138 F.3d 216 (5th Cir. 1998), 96-60443, Streber v. C.I.R.

Docket Nº:96-60443.
Citation:138 F.3d 216
Party Name:Tracy P. STREBER, Teresa P. Deloney, Stephen J. Davis, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
Case Date:April 15, 1998
Court:United States Courts of Appeals, Court of Appeals for the Fifth Circuit
 
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Page 216

138 F.3d 216 (5th Cir. 1998)

Tracy P. STREBER, Teresa P. Deloney, Stephen J. Davis,

Petitioners-Appellants,

v.

COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 96-60443.

United States Court of Appeals, Fifth Circuit

April 15, 1998

Page 217

Michael L. Cook, Patrick Lewis O'Daniel, Jenkins & Gilchrist, Austin, TX, for Petitioners-Appellants.

Marion Elizabeth Erickson, Loretta Argrett, Asst. Atty. Gen., U.S. Dept. of Justice, Tax Div., App. Section, Washington, DC, Gilbert S. Rothenberg, Gary R. Allen, U.S. Dept. of Justice, Tax Div., Washington, DC, Charles Casazza, Clerk, U.S. Tax Court, Washington, DC, Stuart L. Brown, Chief Counsel IRS, Washington, DC, for Resspondent-Appellee.

Casey LeGate Dobson, Scott, Douglas, Luton & McConnico, Austin, TX, Farley P. Katz, Charles J. Muller, III, Wells, Pinckney & McHugh, San Antonio, TX, for Hunter, Edwin Hunter Professional Law Corp., Dupuy, Hunter & Boland, Blazier, O'Dowd and Hunter, Blazier, O'Dowd & Moreno, A Professional Law Corp., Amici Curiae.

Appeals from the United States Tax Court.

Before KING and JONES, Circuit Judges, and KENDALL, 1 District Judge.

EDITH H. JONES, Circuit Judge:

Two sisters were about 20 and 25 years old when they received over a million dollars each, and they hired a lawyer to advise them on potential tax liability. The Commissioner charged them with negligence and substantial understatement penalties 2 for treating the money as a gift even though they followed one alternative course recommended by the tax lawyer and even though the Commissioner herself relied on their theory in asserting tax liability of the girls' father. 3 Under these circumstances, the Tax Court's imposition of the penalties was clearly erroneous. The Tax Court also erred in holding that Teresa's ex-husband procedurally defaulted his case. We REVERSE.

I. BACKGROUND

The underlying facts are simplified for present purposes. In 1979, Larry Parker, the girls' father, acquired an interest in 440 acres of undeveloped land known as Northgate Forest Property. At least part of Parker's interest in this joint venture was held on behalf of his daughters, Teresa Deloney and Tracy Streber, who were then aged nineteen and fourteen. On March 4, 1981, two promissory notes in the amount of $2,000,000 each for sale of the land were endorsed, one to Teresa and the other one to Teresa as custodian for Tracy who was still a minor. Both notes were due and payable on March 4, 1985. Neither Teresa nor Tracy was involved in negotiating the terms of the agreement.

At some point, Parker and his then-wife, the sisters' mother, divorced.

When the notes were not paid on the due date, Parker, Teresa, Tracy, and other interested parties filed a suit against the makers of the notes. On April 23, 1985, the suit was settled, and Teresa and Tracy received eighty-five percent of the face value of the notes, i.e., $1,700,000 apiece.

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Within a few weeks, Teresa and Tracy met with attorney Edwin Hunter to discuss the tax consequences of their income from the joint venture. Hunter provided Teresa and Tracy with two basic alternatives: (1) pay capital gains tax on the income they received; or (2) treat the income as a gift from Parker, who would then be liable for any taxes due on receipt of the money.

Teresa and Tracy chose the latter option. Neither Teresa, who filed a joint return with her then-husband Stephen Davis, nor Tracy reported receipt of the joint venture income on their 1985 tax returns. Parker did not report the receipt of the income either.

On October 22, 1991, the Commissioner issued statutory notices of deficiency to Tracy, Teresa, and Stephen for 1985, stating that Tracy and Teresa should have included the joint venture income they received in their 1985 income. All three filed petitions for redetermination of the deficiency in the Tax Court.

Contemporaneously, the Commissioner, in order to avoid a "whipsaw" situation, also issued a statutory notice of deficiency against Parker and his wife for 1985. The notice of deficiency was based on the determination that the Parkers should have included in their 1985 income tax return the joint venture income that was paid to Teresa and Tracy. Parker and his wife filed a petition for redetermination of the deficiency in the Tax Court.

