                           120 T.C. No. 16



                     UNITED STATES TAX COURT



     WILLIAM T. GLADDEN AND NICOLE L. GLADDEN, Petitioners
        v. COMMISSIONER OF INTERNAL REVENUE, Respondent*



    Docket No. 16932-97.               Filed June 27, 2003.



          Held: Where petitioners made a “qualified offer”
     under sec. 7430(c)(4)(E), I.R.C., on a substantive tax
     adjustment and thereafter litigation occurred and court
     determinations were made on arguments or issues
     relating to the substantive tax adjustment and where
     the parties ultimately entered into a settlement of the
     substantive tax adjustment, the “settlement limitation”
     on qualified offers that is set forth in sec.
     7430(c)(4)(E)(ii)(I), I.R.C., is not applicable.



     William L. Raby, for petitioners.

     Rachael J. Zepeda, for respondent.



*
     This Opinion supplements Gladden v. Commissioner, 112 T.C.
209 (1999), revd. and remanded 262 F.3d 851 (9th Cir. 2001).
                               - 2 -

                       SUPPLEMENTAL OPINION

     SWIFT, Judge:   This matter is before us on petitioners’

motion for partial summary judgment as to the applicability of

the qualified offer provision of section 7430(c)(4)(E).

Petitioners seek a recovery of litigation costs relating to a

Federal income tax deficiency adjustment determined by respondent

with respect to income to be charged to petitioners on

termination of water rights (water rights adjustment).

     Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the year in issue.

     Under the qualified offer provision of section

7430(c)(4)(E), petitioners seek to obtain an award of litigation

costs that they incurred after May 12, 1999, the date on which

petitioners made a qualified offer to respondent to settle the

water rights adjustment.1

     Relying on the “settlement limitation” set forth in section

7430(c)(4)(E)(ii)(I), respondent argues that the ultimate


1
     At this point, it is not clear whether petitioners also (or
in the alternative) will be seeking the recovery of litigation
costs relating to the water rights adjustment under the general
litigation cost recovery provisions of sec. 7430. In any event,
petitioners acknowledge that, under the qualified offer provision
of sec. 7430(c)(4)(E), they are entitled to recover only
litigation costs incurred after May 12, 1999, the date on which
petitioners made their qualified offer to respondent. The
parties suggest that once the issue raised in the instant motion
is resolved, they likely will be able to settle other aspects of
petitioners’ motion for litigation costs.
                              - 3 -

settlement by the parties, on remand to us from the Court of

Appeals for the Ninth Circuit, of factual issues relating to the

water rights adjustment precludes the application of the

qualified offer provision.

     In our prior Opinion in this case, Gladden v. Commissioner,

112 T.C. 209, 217-226 (1999), also involving the water rights

adjustment and the parties’ cross-motions for partial summary

judgment, we held in favor of petitioners that, as a matter of

law, the water rights owned by petitioners constituted capital

assets and the relinquishment thereof by petitioners in exchange

for monetary distributions constituted a taxable sale or exchange

(capital asset issues).

     In the same opinion and in the context of the same cross-

motions for partial summary judgment, we held in favor of

respondent that, as a matter of law, petitioners were not

entitled to allocate any portion of their cost basis in the

underlying land (which petitioners had acquired prior to

acquiring the water rights) to their tax basis in the water

rights (legal allocation issue). Id. at 226-230.2

     Because of our determinations on cross-motions for partial

summary judgment of the capital asset issues and of the legal


2
     The water rights and the land actually were owned by a
partnership in which petitioners had an interest. For
convenience herein, we refer to the water rights and the land as
if owned by petitioners.
                                - 4 -

allocation issue, each of which related to the water rights

adjustment, in our prior opinion we did not address the related

factual issue as to what amount of petitioners’ cost basis in the

land might be allocable to petitioners’ tax basis in the water

rights.

