                             T.C. Memo. 2017-114



                        UNITED STATES TAX COURT



         THOMAS E. WATTS AND MARY E. WATTS, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent

  RW MANAGEMENT, LTD., JRW MANAGEMENT, LLC, TAX MATTERS
   PARTNER, Petitioner v. COMMISSIONER OF INTERNAL REVENUE,
                             Respondent



      Docket Nos. 18882-13, 19973-13.             Filed June 14, 2017.



      David L. McGee and William V. Linne, for petitioners.

      Clint J. Locke, Edwin B. Cleverdon, and Horace Crump for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      NEGA, Judge: By a notice of deficiency dated May 20, 2013, respondent

determined deficiencies in the Federal income tax of petitioners Thomas E. and

Mary E. Watts (Edwin and Mary Watts) for taxable years 2007, 2008, and 2009
                                        -2-

[*2] (years at issue) and imposed accuracy-related penalties under section 6662 as

follows:1

                                                      Penalty
                       Year         Deficiency      sec. 6662(a)
                       2007          $522,418        $104,484
                       2008           112,317           20,463
                       2009             97,917          19,583

On August 15, 2013, Edwin and Mary Watts timely filed a petition with this Court

for redetermination.

      By notice of final partnership administrative adjustment (FPAA) dated May

28, 2013, respondent recharacterized a $754,077 loss as a capital loss, rather than

an ordinary loss, for the taxable year 2007 of RW Management, Ltd. (RWM), and

imposed an accuracy-related penalty under section 6662. On August 27, 2013,

JRW Management LLC, the tax matters partner for RWM, filed a petition for

readjustment of partnership items under section 6226.

      These cases were consolidated for trial, briefing, and opinion. After

concessions by Edwin and Mary Watts, the following issues remain for decision:


      1
       Unless otherwise indicated, all section references are to the Internal
Revenue Code (Code) in effect for the relevant years. All Rule references are to
the Tax Court Rules of Practice and Procedure. All monetary amounts are
rounded to the nearest dollar.
                                         -3-

[*3] (1) whether petitioners’ losses on the disposal of their interests in EWGS

Partners (Partnership) in tax year 2007 are capital, and (2) whether petitioners are

liable for the section 6662(a) accuracy-related penalty for the years at issue.

                               FINDINGS OF FACT

      Some of the facts have been stipulated and are so found. The stipulation of

facts and the attached exhibits are incorporated herein by this reference.

Petitioners Edwin and Mary Watts resided in Florida at the time that the petition

was filed at docket No. 18882-13. RWM was organized and operated in Fort

Walton Beach, Florida, at the time that the petition was filed at docket 19973-13.

      RWM is a limited partnership. JRW Management, LLC (JRW), serves as its

general and tax matters partner. JRW is a single-member LLC. Ronnie Watts

wholly owns JRW and is the only other partner in RWM.2

A Brief History of Golf

      Brothers Edwin and Ronnie Watts (Watts brothers) founded Edwin Watts

Golf Shops (Golf) in 1968, when they opened a small pro shop concession at the

Fort Walton Beach Golf Club. From the onset, the Watts brothers maintained

close familial control of Golf’s operations. Over the years, owing to the Watts


      2
       For clarity, we distinguish Ronnie Watts, RWM, and JRW only where
necessary. We otherwise refer to all three as Ronnie Watts.
                                         -4-

[*4] brothers’ skill and savvy, Golf developed into a strong regional brand

operating in 40 locations across the Gulf Coast. The Watts brothers owned the

real estate underlying 27 of those locations in addition to Golf’s corporate office

and main warehouse. By 2003 Golf was doing nearly $200 million in annual

sales, employed hundreds, and was attracting the interest of potential buyers and

investors.

      Initially, the Watts brothers were hesitant to sell or surrender control of

Golf, but eventually Wellspring, a private equity firm, proposed an arrangement

they found palatable. Wellspring offered to purchase Golf for roughly $93

million, but to do so in a way which allowed the Watts family to retain an equity

interest: join Wellspring in forming a partnership to wholly own Golf. The offer

also respected the brothers’ ownership of the real estate locations by providing

that Golf would remain the brothers’ paying tenant. Most attractive to the Watts

brothers, however, was Wellspring’s express desire to keep the brothers on board

to manage Golf’s day-to-day operations.

      The Watts brothers agreed to Wellspring’s terms and consummated the deal

in December 2003. On December 2, 2003, Edwin Watts’ wholly owned flow-

through entities, Edwin Watts Holding Co. (EWHC) and Watts Management
                                           -5-

[*5] (WM), formed Partnership, a Delaware partnership.3 Partnership’s exclusive

purpose was to own Golf. On December 4, 2003, Edwin Watts and

Wellspring--through its wholly owned subsidiary WS Golf Acquisitions,

Inc.--executed a purchase agreement wherein Edwin Watts sold Wellspring4 an

80.5% interest in the newly formed Partnership for $93 million. Of that amount,

Edwin reinvested approximately $8 million into Partnership.

      Simultaneously with the execution of the purchase agreement, Edwin Watts

and Wellspring entered into an amended and restated partnership agreement

(agreement) reflecting Wellspring’s purchase and status as the majority owner of

Partnership. The agreement was drafted in accordance with and subject to

Delaware law and governed the partners’ roles, rights, and responsibilities as

partners in Partnership; the agreement recognized both Wellspring and Edwin

Watts as Partnership’s general partners.