Upon a motion by the Commissioner, the Tax Court consolidated all three cases for trial. The Commissioner averred that either the Parkers or Teresa and Tracy were liable for the tax, but not both.

The Tax Court found no deficiency in Parker's 1985 income. Instead, the court found that Parker made a gift to his daughters in 1980, and, therefore, Tracy and Teresa were liable for the taxes on the joint venture income received in 1985. The court also sustained the Commissioner's determination of additions to tax for negligence and substantial understatement against Tracy and Teresa. Finally, the Tax Court found that Davis had failed to prosecute his case and held him in default.

Teresa and Tracy filed a motion for reconsideration of the decisions concerning only the additions to tax. They argued that their actions were based on substantial authority and were reasonable and in good faith. Moreover, they maintained that their decision to treat the money as a gift from Parker was based on the advice they had received from counsel. Davis moved for reconsideration, claiming it was wrong for the court to have held him in default. The Tax Court vacated its decision in order to consider these motions.

Upon reconsideration, the Tax Court held that the sisters' assertion that there was substantial legal and factual justification for their failure to report the joint venture income was not sufficient to convince the court to change its determination that the addition to tax should apply. The Court did not believe that Tracy and Teresa "relied on an expert's advice." The Tax Court found:

Movants met with an attorney, Edwin K. Hunter (Hunter), who, based on the facts as he knew them, explained to movants alternative tax reporting positions. However, we do not find that Hunter advised movants that they did not have to report the gains in question. The testimony on that point is ambiguous. Hunter, however, was one of the movant's attorneys and was present throughout the trial. Hunter no doubt could have resolved any ambiguity as to what he advised movants. Nevertheless, movants did not call Hunter as a witness. Our rules do not preclude Hunter from testifying. We infer from Hunter's failure to testify that his testimony would have been adverse to movants. Movants cannot claim that, based on expert advice, they acted with due care, or as a reasonable and ordinarily prudent person would act, in the circumstances.

The Tax Court also rejected Davis's claim, holding that Davis had a full opportunity to participate at the trial and did not do so on his own account, although he participated in the proceedings as a witness.

Tracy and Teresa now appeal. They contend that the Tax Court erred in sustaining the Commissioner's assessment of the negligence and substantial understatement penalties.

Page 219

They argue that they reasonably relied on the advice they received from their attorney, and that reliance is not nullified under the factual circumstances of this case where the taxpayers choose one of the alternatives their advisor recommends. 4 Davis filed a separate appeal making the same claim and also arguing that the Tax Court abused its discretion in holding him in default.

II. ANALYSIS

A. NEGLIGENCE PENALTY

This court reviews the tax court's findings of negligence under the clearly erroneous rule. See Sandvall v. Commissioner, 898 F.2d 455, 459 (5th Cir.1990). Clear error exists when this court is left with the definite and firm conviction that a mistake has been made. See Chamberlain v. Commissioner, 66 F.3d 729, 732 (5th Cir.1995).

"The IRS may penalize taxpayers for an underpayment due to negligence or disregard of rules and regulations. Negligence includes any failure to reasonably attempt to comply with the tax code, including the lack of due care or the failure to do what a reasonable or ordinarily prudent person would do under the circumstances. 'Disregard' includes careless, reckless, or intentional conduct." Heasley v. Commissioner, 902 F.2d 380, 383 (5th Cir.1990) (citations omitted).

The relevant inquiry for the imposition of a negligence penalty is whether the taxpayer acted reasonably. See Reser v. Commissioner, 112 F.3d 1258, 1271 (5th Cir.1997). "Taxpayers may not rely on someone with a conflict of interest or someone with no knowledge concerning the matter upon which the advice is given." Chamberlain, 66 F.3d at 732. "Good faith reliance on professional advice concerning tax laws is a defense." Durrett v. Commissioner, 71 F.3d 515, 518 (5th Cir.1996).

In this case we find that the Tax Court clearly erred when it sustained the Commissioner's assessment of a negligence penalty, because appellants reasonably relied on the advice they received from their attorney, Edwin Hunter.

Due care does not require young, unsophisticated individuals to independently examine their tax liabilities after taking the reasonably prudent step of securing advice from a tax attorney. 5 At relatively tender ages, the appellants received large sums of money. Tracy Streber testified that she and her sister came to the conclusion that they had to seek advice from an attorney to make sure they did "the legal thing." As she explained:

It was just known that when you get money like that, some kind of tax had to be paid and we didn't know what it was, so we went to get counseled.

....

I knew that is why you had to go to a tax person.

Given their level...

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