Phillips v. Comm'r, T.C. Memo. 2017-61

• Decision Date: 10 April 2017
• Docket Number: T.C. Memo. 2017-61,Docket No. 29495-14.
• Parties: RUPERT E. PHILLIPS AND SANDRA K. PHILLIPS, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: United States Tax Court

RUPERT E. PHILLIPS AND SANDRA K. PHILLIPS, Petitioners
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

T.C. Memo. 2017-61
Docket No. 29495-14.

UNITED STATES TAX COURT

April 10, 2017

Anthony J. Carriuolo, for petitioners.

W. Robert Abramitis, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

LAUBER, Judge: The foreclosure tsunami that swept through the country's real estate markets a decade ago has long since subsided. But those sent reeling by it continue to pick up the pieces of their financial and fiscal affairs. Among them are Sandra and Rupert Phillips, a married couple who earned their livelihood from developing and selling real estate in one of the worst-hit areas--the "Wiregrass"

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region spanning the Florida Panhandle and nearby Alabama. Mrs. Phillips owned 50% of an S corporation that did the development, and she and her husband (along with others) personally guaranteed bank loans financing this activity. When these development projects collapsed, the lending banks sued them on their guaranties and recovered judgments, which petitioners were unable or unwilling to pay.

Petitioners nevertheless claimed by reason of these judgments an increased basis in Mrs. Phillips' investment in the S corporation, which they hoped would allow them to claim additional flowthrough loss deductions and net operating loss (NOL) carrybacks for various years. The Internal Revenue Service (IRS or respondent) disappointed these hopes and determined deficiencies and accuracy-related penalties under section 6662(a)¹ as follows:

Year	Deficiency	Penalty; sec. 6662(a)
2004	$751,242	$150,248
2005	871,889	174,378
2008	113,138	22,628
2009	800	160
2010	151,578	30,316

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After concessions,² the main issue for decision is whether petitioners are entitled to basis credit for unpaid judgments entered against Mrs. Phillips on account of personal guaranties she had furnished on loans on which the S corporation or its wholly owned subsidiaries defaulted. We agree with respondent that the answer to this question is "no" and thus rule for the IRS as to the deficiencies. But we find that petitioners are not liable for any penalties.

FINDINGS OF FACT

The parties submitted before trial a stipulation of facts including exhibits that is incorporated by this reference. Petitioners resided in Florida when they timely petitioned this Court.

I. The Real Estate Business

Olson & Associates of NW Florida, Inc. (Olson), was a Florida corporation organized in 2001 and dissolved in 2011. For Federal income tax purposes it was a subchapter S corporation for the duration of its existence. At all relevant times

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Carl R. Olson, Jr., owned 50% of the company's common stock and Sandra Phillips owned the other 50%. Rupert Phillips was employed by the company.

Olson was engaged in developing and selling residential and commercial real estate in northwest Florida and southern Alabama. It undertook about 20 discrete development projects during the decade it was in existence. Like many real estate development businesses, it relied heavily on debt financing; its projects were encumbered at various times with aggregate debt of almost $191 million. The bulk of this debt was incurred by lower tier subsidiaries and was secured by mortgages encumbering the real estate properties. At trial petitioners conceded that, at the time these loans were obtained, they were "clearly supported by * * * collateral that was pledged." A relatively small portion of the debt was incurred at the S corporation level and was unsecured.

For each development project Olson would typically set up a wholly owned special purpose entity (SPE) that was a limited liability company or other pass-through entity. The SPE would acquire raw land and develop subdivisions or other buildings on that land. To finance each project, the SPE would obtain loans from banks or other third parties. These loans were secured by all of the SPE's assets, including the land under development.

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Virtually all of the loans that the banks extended to Olson and its subsidiaries were guaranteed by Olson's two shareholders (including Mrs. Phillips) and/or their spouses. Some of the loans had up to five distinct coguarantors (including Olson itself). There is no evidence that petitioners pledged any personal assets or otherwise provided the banks with any collateral in support of their guaranties. The only collateral to which the banks could look for repayment of their loans was the real estate and other assets held by Olson and its subsidiaries.

The nationwide downturn in the real estate market that began in late 2006 was especially severe in Olson's region of operations. Starting in 2007 the company's business experienced a spiraling decline in sales, revenue, and cashflow from which it never recovered. This precipitated a default on virtually every loan owed by the company and its SPEs. The lenders sued for repayment, typically foreclosing on the property that secured the indebtedness.