Reviewing the Agreement Terms

      The agreement established two classes of partnership interests: preferred

and common. The agreement defined the preferred interests by distinguishing


      3
       For clarity, we distinguish EWHC, WM, and Edwin Watts only where
necessary. We otherwise refer to all three as Edwin Watts.
      4
      Similarly, we distinguish WS Golf Acquisition, Inc., and Wellspring only
where necessary. We otherwise refer to both entities as Wellspring.
                                          -6-

[*6] them from the common interests by way of the rights, powers, and privileges

accorded to the preferred interests. Any partner owning preferred interests was

defined by the agreement to be a “Preferred Partner”.

      Wellspring’s entire 80.5% interest comprised preferred interests. Edwin

owned two tranches of common interests, amounting to 18.5% and 1% of the total

Partnership interests.

Powers of the Preferred Partner

      While the preferred and common classes voted together as a single class, the

two classes diverged by way of the rights, powers, and privileges exclusively

granted to the owner of preferred interests. Those preferred partners held the

power to appoint three of five board members, exclusive rights of first refusal on

resales of Partnership interests, and the ability to convert their preferred interests

to common at their discretion or in the event of an IPO. The agreement also

entitled the preferred partners to exclusive guaranteed annual payments, a

retirement obligation payment, and preferential priority in Partnership liquidating

distributions subordinate to creditors but superior to the common partners.

Greater Than 50% Preferred Stake Powers

      The agreement provided additional rights and powers to preferred partners

owning 50% or more of the outstanding preferred interests. Those partners held
                                           -7-

[*7] the exclusive power to approve or veto any amendment to the agreement, any

issuance of additional Partnership interests, or Partnership’s engagement in any

“Exit/Reorganization” transaction. These preferred partners were also provided

drag-along rights empowering them to force the minority partners to sell their

interests to the preferred partner’s chosen purchaser.

Exit/Reorganization Transactions

      Generally, section 3.4(b) of the agreement defined an exit/reorganization

transaction as one resulting in the conveyance of all or substantially all of

Partnership’s assets, or the consolidation, merger, liquidation, or transfer of

greater than 80% of outstanding Partnership interests. Should Partnership enter an

exit/reorganization transaction, section 3.4(c)(i) of the agreement entitled the

preferred partners party to the transaction to consideration in an amount as

calculated by a formula in section 10.9.

      For the purposes of sections 3.4 and 10.9, the agreement viewed the sale of

the preferred interests in an exit/reorganization as the sale of an equivalent number

of shares in the preferred partner itself, therein defined as the synonymous

“Corporate Partner”.5

      5
      For example: Wellspring’s sale of preferred interests, under the agreement,
would not be treated as a sale of preferred interests but would instead constitute
                                                                        (continued...)
                                          -8-

[*8] The Exit/Reorganization Valuation of the Preferred Partner

      Section 10.9 of the agreement provided that the per share/interest

consideration due a preferred partner under section 3.4 must equal “(A) the sum of

(x) the amount such Corporate Partner would be entitled to obtain under Section

11 at such time if the Partnership were to liquidate, minus the liabilities of the

Corporate Partner, plus (y) the ‘Corporate Partner Excess Value’[6] divided by (B)

the number of outstanding equity securities of such Corporate Partner on the date

of such Transfer”.

Section 11 Providing Liquidation Priority

      Section 11(c) of the agreement provided the priority order for the

distribution of Partnership liquidation proceeds, as applicable for making the

required calculations under sections 3.4 and 10.9. It provided, generally, that

liquidation proceeds first had to be used to satisfy any Partnership debts,

liabilities, and obligations. Any remaining proceeds then had to be used to satisfy


      5
        (...continued)
the sale of an equivalent number of shares in WS Golf Acquisitions, its wholly
owned holding company directly owning the Partnership interests.
      6
       Section 1.1 of the agreement defines “Corporate Partner Excess Value” as
the sum of all cash and “Permitted Temporary Investments” held by the corporate
partner. Section 1.1 defines permitted temporary investments as low-risk
investments, such as Treasuries, CDs, money market accounts, and P-2 or A-2
commercial paper.
                                         -9-

[*9] any accrued but unpaid “Preferred Payment Obligations” (PPO), “Preferred

Retirement Obligations” (PRO), and Preferred Allocations.7 Next, the agreement

entitled the preferred partners to proceeds in amounts equal to their “Initial Capital

Accounts,” reduced by the amounts of any PROs they may have received,

followed by distribution of proceeds to the common partners in amounts equal to

their initial capital accounts. Only once these priority categories were satisfied

would the common and preferred partners share any remaining liquidation

proceeds.

Initial Capital Accounts: A Defined Term

      “Initial Capital Account” was a defined term, or rather a defined value.

Section 1.1 of the agreement defined Wellspring’s initial capital account as $85.5

million, which would be increased by the “Cash Assets” reflected on the “Final

Closing Cash Assets Statement,” as those terms were defined in the purchase

agreement.8 The agreement, referring to the common partners collectively, valued


      7
        As detailed in article VI of the agreement, these provisions appear to
illustrate the agreement’s standard partnership accounting and tax item allocation
practices.
      8
       Again, the term “Purchase Agreement” refers to the separate agreement
wherein Edwin Watts sold Wellspring its 80.5% interest in Partnership for
approximately $93 million. Although the purchase agreement was executed
simultaneously with the agreement and promissory note in the record, petitioners
                                                                    (continued...)
                                        -10-

[*10] Edwin Watts’ Initial Capital Account as $7,945,000, with no provision for

any increase or diminution thereof.9

The Preferred Payment and Retirement Obligations

      Section 12.1 of the agreement entitled the preferred partners to receive

PPOs, which were annual guaranteed payments of 8.4% on the PROs. The

preferred partners were entitled to receive PPOs until the earliest of a partnership

liquidation, the conversion of preferred interests to common interests, an

exit/reorganization transaction, or December 4, 2008.