     On May 12, 1999, after our above opinion was filed in April

of 1999, petitioners made a “qualified offer” to respondent to

settle the water rights adjustment, which offer respondent did

not accept.   On October 20, 1999, a decision was entered in this

case in which we redetermined petitioners’ tax deficiency based

on our prior opinion on summary judgment and on a stipulation

filed by the parties settling remaining issues.

     On January 5, 2000, petitioners filed an appeal with the

Court of Appeals for the Ninth Circuit with regard to our partial

summary judgment in favor of respondent on the legal allocation

issue.    Respondent did not appeal our partial summary judgment in

favor of petitioners on the capital asset issues.

     On August 20, 2001, the Court of Appeals for the Ninth

Circuit in Gladden v. Commissioner, 262 F.3d 851 (9th Cir. 2001),

reversed our partial summary judgment in favor of respondent on

the legal allocation issue and concluded that petitioners may be

entitled to allocate some portion of their cost basis in the land

to their tax basis in the water rights.   Because the trial record

had not been developed on aspects of that factual allocation
                              - 5 -

issue, the Court of Appeals remanded the case to us for a

determination of that factual issue.   Id. at 856.

     Upon remand, petitioners and respondent entered into renewed

settlement negotiations of the water rights adjustment, and on

September 12, 2002, petitioners and respondent agreed to a final

settlement of all aspects of the water rights adjustment under

which petitioners’ Federal income tax liability relating to the

sale of their water rights will be less than what it would have

been under petitioners’ qualified offer that petitioners made in

May of 1999.

     For a discussion of aspects of the qualified offer provision

of section 7430(c)(4)(E), see Haas & Associates Accountancy Corp.

v. Commissioner, 117 T.C. 48, 54-63 (2001), affd. 55 Fed. Appx.

476 (9th Cir. 2003).

     Respondent now claims that, as a matter of law, the

settlement limitation reflected in section 7430(c)(4)(E)(ii)(I)

is applicable to petitioners’ May 12, 1999, qualified offer.

Generally, under the settlement limitation of section

7430(c)(4)(E)(ii)(I), where the parties settle a tax adjustment

rather than litigate and obtain a court determination of the

adjustment, the qualified offer provision will not apply.
                                 - 6 -

     The specific statutory language in section 7430(c)(4)(E)

reflecting the settlement limitation to the qualified offer

provision provides as follows:


     (ii).    Exceptions.--This subparagraph shall not apply to–-

             (I) any judgment issued pursuant to a settlement;


     Respondent argues that this statutory language means that

the ultimate resolution of a disputed tax adjustment pursuant to

“any” settlement disqualifies a taxpayer’s qualified offer from

being treated as such.

     Petitioners contend that the above settlement limitation on

qualified offers should not apply where, as in the instant case,

a disputed tax adjustment is involved in litigation and is

resolved by settlement between the parties only after a court has

decided arguments and issues relating to the adjustment.     Here,

petitioners emphasize that the water rights adjustment was

resolved by the parties by settlement only after this Court had

rendered its opinion on the capital asset issues and on the legal

allocation issue and only after the Court of Appeals for the

Ninth Circuit had rendered an opinion on the legal allocation

issue, each of which was part and parcel of respondent’s water

rights adjustment.

     In support of their position, petitioners cite the policy

underlying the qualified offer provision and respondent’s
                               - 7 -

temporary regulations under section 7430(c)(4)(E).    With regard

to the policy argument, petitioners quote from the Senate report

associated with section 7430(c)(4)(E) as follows:


          The Committee believes that settlement of tax
     cases should be encouraged whenever possible.
     Accordingly, the Committee believes that the
     application of a rule similar to FRCP 68 is appropriate
     to provide an incentive for the IRS to settle
     taxpayers’ cases for appropriate amounts, by requiring
     reimbursement of taxpayer’s costs when the IRS fails to
     do so. [S. Rept. 105-174, at 48 (1998), 1998-3 C.B.
     537, 584.]


