Scallen v. C.I.R., 88-2323

• Decision Date: 09 June 1989
• Docket Number: No. 88-2323,88-2323
• Parties: -5035, 89-1 USTC P 9369 Stephen B. SCALLEN and Chacke Y. Scallen, Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Appellee.
• Court: U.S. Court of Appeals — Eighth Circuit

Page 1364

877 F.2d 1364

64 A.F.T.R.2d 89-5035, 89-1 USTC P 9369

Stephen B. SCALLEN and Chacke Y. Scallen, Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Appellee.

No. 88-2323.

United States Court of Appeals Eighth Circuit.

Argued April 12, 1989.

Decided June 9, 1989.

David R. Brennan, Minneapolis, Minn., for appellants.

Steven W. Parks, Washington, D.C., for appellee.

Before FAGG, Circuit Judge, FLOYD R. GIBSON and TIMBERS, ^* Senior Circuit Judges.

TIMBERS, Circuit Judge.

Stephen B. Scallen (Scallen) and Chacke Y. Scallen (collectively appellants) appeal from a decision (No. 6913-85) entered May 26, 1988 in the United States Tax Court, Mary Ann Cohen, Judge, ¹ determining deficiencies totaling $555,220 in appellants' federal income tax for the tax years 1976, 1977, 1979 and 1981. The court also imposed on Scallen ² additions to tax of $409,525 as civil fraud penalties pursuant to Int.Rev.Code of 1954, Sec. 6653(b), ³ on the ground that some of the underpayment of tax in each year in which a deficiency was determined was attributable to fraud.

Scallen is a tax attorney and law professor who also has engaged in extensive real estate activities. These activities have generated millions of dollars in management fees, gross rental receipts and income from the sale and exchange of real property. Despite this sizeable revenue, appellants reported large net operating losses (NOLs) on their tax returns for each tax year from 1971 through 1981. They paid no income tax for these tax years.

The Commissioner of Internal Revenue began an examination and audit of appellants' tax returns and assessed large deficiencies for the tax years 1976 through 1981. Appellants challenged the deficiencies by filing a petition in the Tax Court.

The parties originally disputed forty-four separate issues. These were narrowed to the twenty-four issues decided by the Tax Court in its memorandum decision of August 24, 1987 (August 24 decision). 54 T.C.M. (CCH) 177 (1987). Most of these issues were decided against appellants. On appeal, appellants have challenged only (1) the imposition in the August 24 decision of the 50% civil fraud penalty pursuant to Sec. 6653(b) for each of the four tax years in which the Tax Court determined a deficiency; (2) the Tax Court's determination of two of the twenty-three other issues disposed of in the August 24 decision; and (3) the Tax Court's order denying appellants' posttrial motion to elect income averaging pursuant to Secs. 1301-1304 for the tax years 1977, 1979 and 1981.

For the reasons which follow, we affirm the decision of the Tax Court.

I.

We summarize only those facts and prior proceedings believed necessary to an understanding of the issues raised on appeal.

A.

Early in his career Scallen worked as a tax attorney and law professor. He graduated from the University of Minnesota Law School (the law school) in 1959, graduating third or fourth in a class of about seventy. He was president of the law review and a member of the Order of the Coif. From 1959 to 1961, he was a tax associate at the Washington D.C. law firm of Covington and Burling. In 1961, Scallen joined the faculty of the law school and remained on the faculty throughout the period in question. He taught various courses in business, real estate and federal tax law. He has written at least three articles for professional legal publications on income tax issues. He was an assistant dean at the law school from 1961 to 1965. In 1965 and 1966, he was a Graduate Fellow at the Harvard Law School where he did research and studied income taxation.

Beginning in 1966, Scallen became involved in the real estate business in Minneapolis. His activities included buying and selling real estate, developing apartment complexes and condominiums, syndicating and managing real estate partnerships, arranging real estate financing, and managing real estate rental properties. His real estate activities became quite extensive. At one point between 1974 and 1978, he either owned, controlled or had an interest in approximately nineteen partnerships, six corporations and eleven sole proprietorships. These entities generated millions of dollars in revenue from the sale or exchange of real estate, management fees and gross rental receipts.

B.

