed,

and the balance is paid at the time the timber is cut.   The

landowner retains ownership of the trees until the contract is

paid in full.   Petitioner, a cash basis taxpayer, deducted the

downpayments on the contracts to cut in the year the payments

were made.

     Upon examination of petitioners' Federal income tax return

for 1994, the Internal Revenue Service (IRS) determined that

petitioners' contract downpayments were not currently deductible.

It was respondent's position at the examination that the contract

payments must be capitalized into "inventory" to match
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expenditures with income in the same taxable period.    The

adjustment proposed was to disallow the deduction in 1994 of

downpayments on five contracts identified by petitioner as signed

in 1994 where it appeared the trees were not cut and sold by him

until 1995.

     Unreported Income

     During the examination of petitioners' return for 1994,

petitioner advised the examining agent that he had some income

that was not reported on the return.    The examining agent

performed a source and application of funds analysis that

indicated petitioners had spent $5,061 more than reported funds

available.    Petitioner explained that he had sold a tractor that

cost $550 for $1,050, and he recalled getting a $5,000 loan from

his brother.

Consideration by Appeals Division

     Petitioners' argument that their lack of ownership in the

trees precluded them from having an "inventory" and their

explanation for the unreported income were not accepted by the

examiner.    Petitioners took their case to the Appeals Division of

the IRS (Appeals).

     In Appeals, petitioners were represented by an enrolled

agent (EA) through whom they argued that as owners of an economic

interest in timber they were entitled as lessees to deduct the

payments at issue in the year paid.     By a letter dated April 20,
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1999, petitioners' EA sent to Appeals a copy of a handwritten

note as evidence of a loan of $10,000 from petitioner's father to

them in July of 1994.

     On June 22, 1999, Appeals issued the notice of deficiency in

this case containing the $15,672 adjustment denying the timber

contract downpayment deduction, the unreported income adjustment

of $5,061, and the adjustment determining an accuracy-related

penalty under section 6662.

Post-Appeals

     The petition was filed with the Court on September 20, 1999,

and by notice dated March 29, 2000, was set for trial at the

Court's Des Moines trial session beginning on June 19, 2000.

     Petitioners retained counsel to represent them in this

matter.   Counsel for the parties discussed the timber cutting

contracts and the unreported income issues for a period of weeks.

Counsel for the parties agreed that inventorying was not

appropriate treatment for petitioners' timber payments.    During

their discussions, counsel for petitioners provided respondent's

counsel with documentation showing that with respect to two of

the five contracts, trees were cut and sold in 1994.   Since the

income for the sale of the trees was reported in the same year as

the deduction of the downpayment, the adjustment for the two

contracts totaling $8,950 was conceded by respondent's counsel.

As part of the overall settlement, petitioners agreed that the
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$6,772 of payments for the other three contracts are not

deductible and must be capitalized.

       Counsel for petitioners submitted to respondent's counsel

unsworn, and on June 15, 2000, sworn statements from petitioner

and his father as evidence of the June 1994 loan to petitioners.

Petitioners also submitted petitioner's father's Federal income

tax return for 1994.    Bank records of petitioner's father from

1994 were unavailable.

       As part of the overall settlement, respondent conceded the

unreported income adjustment and the accuracy-related penalty in

June of 2000.    On July 21, 2000, the Court filed the parties'

stipulation of settlement in which it is agreed that there is a

deficiency in income tax due from petitioners for 1994 in the

amount of $2,055.    Since respondent conceded the unreported

income item, the deficiency necessarily relates to a portion of

the timber contract downpayment adjustment.

                             Discussion

       We apply section 7430 as most recently amended by Congress

in the IRS Restructuring and Reform Act of 1998 (RRA 1998), Pub.

L. 105-206, sec. 3101, 112 Stat. 685, 727.    However, the

amendments made by RRA 1998 to section 7430 apply only to costs

incurred or services performed after January 18, 1999.       Id. at

729.    To the extent the claimed costs were incurred on or before

January 18, 1999, we shall apply section 7430 as amended by the
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Taxpayer Relief Act of 1997 (TRA), Pub. L. 105-34, secs. 1285,

1453, 111 Stat. 1038, 1055.

Requirements Under Section 7430

     Under section 7430(a), a judgment for litigation costs

incurred in connection with a court proceeding may be awarded

only 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.

Sec. 7430(a) and (b)(1), (3).    Similarly, a judgment for

administrative costs incurred in connection with an

administrative proceeding may be awarded under section 7430(a)

only if a taxpayer:    (1) Is the "prevailing party"; and (2) did

not unreasonably protract the administrative proceeding.     Sec.

7430(a) and (b)(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)(1) and (2), (c)(1) and (2).

     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).
                                 - 8 -

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

administrative and court proceedings was substantially justified.