     Petitioners emphasize the purpose underlying rule 68 of the

Federal Rules of Civil Procedure, namely, to encourage

settlements and to reduce litigation.   Fed. R. Civ. P. 68,

Advisory Committee’s Note, 1946 Amendment, 28 U.S.C. app. at 801-

802 (2000); Marek v. Chesny, 473 U.S. 1, 5-7 (1985); Delta Air

Lines, Inc. v. August, 450 U.S. 346, 352 (1981).

     Although technically applicable only to qualified offers

made in administrative and court proceedings after January 3,

2001, petitioners emphasize that the temporary regulations

promulgated under section 7430 support their interpretation of

section 7430(c)(4)(E)(ii)(I) because the temporary regulations

provide that the settlement limitation will apply only where the

settlement occurs and the judgment is entered “exclusively”

pursuant to a settlement.   Sec. 301.7430-7T(f), Temporary Proced.

& Admin. Regs., 66 Fed. Reg. 730 (Jan. 4, 2001).    Section
                                - 8 -

301.7430-7T(a), Temporary Proced. & Admin. Regs., 66 Fed. Reg.

726 (Jan. 4, 2001), provides, in part, as follows:


     The provisions of the qualified offer rule do not apply
     if the taxpayer’s liability under the judgment * * * is
     determined exclusively pursuant to a settlement * * *
     [Emphasis supplied.]


     We agree with petitioners.    The purpose underlying the

qualified offer provision of section 7430(c)(4)(E), like that of

rule 68 of the Federal Rules of Civil Procedure, is to encourage

settlements by imposing litigation costs on the party not willing

to settle.    Herein, legal issues integral to the water rights

adjustment were litigated and decided by this Court and by the

Court of Appeals for the Ninth Circuit.    Only after those legal

issues were litigated and decided was the bottom-line substantive

tax adjustment resolved by way of settlement between the parties.

The ultimate settlement entered into by the parties herein can in

no way be viewed as entered into exclusively pursuant to a

settlement.

     To treat the instant water rights adjustment as resolved

pursuant to the parties’ settlement would require us to ignore

the threshold legal issues relating thereto that were resolved by

way of litigation, not settlement, and would require us to treat

the related factual allocation issue eventually settled by the

parties as controlling for purposes of the settlement limitation

of section 7430(c)(4)(E)(ii)(I).    Further, it would require us
                              - 9 -

to isolate the factual allocation issue that was settled and to

treat it as distinct from the legal issues relating to the water

rights that were litigated and that were not settled and each of

which involved the same underlying substantive tax adjustment.

     The decision to be entered in this case on the water rights

adjustment will be entered not simply “pursuant to” a settlement,

but also “pursuant to” our holdings on the capital asset issues

(decided in favor of petitioners and not appealed) and “pursuant

to” the Court of Appeals’s holding on the legal allocation issue

that was appealed and resolved in favor of petitioners.   In

particular, we note that the appellate litigation and the Court

of Appeals for the Ninth Circuit’s holding relating to the legal

allocation issue occurred after petitioners’ qualified offer was

made to respondent on May 12, 1999.3

     Herein, because legal arguments and issues relating to the

water rights adjustment were litigated and decided by a court,

not by settlement, the judgment to be entered herein with regard

to the water rights adjustment is not to be regarded as issued

merely pursuant to a settlement, and petitioners’ qualified offer

with regard to the water rights adjustment is not limited by the



3
     We do not have before us the situation where no court
determinations were made on any issues relating to a substantive
tax adjustment after a qualified offer was made and where the
pending issues and related tax adjustment were all settled
without any court determinations being obtained after the
qualified offer was made.
                                - 10 -

settlement limitation on qualified offers that is set forth in

section 7430(c)(4)(E)(ii)(I).    Petitioners qualify as a

prevailing party under section 7430(c)(4) by reason of section

7430(c)(4)(E).

     To reflect the foregoing,


                                      An appropriate order will

                                 be issued.