      Section 12.1 of the agreement also entitled the preferred partners to receive

PROs, a guaranteed payment of $52.75 million. The preferred partners were

entitled to receive PROs upon the earliest of a partnership liquidation, the

conversion of preferred interests to common interests, an Exit/Reorganization

transaction, or December 4, 2008.




      8
       (...continued)
did not offer this agreement into evidence.
      9
        Section 5.2 provided a separate definition for “Capital Account” that
reflected the generally understood definition of that term. There, the capital
account reflected each partner’s initial capital account value increased by any
additional capital contributions made by or gains allocated to that partner,
decreased by losses allocated or distributions made to that partner, maintained in
accordance with Code sec. 704(b).
                                        -11-

[*11] The agreement provided that Partnership could satisfy both the PPO and the

PRO by means of offset against any current obligations owed to Partnership by the

preferred partners. Simultaneously with the execution of the agreement,

Wellspring provided Partnership a promissory note, with principal and interest

terms identical to those of the PPO and the PRO. This was a term note with no

provisions for acceleration, payable on December 4, 2008.

Final Partnership Ownership

      By 2007 a number of the common interests had changed hands. Edwin

Watts’ ownership stake, as held by EWHC and WM, had diminished to 9.2% and

0.5%, respectively. Ronnie Watts, however, now owned 7.76% of the common

interests through RWM. The remaining 2.5% of the common interests were split

between a member of the extended Watts family and a Wellspring-appointed

member of the board of directors.

Wellspring’s Desire to Sell

      In 2006 Wellspring began looking to sell its investment in Partnership.

Wellspring engaged UBS to develop a market for Partnership and vet prospective

purchasers. As UBS developed and then whittled down the buyer pool, it sent

serious inquiries to the Watts family for further engagement. Owing to their

intimate knowledge of Golf’s retail operations and their critical relationships with
                                         -12-

[*12] their vendors and customers, the Watts brothers were an important element

of Wellspring’s sale of its Partnership interest.

      When the market development period ended, only two names surfaced as

serious potential purchasers: Sun Capital (Sun), a private equity firm, and Dick’s

Sporting Goods (Dick’s), a major retailer looking to expand its footprint in the

regional golf market.

      The Watts brothers were unimpressed with Dick’s. While Dick’s expressed

its desire to integrate the Watts brothers and the Golf brand into its own corporate

family, Dick’s representations did not speak to the Watts brothers’ greatest

concerns. The Watts brothers knew the fate awaiting regional chains acquired by

Dick’s: brand extinction, location consolidation, and the elimination of redundant

staff. These outcomes were anathema to the Watts brothers’ principal business

and personal concerns. The Watts brothers still retained ownership of the retail

and business office locations leased to Golf, which provided the family with an

annual income stream of $4.4 million. Additionally, Golf employed hundreds,

many of whom the Watts brothers had known for years and considered family. A

sale to Dick’s meant an undesirable outcome for the Watts brothers.

      A sale to Sun, however, did not present the Watts brothers with the same

concerns. Sun, another private equity firm, was attractive to the brothers for the
                                        -13-

[*13] same reasons Wellspring had won them over years earlier: autonomy in

operating Golf and a continued stream of rental income.

      The Watts brothers voiced to Wellspring their opposition to a sale of the

Partnership to Dick’s. The brothers even threatened to walk away from the

business in protest. Although Sun’s bid was roughly $35 million less than Dick’s

bid of $120 million, the Watts brothers implored Wellspring to sell to Sun.

      Wellspring sold to Sun.10 On May 16, 2007, the collective partners

executed a purchase agreement with Sun (Sun sale). The purchase agreement

provided a nominal purchase price of $85 million, to be adjusted upon closing,

reflective of closing costs, expenses, and Partnership’s final working capital and

indebtedness.

      At the closing, Sun paid $87 million for all of Partnership. Approximately

$43.8 million of that amount came in the form of Sun’s payment of Partnership

      10
          Other than petitioners’ uncorroborated testimony, the record does not
indicate what motivated Wellspring’s decision to sell to Sun. No representative of
Wellspring was called to testify, and no documentation reflecting bids, proposals,
negotiated terms, or agreements were entered into evidence.
        Petitioners’ theory of the case does not reconcile the $35 million difference
between the purported Dick’s and Sun bids. Wellspring held exclusive power to
sell all of Partnership, to drag along the common partners. Petitioners avoided
discussion of Wellspring’s drag-along rights and did not address any potential
damage the Watts brothers’ protests and holdout threats may have inflicted on any
potential sale to Dick’s, and whether this may have resulted in Sun’s effectively
being the buyer of last resort.
                                          -14-

[*14] debts to Regions Bank. Exclusive of fees and other sales expenses, Sun paid

the final $34.6 million in proceeds directly to Wellspring, in cash by wire transfer.

