                       T.C. Memo. 2001-144



                     UNITED STATES TAX COURT



      GREG McINTOSH AND SHEILA R. McINTOSH, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 15076-99.             Filed June 19, 2001.


     Greg McIntosh and Sheila R. McIntosh, pro sese.

     Paul L. Dixon, for respondent.




             MEMORANDUM FINDINGS OF FACT AND OPINION



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

petitioners' Motion for Award of Administrative and Litigation

Costs filed pursuant to section 7430 and Rule 231.   All

references to section 7430 are to that section as in effect at

the time the petition was filed.   Unless otherwise stated, all
                               - 2 -

other section references are to the Internal Revenue Code in

effect for the years in issue, and all Rule references are to the

Tax Court Rules of Practice and Procedure.

     Respondent has filed a response to petitioners' motion.

Respondent agrees that petitioners:    (a) Have substantially

prevailed with respect to the amount in controversy, (b) meet the

net worth requirements as provided by law, (c) have exhausted

their administrative remedies, (d) have not unreasonably

protracted the administrative or Court proceedings, and (e) have

claimed a reasonable amount of costs.

     Respondent does not agree, however, that his positions in

the administrative or Court proceedings were not substantially

justified.   The issue for decision, therefore, is whether

respondent's positions in the underlying proceedings were

substantially justified.

     Although petitioners initially requested a hearing in this

case, the parties have agreed upon a stipulation of facts.      We

conclude that a hearing is not necessary to decide this motion.

See Rule 232(a)(2).   Accordingly, we rule on petitioners' motion

for administrative and litigation costs on the basis of the

parties' submissions and the record in this case.

     Petitioners resided in Shasta Lake, California, at the time

they filed their petition.
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                         FINDINGS OF FACT

     Petitioners were notified by letter dated October 20, 1997,

addressed to their accountant, William Brown, that their Federal

income tax returns for 1995 and 1996 were to be examined by the

Internal Revenue Service (IRS).   At the same time, the IRS issued

a Form 4564, Information Document Request (IDR), related to those

years' returns.   Petitioners' Federal income tax return for 1994

was already under examination by the IRS, and some of the

information listed in the IDR of October 20, 1997, relates to tax

year 1994.

     The IDR was directed at obtaining books and records

concerning petitioners' home-building income and expenses for

1994 through 1996 reported on Schedules C, Profit or Loss From

Business; underlying documentation of various Schedule C items;

business and personal bank statements and canceled checks for

1993 through January 31, 1997; and documentation for the sale of

a personal residence and for real estate taxes for 1996.

     On April 16, 1998, the IRS issued another IDR requesting

essentially the same information except with more specificity for

certain Schedule C items.

     On June 4, 1998, the examining agent met with Mr. Brown and

Greg McIntosh (petitioner).   At the meeting petitioner discussed

his wage activities and his Schedules C activity.   Petitioner was

employed as a dispatcher from March 1993 through July 1995 and

was unemployed between July 1995 and May 1996.   Between May and
                                - 4 -

October 1996, petitioner was a firefighter.   In December 1996

petitioner worked "at Saint Elizabeth's in Red Bluff".

     Petitioner told the examiner that he was also in the

business of building and selling houses.    Before 1994 petitioners

had not been involved in building houses.   It was determined that

petitioners did not have a contractor's license and performed no

contracting work personally; they worked through subcontractors.

Petitioners maintained no set of books and failed to provide an

accounting of the expenses associated with their home-building

activity.   Petitioner, however, did present some folders

containing receipts and canceled checks related to the building

of a house on Montana Avenue in Shasta Lake, California, and to

the construction of a house on Vallecito Street in Shasta Lake,

California.   Among the items in the folders was a canceled check

in the amount of $11,104.67 payable to the "US Bank".

     In 1994, petitioners, in a part sale and part gift

transaction, acquired land located at 4511 Vallecito Street in

Shasta Lake, California (Vallecito property), from Sheila

McIntosh's parents.   They had a house built on the property that

they sold in 1996.    Petitioners reported on Schedule C the income

and expenses from the Vallecito property.   They acquired another

piece of property, the "Oasis Road" property, from "a

grandmother" on which they built a house they intended to sell

but had not sold at the time of the income tax examination.
                                - 5 -

Petitioners bought no property from unrelated third parties on

which to build houses for sale.

     After the June 4, 1998, meeting with petitioner and

Mr. Brown, the examining agent made no further request for the

items included in the previously issued IDR's but did make

certain third parties contacts.

     On January 15, 1999, the IRS issued to petitioners a report

of proposed adjustments to their Federal income taxes for 1995

and 1996.    The examining agent's letter enclosing the report

states that she obtained information indicating that petitioners

had lived on the Vallecito property and concludes that "I have

not received adequate information to justify that you are in a

business."   The letter further informs petitioners that the loss

for 1995 has been disallowed, and the small profit for 1996 has

been "reversed out".    Mr. Brown met with the examining agent to

discuss the proposed adjustments and later provided the agent

some additional information.

