Digby v. Comm'r of Internal Revenue

• Decision Date: 07 September 1994
• Docket Number: Nos. 1352–92,26770–92.,s. 1352–92
• Citation: 103 T.C. No. 24,103 T.C. 441
• Parties: Donald R. DIGBY and Lydia Digby, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Tax Court

103 T.C. 441

103 T.C. No. 24

Donald R. DIGBY and Lydia Digby, Petitioners,

v.COMMISSIONER OF INTERNAL REVENUE, Respondent.

Nos. 1352–92

26770–92.

United States Tax Court.

Sept. 7, 1994.

Michael J. Shidler, for petitioners.

Timothy P. Brynteson, for respondent.

R's agent (A) examined P's 1987 income tax return and after review of P's records allowed a loss from a related pass-through entity. The overall examination resulted in a deficiency, and P executed a Form 870 agreeing to assessment. P filed a 1988 return and thereafter filed an amended 1988 return, which claimed additional loss from the same related entity. R's agent (B) in the conduct of a 1988 examination inspected the records relating to the loss and determined that P had inadequate basis to claim a loss for 1988 and 1987. The same records would be considered or inspected to determine whether a loss was allowable for 1987 and/or 1988. B, after obtaining the approval of his supervisor, disallowed the loss for 1988 and 1987.

P contends that B conducted an “unnecessary examination” and/or a second inspection of P's 1987 records without providing written notice, all in violation of the requirements of sec. 7605(b), I.R.C. P also seeks invalidation of the 1987 notice of deficiency as relief from any sec. 7605(b), I.R.C., violation.

Held: Review of the same records for another taxable year that results in a proposed deficiency for an already examined year is not a second inspection within the meaning of sec. 7605(b), I.R.C.

GERBER, Judge:

Respondent determined deficiencies in these consolidated ¹ cases in the amounts of $112,614, $53,103, and $37,731 for petitioners' 1987, 1988, and 1989 taxable years, respectively. The parties have resolved all substantive issues determined in the notices of deficiency and have agreed that there is a $39,346 deficiency due from petitioners for 1988 and a $22,947 overpayment due to petitioners for 1989. With respect to the 1987 tax year, the parties agree that there would be a $21,779 income tax deficiency due from petitioners but for the resolution of a procedural issue which remains in dispute. That issue is whether an unnecessary examination or second inspection of petitioners' records, within the meaning of section 7605(b),² was conducted by respondent's agent for the 1987 taxable year. If we decide that an unnecessary examination or second inspection occurred, we must consider what constitutes an appropriate remedy for a section 7605(b) violation and whether it should be employed in this case.

FINDINGS OF FACT ³

Petitioners resided in Englewood, Colorado, at the time their petitions were filed in these consolidated cases. Revenue Agent William Burlage (Agent Burlage) opened an audit examination of petitioners' 1987 taxable year early in 1989. Petitioners were selected for audit because of a flow-through item from Navajo Shippers, Inc. (Navajo), a related corporate entity which had been examined first. In addition to the flow-through item, other issues were pursued by Agent Burlage.

As of early 1989 petitioners' 1987 subchapter S corporate return for Digby Leasing (Leasing) had not been filed and petitioners' 1987 return did not contain an entry (either a gain or a loss) attributable to Leasing. After conversations with Daniel Johnson, petitioners' certified public accountant/representative (Mr. Johnson), Agent Burlage allowed $103,710 as a flow-through loss to petitioners from Leasing for the 1987 taxable year. Agent Burlage was shown a draft Schedule K–1 and memorandum summarizing the loan documents of Leasing, both of which had been prepared by Mr. Johnson. Agent Burlage reviewed substantial amounts of records and documents, but there is no indication that he personally reviewed Leasing's loan documents in connection with his audit of the 1987 tax year.

Agent Burlage also considered issues involving other entities related to petitioners, including partnerships and corporations. Agent Burlage reviewed petitioners' individual records, including the general ledger. The 1987 audit of petitioners' return was extensive and included multiple matters involving Schedules C, D, E, and computational matters. The examination of all the related entities was also extensive and the audit of all entities, including petitioners, extended over a 1–year period. Agent Burlage periodically spent several weeks at a time working on the examination. Agent Burlage spent from 100 to 200 hours of his time working specifically on petitioners' 1987 return. By means of a letter, dated May 14, 1990, Agent Burlage's report of audit adjustments and an agreement to permit assessment (Form 870) were forwarded to petitioners. For 1987, the report reflected an additional income tax liability of $45,191 and a $18,998 addition to tax, all of which petitioners agreed could be assessed by means of executing a Form 870.