The common partners--including petitioners--received none of these final cash

proceeds.

The Parties 2007 Tax Returns

      The Watts brothers longtime accountant Harry Gates prepared their 2007

individual and entity-level tax returns at issue here. Mr. Gates had served as the

Watts brothers’ primary accountant and adviser for over 35 years, but, he was not

asked to participate in, or consult with them before the Sun sale.

      After the Sun sale closed, the Watts brothers informed Mr. Gates that they

had disposed of their interests in Partnership but that they had received no cash

proceeds from the disposition. They provided Mr. Gates with all documents

relevant to the Sun sale. Mr. Gates determined that the most appropriate manner

of reporting the Watts brothers’ disposal of their Partnership interests, for tax

purposes, was to treat the transaction as an abandonment of their partnership

interests, generating an ordinary loss.

      When respondent selected the Watts brothers’ returns for examination, Mr.

Gates represented petitioners at the administrative level and defended his decision

to treat this as an abandonment. Mr. Gates also credibly testified at trial regarding
                                         -15-

[*15] his treatment of the transaction for tax purposes and the information about

the transaction provided to him by the Watts brothers.

                                      OPINION

I.    Petitioners’ Primary Argument: Substance Over Form

      The parties do not dispute the amounts respondent used in his

determinations, as respondent used the amounts recognized and reported in

petitioners’ returns.11 Instead the deficiency dispute focuses on respondent’s

determinations as to the character of the petitioners’ losses claimed on the disposal

of their Partnership interests.

      In contrast to their original return positions, petitioners invite this Court to

review the totality of the Sun sale in an alternate light. Petitioners assert that they

      11
         Exclusively on brief--in conjunction with their renewed pursuit of ordinary
abandonment losses, addressed, infra, section II--petitioners argue for an increase
in the amounts claimed as bases of their Partnership interests. Petitioners appear
to suggest the bases reported in their initial returns, and used throughout litigation,
are not accurate. Petitioners neither raised in their petitions any error with respect
to basis, nor attempted to present facts or litigate this issue at trial.
       “Issues raised for the first time by brief are not properly before” this Court.
Aero Rental v. Commissioner, 64 T.C. 331, 338 (1975) (citing Nash v. Commis-
sioner, 31 T.C. 569 (1958), and Theatre Concessions, Inc. v. Commissioner, 29
T.C. 754 (1958)). Thus we “will not consider this argument”, as petitioners “had
numerous opportunities to raise this issue, but failed to do so”; and because they
did not do so then, we now deem this argument waived, especially in the light of
the likely prejudice to respondent. Id.; see also DiLeo v. Commissioner, 96 T.C.
858, 891 (1991), aff’d, 959 F.2d 16 (2d Cir. 1992); Armco, Inc. v. Commissioner,
88 T.C. 946, 963 n.8 (1987).
                                        -16-

[*16] agreed to surrender to Wellspring any sale proceeds due them to incentivize

Wellspring’s sale to Sun. Petitioners’ argue this was done with the aim of

preserving their Golf-related stream of rental income and saving the jobs of their

employees (collectively, the incentive theory). Petitioners’ incentive theory argues

that the form of the Sun sale, as documented and originally reported, fails to

comport with its economic reality. Petitioners argue that we can ascertain

economic reality only by looking through the Sun sale. They urge us to examine

the transaction as a series of component steps, and to find the existence of an

undocumented oral agreement with Wellspring.

      Petitioners argue that recognition of the following component steps will

accurately reflect the economic reality of the Sun sale: (1) petitioners orally

offered to surrender their pro rata share of any sale proceeds to Wellspring, in

exchange for Wellspring’s agreement to sell to Sun, an offer that Wellspring

accepted; (2) upon execution of the Sun sale, petitioners contributed their proceeds

to their various flowthrough real estate holding companies; and (3) those

companies instantaneously paid those contributed proceeds to Wellspring,

pursuant to the oral agreement.

      Petitioners argue these transactions resulted in their realization of actual

proceeds from the Partnership sale. Their payments of those proceeds to
                                         -17-

[*17] Wellspring, then, gave rise to the amortizable intangible they seek to

amortize here. We are unmoved by petitioners’ theory.

      When the form of a transaction does not coincide with the economic reality,

the substance of the transaction rather than its form should determine the tax

consequences. Commissioner v. Court Holding Co., 324 U.S. 331, 334 (1945);

Glacier State Elec. Supply Co. v. Commissioner, 80 T.C. 1047, 1053 (1983).

Taxpayers may assert substance-over-form arguments; however, in such situations

taxpayers may face a higher than usual burden of proof. Glacier State Elect.

Supply Co. v. Commissioner, 80 T.C. at 1053-1054. Notwithstanding

respondent’s arguments regarding the application of Commissioner v. Danielson,

378 F.2d 771 (3d Cir. 1967), vacating and remanding 44 T.C. 549 (1965), courts

have long held that taxpayers must adduce “strong proof” to establish at trial their

entitlement to a new position that is at variance with a position reported in their

original returns. Bradley v. United States, 730 F.2d 718, 720 (11th Cir. 1984)

(citing Commissioner v. Nat’l Alfalfa Dehydrating & Milling Co., 417 U.S. 134,

147 (1974)); Ledoux v. Commissioner, 77 T.C. 293, 308 (1981), aff’d per curiam

695 F.2d 1320 (11th Cir. 1983).

      To adopt petitioners’ incentive theory requires us to hold that petitioners

were ab initio entitled to a pro rata share of the proceeds from any sale, that the
                                          -18-

[*18] agreement’s terms provided them an economic entitlement to property or

rights that they could then negotiate to surrender. As discussed below, we reject

petitioners’ theory because it would require us to ignore the unambiguous terms of

the Agreement between petitioners and Wellspring.

