Cellar v. Commissioner, Docket No. 11758-92.

CourtUnited States Tax Court
Writing for the CourtDawson
Citation68 T.C.M. 412
PartiesOak Knoll Cellar, William P. Jaeger, Jr., Tax Matters Partner v. Commissioner.
Docket NumberDocket No. 11758-92.,Docket No. 4239-93.
Decision Date18 August 1994
Memorandum Opinion

DAWSON, Judge:

These cases were consolidated for trial, briefing, and opinion. They have been reassigned to Special Trial Judge Stanley J. Goldberg pursuant to the provisions of section 7443A(b)(4) of the Internal Revenue Code (the Code) of 1986, as amended, and Rules 180, 181, and 183 of the Tax Court Rules of Practice and Procedure. The Court agrees with and adopts the opinion of the Special Trial Judge, which is set forth below.

Opinion of the Special Trial Judge

GOLDBERG, Special Trial Judge:

This matter is before the Court on petitioner's Motion for An Award of Reasonable Litigation Costs under section 7430 and Rule 231. Petitioner does not seek any administrative costs he incurred in connection with the consolidated cases. Section references are to the Code in effect for the taxable years in issue; however, unless otherwise indicated, references to section 7430 are to the Code in effect at the time these cases were filed.1 All Rule references are to the Tax Court Rules of Practice and Procedure.

Respondent, by notices of final partnership administrative adjustment (FPAA), determined adjustments to the income of Oak Knoll Cellar (the partnership) for its fiscal years ended June 30, 1988 (1988 year), and June 30, 1989 (1989 year), in the amounts of $3,240,963 and $169,412, respectively. The adjustments are attributable to respondent's termination of the partnership's election to use the last-in, first-out (LIFO) method of valuing inventory and recomputation of the value of the inventory using the first-in, first-out (FIFO) method; adjustments to the capitalization of inventory costs under section 263A; and adjustments made to the depreciation deductions the partnership claimed for certain caves used to store wine. The substantive issues in these cases were conceded by respondent shortly before trial.

The issue for decision is whether William P. Jaeger, Jr. (petitioner), is entitled to an award of litigation costs. For purposes of petitioner's motion, respondent concedes that petitioner has substantially prevailed with respect to the amounts in controversy and that petitioner has exhausted the administrative remedies available to him.2 We must decide whether respondent's position was substantially justified within the meaning of section 7430(c)(4)(A)(i).

In accordance with Rule 232, the parties have submitted declarations and memoranda supporting their positions. We decide the motion for litigation costs based on petitioner's motion, respondent's objection, petitioner's reply to respondent's objection, and the declarations and exhibits provided by both parties. There are conflicts of facts presented by each party. Neither party requested a hearing, however, and we conclude that a hearing is not necessary for the proper consideration and disposition of this motion because the facts in dispute are not relevant to our conclusion. Rule 232(a)(3). The relevant facts, as drawn from the record and set out below, are not disputed.

In General

The partnership is a California limited partnership whose principal place of business at the time of the filing of the petitions was St. Helena, California. The partnership, formed in April 1976 to manufacture and sell premium Napa Valley wines, operates a winery located near St. Helena, California, and produces premium wines under the Rutherford Hill Winery label.

Each year the partnership crushes several different varieties of grapes and produces several different varieties of wine from the resulting juices. Among the varieties of wine produced by the partnership are Cabernet Sauvignon, Sauvignon Blanc, Chardonnay, Zinfandel, and Merlot.

The partnership did not own or operate any vineyards before July 1, 1988. Rather, the partnership purchased all of the grapes it used in the production of its wines. The grapes are of the same type, from the genus Vitis vinifera, and are all grown in Napa County, California.

Grapevines are divided by variety, by location, and by ownership into blocks. Grapes are harvested when the partnership's winemaking team determines that the grapes on the vine are ripe, i.e., have reached the desired sugar level. Identical grape varieties in different blocks located only a few miles distant from each other may reach the desired sugar level several weeks apart, depending on a variety of factors including soil, water content of the soil, age of the vines, size of the crop being ripened, and elevation and microclimate of the location of the block. From year to year, the sequence in which the grape varieties have been harvested has changed, depending on when each particular block of grapes reaches its desired sugar levels.