Despite the potentially large income indicated by Scallen's real estate activities, appellants reported large NOLs for each tax year from 1971 through 1981 and paid no income tax for those tax years. In late 1978 or early 1979, the Commissioner began an examination and audit of appellants' tax returns. On December 20, 1984, the Commissioner issued to appellants two statutory notices of tax deficiency--one for the tax years 1976, 1977 and 1978, and the other for the tax years 1979, 1980, and 1981. ⁴ The Commissioner also examined appellants' tax returns for the tax years 1973, 1974 and 1975, because the large NOLs appellants reported in those years were carried forward as deductions on their tax returns for the tax years 1976 through 1981.

Appellants challenged the Commissioner's assessments by filing a joint petition in the Tax Court. The case was tried in the Tax Court on appellants' petition on June 20, 23 and 24, 1986. The issues litigated at the trial were decided in the August 24 decision. On May 26, 1988, the Tax Court entered its decision setting forth its final determinations of appellants' tax deficiencies and the additions to tax owed by Scallen pursuant to Sec. 6653(b). Appellants filed a notice of appeal to our Court on August 29, 1988. They challenged the Tax Court's rulings on only three of the twenty-four issues decided by the Tax Court in the August 24 decision. On appeal we find that appellants assert two principal claims of error: the imposition pursuant to Sec. 6653(b) of the 50% fraud penalty for each of the four years involved and the treatment of the gain from the sale of certain real estate. They also assert a number of subordinate claims of error, each of which we shall discuss.

C.

As their first claim of error appellants challenge on two grounds the Tax Court's imposition of the 50% civil fraud penalty pursuant to Sec. 6653(b) for each of the four years in which the court determined a deficiency. First, they assert that the Commissioner failed to meet his burden of proving fraud by clear and convincing evidence. The Tax Court, however, held that the Commissioner had met his burden of proving fraud. The court pointed to several factors relevant to the issue of fraud. They included Scallen's use of a large number of entities to do business, his cash management methods which made it difficult to trace income, his failure to maintain accurate and complete records, his failure to produce records during discovery, and his handling of several deductions, especially those for bad debts. The court rejected appellants' arguments that their tax deficiencies were the result of honest errors or positions taken in good faith. The court observed that Scallen was a law professor who had taught and practiced tax law.

Second, appellants challenge the imposition of the fraud penalty on the ground that the Commissioner failed to prove that the tax deficiencies that the Tax Court found to be fraudulent (the fraud items) actually caused an underpayment of tax for each of the four tax years in question. Appellants assert that most of their tax deficiencies were not attributable to fraud (the non-fraud items), and that these non-fraud items alone were large enough to generate the originally reported NOLs that appellants claimed entitled them to pay no taxes. They argue that the fraud items did not cause their underpayment of taxes, because even with the fraud items removed from their original tax calculations they still would have reported NOLs for each tax year in question and for which they paid no taxes. The Commissioner asserts that appellants' contention is contrary to the statutory language and the congressional policy expressed in Sec. 6653(b).

D.

Appellants' second claim of error arises out of the Tax Court's treatment of the gain from the sale of certain real estate. In 1977, Scallen purchased a 114-unit apartment/hotel known as the Mark Twain Hotel/Brittany Apartments (Brittany). In January 1979, Scallen sold Brittany to Gerald Hansen (Hansen) and realized a $760,104 gain (the sale or the January 1979 sale). ⁵ The next day Hansen sold Brittany to Bradley Herman (Herman). Herman held Brittany until November 1979 when he sold it back to Scallen. Since he repurchased the property, Scallen treated this sale on appellants' 1979 return as a nullity and reported only that portion of the gain on the sale ($172,300) that he received in cash, stepping up his basis in Brittany accordingly. The Tax Court rejected this approach and required appellants to report the entire gain on their 1979 return.

At trial, appellants asserted that, if the Tax Court rejected their treatment of the gain from the January 1979 sale, they were entitled to elect to report the gain from the sale under the installment method of reporting income set forth in Sec. 453(b). They also asserted that they could treat the reacquisition of the building as a repossession under Sec. 1038. By invoking a combination of the two statutes they asserted that they could shift much of the net gain to tax year 1980 when Scallen resold the building. ⁶ The Tax Court rejected both appellants' original claim and their alternate claim that they could report the gain from the sale under Sec. 453(b) and Sec. 1038. The court held that the entire net gain was taxable in 1979. Appellants challenge on appeal the Tax Court's rulings concerning Sec. 453(b) and Sec. 1038. The Commissioner asserts that the Tax Court correctly decided the issue since neither Sec. 453 nor Sec. 1038 is available to appellants upon the facts of this case.

E.

This brings us to several subordinate claims of error asserted by appellants on appeal.

First, Scallen challenges the...