       We turn initially to petitioners’ argument that surrendering to Wellspring

their purported entitlement to a pro rata share of the Sun sale proceeds resulted in

the creation of an amortizable intangible.

       A.    Amortizable Intangible

       A taxpayer must capitalize an expenditure when it: (1) creates or improves

a separate and distinct asset, (2) produces a significant future benefit, or (3) is

incurred in connection with the acquisition or creation of a capital asset. Lychuk

v. Commissioner, 116 T.C. 374, 385-386 (2001). Capital expenditures, unlike

ordinary and necessary business expenses, must be recovered over time.

INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992); see also secs. 263, 167,

197.

       The amortization of an expenditure begins with determining the amount of

the capital outlay, establishing the basis to be amortized. Basis is the capital cost

incurred by a taxpayer when buying, creating, or improving an asset. Secs. 167,

197, 1011, 1012. A taxpayer claiming an amortization deduction bears the burden
                                         -19-

[*19] of establishing its depreciable basis for that expense’s account. See Cluck v.

Commissioner, 105 T.C. 324, 337 (1995); Reinberg v. Commissioner, 90 T.C.

116, 139 (1988). Petitioners’ incentive theory relies on the presumption that the

terms of the agreement guaranteed them rights to a pro rata share of the sale

proceeds. It is this share of sale proceeds that they claim to have surrendered,

giving rise to the tax benefit--the recovery of basis--they now seek and bear the

burden of proving.

      B.     Application of Delaware Contract Law

      To determine interests in and rights to property for Federal tax purposes, we

apply the relevant State law. United States v. Nat’l Bank of Commerce, 472 U.S.

713, 722 (1985); Woods v. Commissioner, 137 T.C. 159, 162 (2011). The

agreement between petitioners and Wellspring governed their rights as partners.

Because the agreement contained a choice-of-law provision specifying Delaware

law, we apply the law of that State in interpreting the provisions of the agreement.

      A partnership agreement governed by Delaware law will be interpreted

using principles of contract law. Norton v. K-Sea Transp. Partners L.P., 67 A.3d

354, 360 (Del. 2013). “The primary goal of contract interpretation is to ‘attempt to

fulfill, to the extent possible, the reasonable shared expectations of the parties at

the time they contracted’.” Comrie v. Enterasys Networks, Inc., 837 A.2d 1, 13
                                         -20-

[*20] (Del. Ch. 2003) (quoting U.S. West, Inc. v. Time Warner, Inc., 1996 Del.

Ch. LEXIS 55, at *28-*29 (June 6, 1996)).

      Unless there is an ambiguity in or an internal conflict among contract

provisions, courts must give effect to the parties’ intentions as reflected within the

four corners of the agreement, construing the agreement as a whole and giving

effect to all provisions therein. GMG Capital Invs., LLC v. Athenian Venture

Partners I, L.P., 36 A.3d 776, 779-780 (Del. 2012).

      Ambiguity does not arise “merely because the parties dispute” what the

contract language means. Alta Berkeley VI C.V. v. Omneon, Inc., 41 A.3d 381,

385 (Del. 2012). Ambiguities arise only when the terms of the contract are fairly

susceptible of different interpretations or carry different meanings. GMG Capital

Invs., LLC, 36 A.3d at 780. Ambiguity does not exist when the court can

determine the meaning of a contract without any guide other than a knowledge of

the simple facts on which, from the nature of language in general, its meaning

depends. AT&T Corp. v. Lillis, 953 A.2d 241, 252 (Del. 2008) (citing Lorillard

Tobacco Co. v. Am. Legacy Found., 903 A.2d 728, 739 (Del. 2006)). A contract’s

defined terms will control when they establish the parties’ intent in a manner “that

a reasonable person in the position of either party would have no expectations
                                        -21-

[*21] inconsistent with the contract language.” GMG Capital Invs., LLC, 36 A.3d

at 780.

      C.     Interpreting the Partnership Agreement

             1.    Preferred Status

      The agreement defined a “Preferred Partner” as any partner owning

“Preferred Interests.” Section 3.2 of the agreement defined the preferred interests

by distinguishing them from the common interests by way of the rights, powers

and privileges accorded to the preferred interests. Throughout the agreement

Wellspring was clearly and unambiguously described as the preferred partner, and

its ownership stake comprised preferred interests.

      However, petitioners contend that none of the partners was in a preferred

position and that Wellspring would achieve preferred partner status only when it

paid the Partnership the principal on the $52.75 million promissory note.

Petitioners cite for this proposition section 12.1 of the agreement, the provision

governing the PPO and the PRO.

      Petitioners’ contention runs contrary to the unambiguous terms of the

agreement.12 Nowhere in the agreement were the preferred interests’ status,

      12
       This contention also runs contrary to the facts presented at trial.
Wellspring appointed three of the five members of the board of directors, received
                                                                       (continued...)
                                         -22-

[*22] powers, rights, or privileges subjected to contingency or qualification. Had

petitioners and Wellspring intended to constrain or make contingent any preferred

status, rights or powers, they could have easily done so. They did not. The

meaning of the agreement, in this regard, is obvious.