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

     Substantial Justification

     The Commissioner's 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).   In other words, to be substantially justified, the

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

and fact.   See Pierce v. Underwood, supra; Rickel v.

Commissioner, 900 F.2d 655, 665 (3d Cir. 1990), affg. in part and

revg. in part on other grounds 92 T.C. 510 (1989).    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 the Equal Access to

Justice Act).   Thus, the Commissioner's position may be incorrect

but nevertheless be substantially justified "'if a reasonable

person could think it correct'".     Maggie Management Co. v.
                                - 9 -

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

Underwood, supra at 566 n.2).

     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 took his

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

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

     The fact that the Commissioner eventually concedes, or even

loses, a case does not establish that his position was

unreasonable.    See 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 remains 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 the Commissioner 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 in light of the substantial
                              - 10 -

justification standard with respect to the recovery of litigation

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

the petition.   See Bertolino v. Commissioner, 930 F.2d 759, 761

(9th Cir. 1991), affg. an unpublished decision of this Court;

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

Ordinarily, we consider the reasonableness of each of these

positions separately.   See Huffman v. Commissioner, 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.   There was no

answer filed in this case.   See Rule 175(b).   There is, however,

no indication that respondent's position changed between the

issuance of the notice of deficiency and the partial concession

by respondent's counsel.

     The issue of whether respondent's positions in the

underlying proceedings were substantially justified shall be

addressed first.   In order to decide whether a position of

respondent was substantially justified, we must review the

substantive merits of the case.

          Reasonable Basis In Fact

     Petitioners do not suggest that respondent applied the wrong

legal standard in taking a position on their documentation of the

loan in 1994 as an explanation of apparent unreported income.

Petitioners argue that respondent's position on the adjustment

was not reasonable in fact based on the evidence they presented.
                              - 11 -

     As to that argument, respondent asserts that it was

incumbent upon petitioners to substantiate the fact and amount of

the loan.   It is reasonable, according to respondent, not to

concede an adjustment until he has received and verified adequate

substantiation for the item in question.   He therefore concludes

that as to the unreported income adjustment, his position was

reasonable when taken and appropriately conceded when

substantiation was provided to Appeals.

     Petitioners argue that they provided to Appeals a copy of a

"loan document" that verifies a $10,000 loan received by them

from petitioner's father.   Mere presentation of a note or "loan

document" may not be sufficient evidence of the existence of such

a loan.   See Sullivan v. Commissioner, T.C. Memo. 1985-217.

Further documentation and testimony might be required.   See Kim

v. Commissioner, T.C. Memo. 2000-83; Coutsoubelis v.

Commissioner, T.C. Memo. 1993-457; Facuseh v. Commissioner, T.C.

Memo. 1988-10; Mahigel v. Commissioner, T.C. Memo. 1983-529;

Adams v. Commissioner, T.C. Memo. 1980-398.

     It is reasonable for respondent to make an adjustment for an

item and refuse to concede the adjustment until he has received

and verified petitioners' substantiation for the amount adjusted.

See Beecroft v. Commissioner, T.C. Memo. 1997-23; Simpson

Financial Servs., Inc. v. Commissioner, T.C. Memo. 1996-317;

McDaniel v. Commissioner, T.C. Memo. 1993-148.
                              - 12 -

     We are persuaded that respondent's position on the

unreported income issue was reasonable.   Respondent's position

was based on petitioners' failure to fully account for the item.

Further, the issue was settled within a reasonable period after

petitioners gave sufficient information to respondent.    See

Harrison v. Commissioner, 854 F.2d 263, 265 (7th Cir. 1988),

affg. T.C. Memo. 1987-52; Wickert v. Commissioner, 842 F.2d 1005

(8th Cir. 1988), affg. T.C. Memo. 1986-277; Ashburn v. United

States, 740 F.2d 843 (11th Cir. 1984); McDaniel v. Commissioner,

supra.

          Reasonable Basis in Law

     According to petitioners, respondent unreasonably determined

that they were not entitled to current deductions for

downpayments on "right to cut" timber contracts.    Petitioners

argue that the payments on the timber contracts were either

amounts subject to regular depletion deductions or depletable

advanced royalty payments deductible for 1994.

     In the case of timber, taxpayers are allowed as a deduction

in computing taxable income, a reasonable allowance for depletion

under regulations prescribed by the Secretary.    See sec. 611.   In

the case of standing timber, the depletion must be computed

solely upon the adjusted basis of the property.     See sec. 1.611-

1(a), Income Tax Regs.   The depletable basis applicable to timber

is contained in section 1.611-3(a), Income Tax Regs. which
                              - 13 -

describes the cost basis provided by section 612, which, in turn,

describes an "adjusted basis" provided by section 1011.   The

adjusted cost basis under section 1011 for determining gain or

loss from the sale of property is the cost basis or other basis

determined under section 1012 adjusted as provided by section

1016.