On August 29, 1990, respondent received a Form 1040X for petitioners' 1988 taxable year and it was assigned to Revenue Agent Timothy Chase (Agent Chase) for examination during March 1991. The Form 1040X contained three major changes from the original 1988 Form 1040 income tax return. It also contained several computational adjustments which flowed from the three major changes. The three major changes included: (1) $188,125 of increased wages from Navajo; (2) $406,997 of pass-through loss from Leasing; and (3) $79,035 in additional Schedule C business deductions. In order to support the claimed loss from Leasing, petitioner explained on the Form 1040X that Leasing's debt should be considered for purposes of petitioners' adjusted basis, because (1) Leasing was thinly capitalized, (2) the creditors looked to the shareholder primarily for repayment, and (3) the creditors would not have advanced the funds to the corporation alone. Petitioner was a guarantor of Leasing's debt. Petitioners pointed out that the case law on whether guarantees could be considered by subchapter S shareholders as basis for purposes of section 1366(d)(1) was varied, and several cases were cited. Petitioners also provided an explanation regarding the “passive activity” requirement of section 469 and pertinent regulations.

At the first meeting with petitioners' representative, Agent Chase was advised that petitioners' 1987 return had already been examined and another revenue agent had previously addressed some of the same issues as were being pursued for the 1988 tax year. After considering some of the aspects of the Leasing transactions for 1988, Agent Chase realized that there might be insufficient basis for petitioners to claim a loss for 1988 and for prior years, including 1987. Agent Chase called Agent Burlage and discussed the matter, being aware that the period for assessment of a 1987 deficiency had not expired. Around June 20, 1991, Agent Chase requested a copy of Agent Burlage's 1987 audit report, and it was received from his local office on August 27, 1991. Agent Chase also obtained, from internal sources, petitioners' individual 1987 income tax return and the related administrative files and determined that there would also be a proposed income tax deficiency for petitioners' 1987 tax year.

The records used during the audit of petitioners' 1988 tax year also reflected a deficiency for 1987 with respect to the basis issue regarding Leasing. When the expiration of the 1987 assessment period was approaching, Agent Chase, after consulting with and obtaining the agreement of his manager, decided to pursue the basis question with respect to petitioner's 1987 tax year. Written notice of a second examination or inspection was not sent or provided to petitioners prior to the determination and issuance of the notice of deficiency for 1987. Around mid-September 1991, Agent Chase orally advised Mr. Johnson, petitioners' representative, of the re-examination of the 1987 year with respect to the losses claimed in connection with Leasing. Through Mr. Johnson, petitioners were asked to extend the 1987 assessment period. Petitioners refused to extend the period, and respondent issued a notice of deficiency for the 1987 tax year.

OPINION

Section 7605(b) provides that:

No taxpayer shall be subjected to unnecessary examination or investigations, and only one inspection of a taxpayer's books of account shall be made for each taxable year unless the taxpayer requests otherwise or unless the Secretary, after investigation, notifies the taxpayer in writing that an additional inspection is necessary.

The Supreme Court, after a review of the legislative history, interpreted the purpose of section 7605(b) as being congressional recognition of “a need for a curb on the investigating powers of low-echelon revenue agents, and considered that it met this need simply and fully by requiring such agents to clear any repetitive examination with a superior.” United States v. Powell, 379 U.S. 48, 55–56 (1964); 61 Cong.Rec. 5855 (Sept. 28, 1921). The Powell case involved the enforcement of a summons to appear before a special agent and produce for reexamination certain corporate records, on the ground that suspected fraud would reopen the expired 3–year period of limitations on assessment and collection. Section 7605(b) was considered in that context to determine whether that section, either alone or in conjunction with others, placed a probable cause standard or other restrictions on the Commissioner's agents before a tax year may be reexamined. The Supreme Court held, with respect to section 7605(b) that, generally, “no severe restriction was intended”, and regarding unnecessary examinations, courts are not required “to oversee the Commissioner's determinations to investigate.” United States v. Powell, supra at 54, 56.

With this background we consider petitioners' contention that respondent has violated the requirements of section 7605(b). Petitioners' 1987 tax return was examined and respondent's agent allowed a subchapter S corporation pass-through loss. That loss was...