                2.   Exit/Reorganization and Consideration Thereunder

      As relevant here, section 3.4(b) of the agreement clearly defined an

exit/reorganization transaction as any transaction transferring ownership of 80%

or more of the total Partnership interests. At the time of the Sun sale, Wellspring

owned more than 80% of the total Partnership interests. Wellspring’s divesting

itself of its Partnership interests in the Sun sale constituted an exit/reorganization

transaction. Section 3.4(c) of the agreement provided that, in the event of an

exit/reorganization transaction, any preferred partners participating in the

transaction were entitled to consideration for their interests as calculated under

section 10.9.

      The formula in section 10.9 of the agreement established a per-interest value

for the preferred interests sold in an exit/reorganization transaction. This formula


      12
         (...continued)
offsetting PPO payments, and likely exercised or attempted to exercise its drag-
along rights to trigger the complete sale of the Partnership. Wellspring held and
exercised preferred status and power.
                                         -23-

[*23] established that value as the quotient of (1) the sum of the preferred

partner’s rights to proceeds in a hypothetical Partnership liquidation under section

11 of the agreement, plus or minus (2) the net of certain external variables, all

divided by (3) the outstanding equity interests of the partner itself.

             3.     Section 11: Liquidation Provisions and Priority

      Section 11(c) laid out Partnership’s liquidation distribution priority. In an

actual or constructive liquidation, the preferred partner would receive payment

satisfying any accrued but unpaid PPO,13 PRO,14 outstanding preferred

allocations,15 and the adjusted balance of the preferred partner’s initial capital

account.16 The preferred partner’s liquidation position was subordinate to

Partnership creditors, but superior to that of all common partners.



      13
        As defined in section 12.1, PPOs were an annual 8.4% on the $52.75
million payment made to Wellspring.
      14
        As defined in section 12.1, the PRO constituted a $52.75 million payment
to be made to Wellspring on the earlier of, among others, an exit/reorganization
transaction or December 4, 2008.
      15
         As detailed in article VI of the agreement, these provisions appeared to
illustrate Partnership’s standard accounting and tax practices.
      16
        In addition to the adjustments discussed in, and associated with note 9,
supra, section 11(c) provided a liquidation-specific adjustment to the preferred
partner’s initial capital account, reducing the account value equal to the amount
distributed or offset in satisfaction of the PRO.
                                         -24-

[*24] When the parties closed the sale, Sun paid $43.79 million to Regions Bank,

extinguishing Partnership’s debt. Accordingly, in a hypothetical liquidation

Wellspring’s preferred liquidation positions were no longer subordinate to

Partnership creditors. Assuming arguendo that Partnership owed Wellspring no

accrued but unpaid PPO, PRO, or preferred allocations that might have otherwise

increased the total amount due Wellspring, then Wellspring was entitled to recover

to the greatest extent possible its initial capital account of $85.5 million from the

proceeds of the hypothetical section 11 Partnership liquidation.

             4.     Final Section 10.9 Operation

      We cannot determine Wellspring’s entitlement under section 10.9 as the

record is devoid of any evidence regarding the values for the variables defined in

the agreement that might have increased or decreased the amount of Wellspring’s

entitlement. Petitioners did not provide the Court with any evidence that might

have proven helpful in determining the precise amount of consideration due

Wellspring in the Sun sale.

      In fact petitioners--at trial and on brief--entirely avoid discussing section 10

of the agreement. Petitioners similarly avoid discussing section 3.4, the

liquidation priority provisions, or the impact of any relevant defined terms or

Wellspring’s $85.5 million initial capital account. They made no effort to address,
                                         -25-

[*25] examine, construe or even allege any ambiguity within the terms of the

agreement. Petitioners did not even offer testimony as to their own personal

knowledge and understanding of these provisions. They offered no Partnership

balance sheets, books, audit statements, or other accounting records as evidence or

exhibit. Petitioners called no members of Wellspring or Sun to testify and

corroborate their theory at trial.

      Petitioners’ argument begins with a conclusion: They were entitled to a pro

rata share of the cash proceeds from the Sun sale. It ends there, too. Petitioners’

conclusory presumption runs contrary to the unambiguous wording of the

agreement. Sections 3.4(c) and 10.9 did not provide for a pro rata split; they

provided Wellspring a priority payment for its interests in the event of an

exit/reorganization transaction, by definition the transaction at issue here.

      It is clear to us that these are negotiated contract provisions meant to narrow

the preferred partner’s exposure to risk, as are arguably all the powers conferred

by the agreement on the owners of preferred interests. In the event the marketable

value of Wellspring’s Partnership stake slipped below its initial investment--

reflected in the agreement as its initial capital account value--these provisions

operate to recover Wellspring’s investment to the greatest extent possible, even if

that recovery comes at the expense of the minority partners.
                                         -26-

[*26] We are asked to conclude that petitioners were entitled to a portion of the

cash proceeds from the Sun sale. Because of the lack of material facts, we cannot

ascertain the total proceeds to which the agreement entitled Wellspring in the Sun

sale. And as a corollary, because payment of Wellspring’s priority positions is a

predicate consideration, we cannot surmise what--if any--proceeds petitioners may

have been entitled to.