     Annual depletion deductions are allowed only to the owner of

an "economic interest" in standing timber.    See Palmer v. Bender,

287 U.S. 551, 557 (1933); Georgia-Pacific Corp. v. United States,

648 F.2d 653, 657-659 (9th Cir. 1981); sec. 1.611-1(b)(1), Income

Tax Regs.

     For purposes of this discussion it is assumed that

petitioners' right to cut contracts made them owners of economic

interests in timber in the year at issue.    See International

Paper Co. v. United States, 33 Fed. Cl. 384, 407-409 (1995).      As

owners of economic interests in timber, petitioners would, as

they contend, be entitled to depletion deductions.   That would

not, however, change the result in this case because "The

depletion of timber takes place at the time timber is cut", not

at the time of payment.   Sec. 1.611-3(b)(1), Income Tax Regs.    To

the extent that depletion is allowable in a year with respect to

timber the products of which are not sold during the taxable

year, the depletion allowable is included "as an item of cost in

the closing inventory of such products for such year."    Id.
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     Since, with respect to three of the contracts at issue,

petitioners did not cut the timber in the year that the

downpayment was made, they were not entitled to a current

depletion deduction for the payment.

     Under regulations provided by the Secretary, "advanced

royalties" in the case of mineral deposits and standing timber

may be the subject of depletion deductions.    Sec. 1.612-3(b),

Income Tax Regs.   An advanced royalty is a required payment of

royalties on a specified number of units of timber annually

whether or not cut within the year that may be applied against

the royalties on the timber thereafter cut.    See sec. 1.612-

3(b)(1), Income Tax Regs.   The facts in the record of this case

are not sufficient to support the treatment of petitioners'

downpayments as advanced royalties.     The timber contracts are not

part of the record.   There is no evidence that petitioners'

downpayments were based on a specified "number of units of

timber", or that the downpayments were capable of being applied

to any future royalties, and there were no "annual" payments.

From the facts available in the record, we are unable to find

that petitioners were entitled to treat their downpayments on

timber contracts as advanced royalties.

     Even if petitioners' payments did constitute advanced

royalties, we find no authority for their current deductibility

by petitioners.    Section 1.612-3(b)(1), Income Tax Regs., allows,
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in certain circumstances, the payee receiving the advanced

royalty payments on standing timber to take a depletion deduction

from his gross income in the year the payments are made.      And

section 1.612-3(b)(3), Income Tax Regs., allows the payer of

amounts under a "minimum royalty provision" to deduct them when

paid, but only in connection with mineral property.

        Petitioners' payments are not described in section 1.612-

3(b)(1), or (3), Income Tax Regs., and their downpayments must be

capitalized.      Section 1.631-2(e)(1), Income Tax Regs., requires

that amounts paid for timber cutting rights be treated as the

cost of timber and "constitute part of the lessee's depletable

basis of the timber, irrespective of the treatment accorded such

payment in the hands of the lessor."1

     Once petitioners' counsel presented to respondent's counsel

sufficient evidence that two of the contracts represented

situations where the timber was cut in the same year the payments

were made, respondent conceded the issue within a reasonable

time.       See Harrison v. Commissioner, supra at 265; Ashburn v.

United States, supra; Wickert v. Commissioner, 842 F.2d 1005 (8th


        1
      Generally, sec. 162 requires that an item be paid or
incurred and the benefit exhausted during the taxable year to be
a business deduction. Where the value of the item extends beyond
the taxable year, that is evidence that the expenditure is a cost
of acquisition, a capital item. See Wells Fargo & Co. v.
Commissioner, 224 F.3d 874 (8th Cir. 2000), affg. in part and
revg. in part sub nom. Norwest Corp. v. Commissioner, 112 T.C. 89
(1999); Central Tex. Sav. & Loan Association v. United States,
731 F.2d 1181, 1183 (5th Cir. 1984); see also sec. 1.461-1,
Income Tax Regs.
                              - 16 -

Cir. 1988); McDaniel v. Commissioner, T.C. Memo. 1993-148.

     We find that respondent's positions on the disputed issues

were reasonable positions sufficiently supported by the facts and

circumstances in petitioner's case and the existing legal

precedent.   See Pierce v. Underwood, 487 U.S. 552 (1988).

     Because we find respondent's positions to have been

reasonable, we cannot find petitioners to be "prevailing"

parties, and their motion will therefore be denied.   Because we

find that petitioners are not prevailing parties, we do not

address the other issues raised by respondent.

     To reflect the foregoing,

                                         An appropriate Order

                                    and Decision will be entered.