     The additional information was in the form of a letter, with

enclosures, dated February 11, 1999.    The letter primarily

addresses the issue of whether the Vallecito property was

petitioners' personal residence or was held for sale in the

ordinary course of business.    The letter recites petitioners'

position that it was not their personal residence.    Petitioners

admit in the letter, however, that they used the Vallecito

property as an office from February to October 1995, that they
                               - 6 -

stored their furniture in the house, that the property was

occupied by petitioners' cousin from December 1995 through March

1996, and that the house was covered by a homeowner's insurance

policy in their names.   The letter, however, enclosed other

letters written by third parties that were intended to show that

petitioners had not used the house as a personal residence.

     Respondent, on the other hand, had obtained third party

information suggesting that petitioners had resided in the

Vallecito property.   Respondent also obtained a "Real Estate

Transfer Disclosure Statement" signed by petitioners on July 19,

1995, indicating that the sellers, petitioners, were occupying

the property.

     On May 5, 1999, the examining agent asked petitioners to

agree to extend the period for the assessment of income tax.

Through Mr. Brown, in a letter dated May 10, 1999, petitioners

declined to extend the period for assessment.

     A statutory notice of deficiency for the years 1995 and

1996, along with a very detailed explanation of the items of

adjustment to petitioners' income, was issued on July 21, 1999.

     Mr. Brown sent to the IRS a letter dated September 2, 1999,

with enclosures.   The enclosures were intended to be

"documentation for two issues that were raised in the Notice of

Deficiency and one issue being raised by the taxpayers".   Among

the enclosures was documentation showing that petitioners had in

March 1996 contracted to sell the Vallecito property to
                                - 7 -

petitioners's cousin and his wife, Keith and Renee McIntosh.      In

addition, petitioners provided verification for property taxes

paid in 1995 and legal and professional fees paid in 1996.

     The enclosures further included a copy of an escrow

statement dated August 30, 1994, from the Fidelity National Title

Insurance Company of California (Fidelity National) for "PROPERTY

ADDRESS:   AP #007-060-04" crediting petitioners with a deposit of

$11,104.67 (the same amount as the "US Bank" check mentioned

above).    Petitioners also enclosed a copy of a handwritten

receipt to petitioners from Fidelity National dated August 29,

1994, in the amount of $11,104.67, naming "US Bank" as "maker".

The items were submitted as verification of a portion of the cost

of goods sold claimed on the Schedules C for 1996.

     The petition in this case was filed on September 16, 1999.

The Court filed respondent's answer on October 26, 1999.

Mr. Brown faxed additional information to the IRS Office of

Appeals (Appeals) on November 11, 1999.    The information was

related to petitioners' 1994 tax year.    Mr. Brown settled the

1994 tax issues with the IRS, and he considered the "auto,

property taxes, and insurance" issues to be "carryover" issues

from the settlement to 1996.

     In a letter to Mr. Brown dated November 17, 1999, Appeals

requested additional information about the settlement of the

1994 "carryover" adjustments and additional information to verify

insurance and interest expenses.    Appeals also requested
                                - 8 -

additional information on the Vallecito property, including

verification that the escrow statement referencing the $11,104.67

deposit related to the Vallecito property and not to another.

The letter also states that "there appears to be conflicting

evidence as to whether the taxpayers resided in the Vallecito

property."

     On January 11, 2000, Appeals faxed to Mr. Brown an offer in

settlement of the disputed items for the 1995 and 1996 tax years.

A number of items were included in the settlement.     Among those

agreed upon was the cost of goods sold adjustment for 1996 of

$8,412.   It was reduced by $9,097, the US Bank check amount of

$11,104.67 less $2,008.06 of expenditures previously allowed as

capital items that for settlement purposes were to be allowed as

expense deductions in 1995.    Under the proposed settlement, the

1996 adjustment for legal and professional fees of $625 would be

conceded by the IRS as well as the utilities adjustment of $547

for 1995.    The letter makes an inquiry as to:   "What is the

additional $153 of utilities (700-547)?"    That same day the

parties participated in a telephone conference regarding the

settlement offer.

     A revised settlement offer was accepted on January 19, 2000.

On February 10, 2000, the Court issued its notice setting

petitioners' case for trial at the May 4, 2000, trial calendar in

Reno, Nevada.    The documents embodying the settlement agreement

were signed by petitioners on February 22, returned to
                               - 9 -

respondent's counsel March 28, and signed by respondent's counsel

and sent to the Tax Court on April 10, 2000.