      Petitioners failed to establish they were entitled to any cash proceeds from

the Sun sale. It follows, then, that petitioners could not offer to surrender such

proceeds to entice or incentivize Wellspring’s sale to Sun.17 Accordingly, the

amortizable expense of petitioners’ incentive theory fails for lack of proof as to

their purported bases.

      We decline to further consider petitioners’ request for amortization. We

need not address whether this purported incentive payment should be capitalized

into the existing leases or other assets, nor whether the purported contractual

agreement between the Watts brothers and Wellspring might have created a

separate and distinctly bargained-for amortizable asset, as petitioners have failed




      17
        Petitioners did not advance any other ostensible source of funding for their
incentive theory (e.g., their own liquid capital, assumption of debts, etc).
                                        -27-

[*27] to meet their burden of proving they incurred the expense underlying the

now-claimed amortization deduction.

      D.     Latent Ambiguities

      Under Delaware law, a latent ambiguity may exist when the seemingly

unequivocal terms of a contract are rendered ambiguous by extrinsic

circumstances to which the contract refers. See Klair v. Reese, 531 A.2d 219, 223

(Del. 1987). Delaware law, however, still requires a determination that a contract

is ambiguous on its face--open to competing reasonable interpretations--before

courts may construe a latent ambiguity and consider extrinsic evidence to aid in

understanding its terms. See Cincinnati SMSA v. Cincinnati Bell Cellular Sys.

Co., 1997 Del. Ch. LEXIS 109, at *11-*18 (1997), aff’d, 708 A.2d 989 (Del.

1998); see also Motors Liquidation Co. v. Allianz Insurance Co., 2013 Del. Super.

LEXIS 605, at *14 (2013); U.S. West, Inc. v. Time Warner Inc., 1996 Del. Ch.

LEXIS 55, at *31 n.10 (1996); Bell Atl. Meridian Sys. v. Octel Commc’ns Corp.,

1995 Del. Ch. LEXIS 156, at *18 n.5 (1995).

      Petitioners contend their incentive theory harmonizes the zero-proceeds

result of the Sun sale with their pro rata entitlement under the agreement; that

Wellspring’s status as a preferred partner was contingent on the repayment of a

promissory note. Petitioners have not invited our attention to any contract
                                            -28-

[*28] language that might support their positions, nor have they presented any

reasonably developed interpretation of any term or provision of the agreement.

As discussed, the provisions of the agreement are unambiguous on their face, and

petitioners’ presumptions are clearly at odds with those provisions. The record

and facts before us offer no hint of latent ambiguity: Objectively, the zero-

proceeds result of the Sun sale does not contradict the terms of the agreement as

applied to the facts presented.

         Consequently, we hold petitioners have failed to satisfy their burden of

proof.

II.      Petitioners’ Alternative Argument: An Abandonment Loss

         On brief petitioners retreat to their original return position,18 arguing that if

we reject their incentive theory, then we must recognize the transaction as an

ordinary abandonment loss under section 165.

         A.    Burden of Proof

         The Commissioner’s determinations are presumed correct, and taxpayers

generally bear the burden of proving entitlement to the deductions they claim.

         18
        Other than mentioning it as an afterthought--as the last sentence in
petitioners’ opening statement--this argument appears nowhere else in the record.
Petitioners did not present any evidence as to this contention at trial. Arguably,
petitioners abandoned this argument before petitioning this Court for
redetermination.
                                         -29-

[*29] Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933); INDOPCO, Inc.

v. Commissioner, 503 U.S. 79, 84 (1992). In certain circumstances, the burden of

proof shifts to the Commissioner when a taxpayer introduces credible evidence

with respect to any relevant factual issue. Sec. 7491(a)(1). Petitioners do not

contend, and the record does not establish, that we ought shift to respondent the

burden as to any issue of fact. We therefore decline to do so.

      B.     Section 741 or Section 165?

      Generally, section 741 requires that taxpayers recognize as capital all gains

or losses realized in the sale or exchange of a partnership interest--except to the

extent section 751 applies.19 To the extent that a noncorporate taxpayer incurs

capital losses, the taxpayer may deduct those capital losses currently against

capital gains and up to $3,000 of ordinary income. Secs. 165(f), 1211(b). Section

165(a) provides taxpayers ordinary loss deductions for abandonment losses. To

qualify for an abandonment loss, a taxpayer must demonstrate that: (1) the

transaction under review does not constitute a sale or exchange and (2) he or she

abandoned the asset, intentionally and affirmatively, by overt act. Sec. 1.165-2,


      19
        Neither party raised any argument nor presented any evidence of
unrealized receivables or inventory held by the Partnership, foreclosing our
consideration of any portion of a potential loss receiving ordinary treatment under
sec. 751.
                                        -30-

[*30] Income Tax Regs.; see Citron v. Commissioner, 97 T.C. 200, 209-215

(1991) (citing Middleton v. Commissioner, 77 T.C. 310, 319-324 (1981), aff’d,

693 F.2d 124 (11th Cir. 1982)).

      Subject to the prohibition on sales or exchanges giving rise to ordinary

abandonment losses, partnership interests may be abandoned. Echols v.

Commissioner, 935 F.2d 703 (5th Cir. 1991), rev’g and remanding 93 T.C. 553

(1989); Citron v. Commissioner, 97 T.C. at 213.