The cost of the grapes, the production costs, and the aging periods vary for each type of wine. The removal of the skins and seeds from the grape juice generally occurs immediately or soon after crushing for white grapes or red grapes made into pink wine, and as much as several days to a week later for red grapes which are to be made into red wine. Some wines are fermented in steel tanks while others are fermented in redwood or oak barrels. White wines take about 6 to 12 months to age, and red wines take 12 to 24 months to age. White wines are aged an additional 3 to 6 months. Red wines are aged for an additional 1 to 2 years. The partnership sells wine in bulk as well as in bottled form. After the completion of the holding period in barrels or tanks, each wine variety that is not sold as bulk wine is bottled. Before bottling, the winemaking team decides what, if any, blending of different varieties is to occur. Some wine varieties, such as Chardonnay, usually are not blended before bottling. Other wine varieties, such as Cabernet Franc, are used almost exclusively as blending wines. Still other varieties, such as Cabernet Sauvignon and Merlot, are used for blending as well as being bottled as varietal wines.

The partnership uses the specific-goods LIFO method, and two pools, i.e., wine and bottling costs, in accounting for inventory and cost of goods sold. In computing the value of inventory, the partnership uses an average cost per gallon to determine increments and decrements to the pool of wine gallons regardless of the varietal.

During 1985 the partnership completed construction of some caves being built into a hillside to store and age wine (caves). The partnership depreciated the caves on its Form 1065, U.S. Partnership Return of Income (partnership return), using a 5-year useful life. The caves have electricity and consist of a series of tunnels and side caves. The floors, walls, and ceilings are a combination of concrete and shotcrete.

Examination of the Partnership Returns
The 1988 Return

Respondent's revenue agent Barbara Osborne (Osborne) started the examination of the partnership return for the 1988 year on December 6, 1990. During the audit of the 1988 year, Osborne toured the caves at the partnership's winery. She observed that the walls and floor of the caves were dry and that the partnership was in the process of digging a new cave and finishing an underground entertainment room at one end of the caves. In a summary report for the 1988 year (the summary report), Osborne proposed changing the partnership's method of accounting for inventory from the LIFO method to the FIFO method because she believed that the partnership had valued some of its inventory using the lower of cost or market method, contrary to the provisions of section 1.472-2(b), Income Tax Regs., which generally requires that inventory must be valued at cost regardless of market value when the LIFO method for valuing inventory is used on the tax return. In the alternative, in order to clearly reflect income under the specific-goods LIFO method, Osborne proposed changing the partnership's LIFO method to (1) accounting for each varietal as an item within the LIFO pool in the manner prescribed under the regulations for the dollar-value LIFO method, or (2) accounting for each varietal as a separate pool under the specific-goods LIFO method of valuing inventory. In the summary, Osborne further proposed adjustments to the costs required to be capitalized and included in inventory pursuant to section 263A on the ground that the partnership had not capitalized interest on its Cabernet wine and had not accounted for cumulative section 263A costs. She also proposed changing the useful life of the caves from 5 to 18 years on the ground that the caves were a building and not a special purpose structure within the meaning of section 1.48-1(e)(1), Income Tax Regs.

The partnership replied to the summary report in a written response dated August 27, 1991. In its reply, the partnership asserted, among other things, that it had not used market value for valuing inventory on its tax return but had used a market value reserve only for financial statement purposes.

A closing conference for the 1988 year was held on August 27, 1991 (closing conference). That morning during a telephone conversation before the closing conference, Timothy Kelly (Kelly), who at the time apparently was the revenue agent in charge of respondent's Santa Rosa, California, office, informed Stephen Buehl (Buehl), the partnership's general counsel, that the revenue agents who were attending the closing conference might want to inspect the caves to resolve certain unagreed items, such as whether there was mold in the caves. Buehl responded that respondent's agents could inspect the caves at the end of the closing conference. Respondent's agents did not inspect the caves at that...

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