     Under the settlement agreement between the parties, the

amounts proposed in the Appeals letter of January 11, 2000, for

cost of goods sold and legal and professional fees for 1996 were

accepted.   The utilities expense adjustment for 1995 of $547 was

reduced by $700 under the agreement.

     The parties have stipulated that petitioners take the

position that respondent was not substantially justified in

making adjustments to petitioners':    (a) Deduction of certain

utilities expenses for 1995; (b) deduction of a portion of car

and truck, insurance, office, and utilities expenses for 1995;

(c) claim of a portion of cost of goods sold for 1996; and (d)

deduction of legal and professional fees for 1996.
                                - 10 -

                                OPINION

     We apply section 7430 as most recently amended by Congress

in the Internal Revenue Service 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.    See id. sec. 3101(g), 112 Stat. 729.   To the extent the

claimed costs were incurred on or before January 18, 1999, we

shall apply section 7430 as amended by the Taxpayer Relief Act of

1997, 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
                              - 11 -

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).

Respondent concedes that petitioners have satisfied the

requirements of section 7430(c)(4)(A).   Petitioners have

nevertheless failed 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,

on the basis of 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
                                - 12 -

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.

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.
                               - 13 -

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 in light of 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); 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.    In the

present case, however, we need not consider two separate

positions because there is no indication that respondent's

position changed between the issuance of the notice of deficiency

(on July 21, 1999) and the filing of the answer to the petition

(on October 26, 1999).   See Swanson v. Commissioner, 106 T.C. 76,

87 (1996).

     In order to decide whether respondent's position was

substantially justified, we must review the substantive merits of

the case.
                                - 14 -

          Reasonable Basis in Fact

     Petitioners do not suggest that respondent applied the wrong

legal standard in taking positions on their documentation of cost

of goods sold for 1995, capitalized costs from 1994, legal and

professional expenses for 1996, and utilities expenses for 1996.

Petitioners argue that respondent's positions on those

adjustments were not reasonable in fact based on the evidence

they presented.

     As to that argument, respondent asserts that it was

incumbent upon petitioners to substantiate the amounts and

purposes of the items claimed.    It is reasonable, according to

respondent, not to concede adjustments until he has received and

verified adequate substantiation for the items in question.     He

therefore concludes that as to the four stated adjustments, his

position was reasonable when taken and appropriately conceded

when substantiation was provided to Appeals.    The Court agrees.

     Taxpayers are required to maintain books and records in

accordance with rules and regulations prescribed by the

Secretary.   See sec. 6001.   Generally, taxpayers must "keep such

permanent books of account or records, including inventories"

sufficient to establish gross income, deductions,    or other

matters required to be shown on the return.    Sec. 1.6001-1(a),

Income Tax Regs.   Accounting records include the taxpayer's

regular books and other records and data necessary to support

entries on books and returns.    See sec. 1.446-1(a)(4), Income Tax
                                  - 15 -

Regs.     Such books and records should properly classify

expenditures as between capital and expense.     See sec. 1.446-

1(a)(4)(ii), Income Tax Regs.

     Petitioners did not maintain a set of books and failed to

provide an accounting of the expenses associated with their home-

building activity.     Although petitioners presented some folders

containing receipts and canceled checks related to the building

of the Vallecito property, they were intermingled with those from

the construction of a personal home on Montana Avenue, Shasta

Lake, California.     In an attempt to verify the amounts shown on

petitioners' returns, respondent's agent had to reconstruct the

costs incurred in acquiring and constructing the Vallecito

property.

             Cost of Goods Sold

        Any amount claimed as cost of goods sold must be

substantiated.     See sec. 6001; Ranciato v. Commissioner, T.C.

Memo. 1993-536.     Among the items in the folders presented by

petitioners during the examination was a canceled check in the

amount of $11,104.67 payable to the "US Bank".     It was not

readily apparent that the US Bank check represented an amount

associated with the cost of acquiring or constructing the

Vallecito property.     It was only after the notice of deficiency

was issued on July 21, 1999, that petitioners supplied on

September 2, 1999, a copy of an escrow statement indicating that

petitioners had made a deposit for an unnamed property in the
                               - 16 -

amount of $11,104.67.   The property for which the escrow deposit

was made was not identified in a way that was understandable to

the examining Internal Revenue agent ("PROPERTY ADDRESS:     AP

#007-060-04").

     Appeals later requested on November 17, 1999, identifying

information for the purchase and sale of the Vallecito property.

The identifying information must therefore have been received

sometime after that date, and after the October 26, 1999, filing

of respondent's answer in the case.

          Capitalized Costs From 1994

     During the examination of petitioners' 1994 Federal income

tax return, respondent disallowed Schedule C deductions for

automobile expenses, property taxes, and insurance.   Petitioners

allege that there was an "informal agreement" to allow them to

capitalize a portion of the costs and to allow "deduction" of

them in 1996.    The notice of deficiency for 1996 does not reflect

such an informal agreement.