      When a partner is relieved of his or her share of partnership liabilities, the

partner is deemed to receive a distribution of cash. Sec. 752(b). Section 731(a)

requires distributions to partners to be treated as payments arising from the sale or

exchange of a partnership interest. Secs. 752(b), 731(a); Citron v. Commissioner,

97 T.C. at 214-215 n.11. Thus, ordinary abandonment losses may arise only in a

narrow circumstance where the partner: (1) was not personally liable for the

partnership’s recourse debts or (2) was limited in liability and otherwise not

exposed to any economic risk of loss for the partnership’s nonrecourse liabilities.

See sec. 752(b), (d); sec. 1.752-3, Income Tax Regs.; see also Commissioner v.

Tufts, 461 U.S. 300 (1983).

      Respondent determined petitioners’ disposal of their Partnership interests

did not fall within these narrow exceptions. Accordingly, respondent
                                         -31-

[*31] recharacterized petitioners’ losses from ordinary abandonment losses to

capital losses on the sale or exchange of the interests.

      In contesting this determination, petitioners were tasked with the burden of

proving respondent’s determination incorrect. Petitioners have not met this

burden. Petitioners presented no documentary or testimonial evidence to establish

their eligibility for an abandonment loss deduction. Petitioners failed to prove

their individual shares of any Partnership liabilities, capital restoration obligations,

or lack thereof, in the light of documentary evidence suggesting otherwise.

Additionally, petitioners did not offer any evidence or analysis as to how their

actions constituted an intentional and overt manifestation of abandoning their

Partnership interests.

      In nearly every filing with the Court, and at trial, petitioners repeatedly

characterized the abandonment loss positions taken on their returns as erroneous.20

To that extent, we agree. Accordingly, respondent’s determination is sustained.




      20
         For example: Petitioners stipulated that they were “not entitled to ordinary
losses” on the “sale of their partnership interests in EWGS” and that they are
“liable for capital gains on the sale of their” Partnership interests.
                                          -32-

[*32] III.   The Section 6662 Penalty

      A.     Generally

      Section 6662(a) and (b)(1) and (2) imposes a penalty in an amount equal to

20% of the portion of an underpayment attributable to negligence, disregard of

rules or regulations, or a substantial understatement of income tax. This accuracy-

related penalty will not apply to any portion of an underpayment for which a

taxpayer establishes that he or she had reasonable cause and acted in good faith.

Sec. 6664(c)(1).

      In the notice of deficiency issued to petitioners Edwin and Mary Watts,

respondent determined they were liable for the section 6662 penalty for all three of

their years at issue. In the FPAA respondent determined petitioner RWM was also

liable for the section 6662 penalty, as related to its sale of Partnership interests.

      The determination of whether petitioners acted with reasonable cause and in

good faith is made on a case-by-case basis, taking into account all the pertinent

facts and circumstances, including their efforts to assess their proper tax liability,

their knowledge and experience, and the extent to which they relied on the advice

of a tax professional. See sec. 1.6664-4(b)(1), Income Tax Regs.

      As to RWM, this determination is made at the partnership level, taking into

account the state of mind of the general partner. Superior Trading, LLC v.
                                         -33-

[*33] Commissioner, 137 T.C. 70, 91 (2011), aff’d, 728 F.3d 676 (7th Cir. 2013).

Ronnie Watts, as the sole “owner” of the partners of RWM, was the only

individual with authority to act on behalf of RWM, and thus his actions are

pertinent in establishing a reasonable cause defense for RWM.

      Whether a taxpayer has reasonable cause within the meaning of section

6664(c) may depend upon whether the taxpayer exercised “ordinary business care

and prudence” in relying on the tax advice of his or her chosen professional.

Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 98-99 (2000), aff’d,

299 F.3d 221 (3d Cir. 2002).

      B.     Reasonable Cause and Good Faith

      We understand petitioners to contend that no penalty should be imposed

against them, with respect to their losses on the sale of their Partnership interests,

because their initial return position was taken with reasonable cause and in good

faith, or more particularly, in reliance on the advice of their longtime accountant,

Mr. Gates.

      Mr. Gates credibly testified that petitioners provided him with all pertinent

facts and materials necessary to accurately report their tax liabilities on the sales of

their Partnership interests. Mr. Gates testified his research led him to determine

they could report the disposition as an abandonment loss of ordinary character, a
                                         -34-

[*34] position Mr. Gates defended as their representative throughout their pre-

petition administrative proceedings.

         While Mr. Gates’ determination was incorrect, it was reasonable and

prudent for petitioners to rely on his advice and direction as to the intricate subject

matter at hand. Mr. Gates served as their accountant and adviser for over 30 years,

and had sufficient experience and expertise in the field to justify his retention by

the Watts family and their reliance on his professional opinion. We hold that

petitioners are not liable for the section 6662(a) penalty for the portion of the

underpayment arising from the erroneous reporting of the sale of their Partnership

interests in 2007. See Walker v. Commissioner, T.C. Memo. 2016-159, at *10-

*12; see also Rawls Trading, L.P. v. Commissioner, T.C. Memo. 2012-340.

         In reaching our holdings, we have considered all arguments made, and, to

the extent not mentioned above, we conclude they are moot, irrelevant, or without

merit.
                                   -35-

[*35] To reflect the foregoing,


                                          Decision will be entered for

                                  respondent in docket No. 19973-13, except

                                  with respect to the accuracy-related penalty

                                  under section 6662(a).

                                          Decision will be entered under

                                  Rule 155 in docket No. 18882-13.