Because the real estate had declined so precipitously in value, the collateral was usually insufficient to satisfy these judgments. The lenders accordingly sued the guarantors, seeking enforcement of the personal guaranties to satisfy the deficiencies. Ten of these actions resulted during 2008-09 in final judgments, issued by Florida State courts, aggregating about $105 million against Mrs. Phillips and the coguarantors, including her husband.

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The coguarantors bore joint and several liability for each of these judgments. As of the time the record in this case closed, neither petitioner had paid any amount toward these judgments. Nor had either petitioner made any direct payments to Olson's lenders under his or her guaranties.

Nonetheless, after receiving professional advice in 2010, including a formal opinion from tax counsel, petitioners took the position that Mrs. Phillips was entitled to increase her basis in her Olson stock as a result of these judgments. Petitioners assigned $7,069,639 of the unpaid judgments to 2008 and the remaining $97,703,385 to 2009. For each year, petitioners then allocated to each coguarantor a pro rata share of the unpaid judgment amounts exceeding all available collateral. After allocating to Mrs. Phillips her "proportionate share of the judgments less the fair market value (FMV) of the underlying property securing the liabilities," petitioners claimed that she had made deemed capital contributions to Olson, and thereby secured additional basis in her stock, of $1,553,360 in 2008 and $30,187,249 in 2009.³

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II. Petitioners' Tax Returns and IRS Audit

Petitioners timely filed their 2008 joint Federal income tax return, which reported a loss of $2,434,648 on Schedule E, Supplemental Income and Loss. They requested a refund for 2008 of $26,989, which they apparently received. After securing the tax advice mentioned above, petitioners in October 2010 filed an amended 2008 return and concurrently filed a timely 2009 return. With each of these returns petitioners included a disclosure statement noting that they were claiming a basis increase in Mrs. Phillips' stock in Olson, of $1,553,360 and $30,187,249, respectively, and briefly explaining how they determined these amounts.

The tax ramifications flowing from these claimed basis increases are complex but may be summarized as follows. On their 2008 amended return petitioners claimed a Schedule E loss deduction of $3,890,069, which was $1,455,421 larger than that claimed on their original 2008 return. For 2009 petitioners claimed a Schedule E loss deduction of $10,518,948 and an NOL of $10,349,265. Under former section 172(b)(1)(H), petitioners elected a five-year carryback period for this NOL, applying $4,625,394 against their 2004 tax liability and the remaining $5,723,871 against their 2005 tax liability. Petitioners filed for each of those two

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carryback years a Form 1045, Application for Tentative Refund, and received from the IRS the refund they requested.

Petitioners timely filed their 2010 return, on which they claimed a Schedule E deduction of $937,000 for the flowthrough loss from Olson, presumably relying on the unused portion of Mrs. Phillips' purported stock basis increase from 2009. That helped generate an NOL for 2010 of $525,710; the record does not establish whether or to which year(s) petitioners carried this NOL.

The IRS examined petitioners' returns for the years at issue and determined that Mrs. Phillips was not entitled to any basis increase on account of her loan guaranties or the unpaid judgments against her. The IRS accordingly adjusted downward petitioners' 2008 flowthrough loss deduction, allowing a Schedule E loss deduction of $2,378,899 (as compared with the $3,890,069 loss deduction claimed on petitioners' amended return). The IRS likewise adjusted downward petitioners' 2009 flowthrough loss deduction, reducing the Schedule E loss deduction from the claimed $10,518,948 to $2,006,205. That left a 2009 NOL of only $1,672,363; this revised NOL was exhausted after application against petitioners' 2004 tax liability, leaving no remaining NOL for application against their 2005 tax liability. Finally, the IRS adjusted downward petitioners' 2010 claimed Schedule E flowthrough loss deduction by $937,000, eliminating the

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claimed NOL for that year. The IRS sent petitioners a timely notice of deficiency reflecting these adjustments, and they timely petitioned this Court.

OPINION

The IRS' determinations in a notice of deficiency are generally presumed correct though the taxpayer can rebut this presumption. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). The taxpayer bears the burden of proving her entitlement to deductions allowed by the Code and of substantiating the amounts of claimed deductions. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); sec. 1.6001-1(a), Income Tax Regs. In certain circumstances the burden of proof on factual issues may...