     There is but scant evidence in the record of an informal

agreement as alleged by petitioners.    It is not apparent what the

terms of such an agreement may have been.   And it was, by

petitioners' own description, an "informal" agreement.   After

reviewing documents submitted by petitioners on November 11,

1999, Appeals agreed to allow petitioners to capitalize as part

of the cost of the Vallecito property a portion of the 1994

expenditures for automobile expenses and property taxes.
                                 - 17 -

            Legal and Professional Expenses

     Respondent disallowed a deduction for a legal fee expense

and a tax preparation fee expense for 1996.    After consideration

of information sent in by petitioners on September 2, 1999,

respondent conceded most of the adjustment.

            Utilities Expenses

     On Schedules C of their 1995 return, petitioners claimed

$547 as an expense for utilities at the Vallecito property.

Because respondent had evidence that petitioners had resided at

the Vallecito property, he took the position that the utilities

expense was a nondeductible personal living expense.    Petitioners

had submitted statements from individuals indicating that

petitioners did not reside at the property.    As late as

November 17, 1999, Appeals requested additional information

concerning the occupation of the Vallecito property.    For

settlement purposes, respondent conceded his position although

the evidence remained ambiguous.     See Creske v. Commissioner,

T.C. Memo. 1990-318, affd. 946 F.2d 43 (7th Cir. 1991).

     It was reasonable for respondent to make adjustments for

items and to refuse to concede the adjustments until he had

received and verified petitioners' substantiation for the amounts

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

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

McDaniel v. Commissioner, T.C. Memo. 1993-148.
                               - 18 -

     We are persuaded that respondent's positions on the above

issues were reasonable.   Respondent's positions were based on

petitioners' failure to fully substantiate or account for the

respective items.   Further, the issues were settled within a

reasonable time 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 car and truck, insurance, office, and utilities expenses

totaling $2,008.06 incurred in 1995 were not deductible expenses

but instead must be capitalized into the cost of the Vallecito

property sold in 1996.    Petitioners appear to argue that

respondent's position was legally infirm, although their argument

seems to be inconsistent with the "informal agreement" they urge

for the treatment of similar 1994 expenses as capital

expenditures.

     Although petitioners did not maintain a set of books and

failed to provide an accounting of the expenses associated with

their home-building activity, they reported a reduction of

$77,462 of Schedule C gross receipts for "cost of goods sold" in

connection with their home-building activity for 1996.    Because
                              - 19 -

of their lack of an accounting for costs, respondent attempted to

reconstruct them from petitioners' receipts and canceled checks.

     In the reconstruction, respondent included as cost of goods

sold $2,008.06 of indirect costs incurred in 1995 along with

other verified Vallecito costs of $61,353.99 to arrive at a cost

of goods sold of $69,049.98, an amount less than that reported on

the return.   Had respondent allowed the $2,008.06 as expenses for

1995, the adjustment to cost of goods sold for 1996 would have

been larger by that amount.

     The uniform capitalization rules of section 263A(a)(1)

require that all direct costs and certain indirect costs

allocable to certain property be included in inventory, or

capitalized if such property is not inventory.   Items that would

not otherwise be taken into account1 in computing taxable income

may not be taken into account as costs allocable to property

under section 263A.   See sec. 263A(a).

     For settlement purposes, after verification of the purpose

of the $11,104.67 check to the US Bank, Appeals agreed that the

$2,008.06 in costs was associated with the construction or

acquisition of the Vallecito property sold in 1996 and is

deductible as expenses for 1995.   Appeals cited as authority for

the agreement the de minimis rule of the simplified production

method of section 1.263A-2(b)(3)(iv), Income Tax Regs.   The


     1
      If, for example, an item of indirect cost were not properly
substantiated under sec. 274, it would not be a proper cost under
sec. 263A. See sec. 1.263A-1(c)(2), Income Tax Regs.
                                - 20 -

simplified production method may be elected for any trade or

business as a method for determining costs allocable to ending

inventories of produced and other eligible property on hand at

the end of the year.   See sec. 1.263A-2(b)(1) and (2), Income Tax

Regs.   The record in this case fails to show that petitioners

ever made any such election or that they made any argument to

respondent that they relied upon the above provision when

reporting the expenses on their return for 1995.

     We find that respondent's position that the $2,008.06

represented an amount that had to be capitalized into the cost of

the Vallecito property was a reasonable application of the law

given the available facts and circumstances at the time that

respondent took his position.

Conclusion

     We find that respondent's positions on the disputed issues

were reasonable positions sufficiently supported by the facts and

circumstances in petitioners' 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.

     To reflect the foregoing,

                                      An appropriate order will

                                 be issued, and decision will be

                                 entered under Rule 155.
