Sealy Power, Ltd. v. C.I.R.

• Citation: 46 F.3d 382
• Decision Date: 15 February 1995
• Docket Number: No. 93-4269,93-4269
• Parties: -1213, 95-1 USTC P 50,103 SEALY POWER, LTD., Donald E. Rutt, Tax Matters Partner, Petitioners-Appellants Cross-Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee Cross-Appellant.
• Court: United States Courts of Appeals. United States Court of Appeals (5th Circuit)

Page 382

46 F.3d 382

75 A.F.T.R.2d 95-1213, 95-1 USTC P 50,103

SEALY POWER, LTD., Donald E. Rutt, Tax Matters Partner, Petitioners-Appellants Cross-Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee Cross-Appellant.

No. 93-4269.

United States Court of Appeals, Fifth Circuit.

Feb. 15, 1995.

Ruth E. Salek, Houston, TX, for appellant.

Abraham N.M. Shashy, Jr., Chief Counsel, I.R.S., David L. Jordan, Washington, DC, Regina S. Moriarty, Gary R. Allen, Chief, John A. Dudeck, Jr., Appellate Section, Richard Farber, Tax Div., U.S. Dept. of Justice, Washington, DC, for appellee.

Appeal from a Decision of the United States Tax Court.

Before HIGGINBOTHAM and WIENER, Circuit Judges, and KAUFMAN ^*, District Judge.

WIENER, Circuit Judge:

On the procedural level, Plaintiff-Appellant Sealy Power, Ltd. (Sealy), a Texas limited partnership, appeals the Tax Court's determination that the notice of Final Partnership Administrative Adjustment (FPAA) issued by the Commissioner of Internal Revenue (Commissioner) did not shift to the Commissioner the burden of going forward with the evidence. On the substantive level, Sealy appeals the Tax Court's denial of its claimed depreciation deductions and energy and investment tax credits.

With respect to the FPAA, we affirm the Tax Court's determination that such adjustment did not shift to the Commissioner the burden of going forward with the evidence. In determining that Sealy's property was placed in service in 1984, we reverse the Tax Court's ruling on Sealy's entitlement to the depreciation deductions and credits.

The Commissioner cross-appeals the Tax Court's refusal to address the pre-operating expense issue concerning the deductibility of certain of Sealy's expenses. As we conclude that the Tax Court erred in finding that the Commissioner did not properly raise the pre-operating expense issue prior to the Rule 155 computation proceeding, we reverse and remand on this point.

I FACTS AND PROCEEDINGS

The parties submitted an extensive Stipulation of Facts and Supplemental Stipulation of Facts which the Tax Court incorporated by reference in its opinion. The facts necessary to resolve the disputed issues are set forth below.

In 1983, Sealy engaged the engineering firm Energy Advancement, Inc. (EAI) to build a power production facility in Sealy, Texas (the City) on property leased from the City and located next to the City's landfill. ¹ Sealy's plan was to generate electricity by incinerating the solid waste deposited in the landfill and then sell the electricity to Houston Lighting and Power (HL & P). The electric generating project was an attractive way for the City to avoid the rising costs of obtaining additional landfill space, delegate the operation of the landfill, and foster the creation of alternative energy sources in its community.

Tor Lileng, an EAI engineer, designed and supervised the construction of the facility. Lileng's design involved acquiring various ready-made manufacturer components with a certain capacity rating, constructing foundations for these components, and connecting them through wiring and piping. Construction began early in 1983 and the facility was substantially completed that same year at a cost of approximately $3,500,000. In 1984, Sealy completed its agreement to sell its electricity to HL & P. From the winter of 1983 through a portion of 1988, Sealy operated the landfill adjacent to the facility, employing two gatekeepers and receiving small tipping fees from commercial establishments for garbage disposal. Under the terms of Sealy's ground lease with the City, its residents could dispose of their garbage at the landfill at no charge.

Sealy first operated the incinerator at the facility in 1983. Two pieces of equipment in the facility, the feed mechanism and the ash conveyor, presented minor, correctable difficulties in the operation of the facility. The most severe problem, however, was the incinerator, the centerpiece of the facility. The function of the primary chamber of the incinerator was to burn the garbage into gases which in turn would be burned in a second chamber and passed through the vaporizer A few months earlier, on March 30, 1988, the Commissioner had issued a notice of Final Partnership Administrative Adjustment (FPAA) determining that Sealy was not entitled to several deductions and credits. ² Donald E. Rutt, Sealy's tax matters partner, then filed a petition for readjustment of partnership items. The Tax Court ruled against Sealy on all tried issues. Pursuant to Rule 155 of the Tax Court Rules of Practice and Procedure, the court required the parties to submit proposed decision documents consistent with the court's opinion.

steam superheater, and steam turbines to create energy. The manufacturer of the incinerator had claimed it would generate 20 million BTUs per hour, but the incinerator never reached its rated capacity of electricity generation because the manufacturer had delivered a primary chamber considerably smaller than the one EAI had specified for Sealy. These equipment deficiencies prevented the facility from generating commercial quantities of electricity, so Sealy tried to find investors willing to provide the additional funds required to correct the facility's operational problems. After all such efforts failed, Sealy filed for bankruptcy on July 1, 1988.

Sealy timely objected to the Commissioner's proposed computation, disallowing deductions for certain expenses incurred in 1983 and 1984 which the Commissioner deemed to be nondeductible pre-operating expenses. Sealy maintained that it was entitled to a deduction for its ordinary business expenses, insisting that the Commissioner's computation was inconsistent with the Tax Court's ruling on that point. The Tax Court agreed with Sealy and issued an order requiring the entry of a new computation. Both Sealy and the Commissioner timely appealed the respective portions of the court's decision that were adverse to them.

II ANALYSIS

A. STANDARD OF REVIEW

Our standard of review for appeals from the United States Tax Court is the same as for civil actions decided by the district courts. ³ Thus, we review findings of fact under a clearly erroneous standard and legal conclusions de novo. ⁴

B. THE FPAA NOTICE

The Tax Court held that the nature of the FPAA notice did not shift to the Commissioner the burden of going forward with the evidence. Sealy appeals this ruling, arguing that the Commissioner issued an FPAA that was arbitrary and capricious, thereby meriting a shift of the burden. Alternatively, Sealy argues that the FPAA is invalid because it was not a considered determination and that the Tax Court therefore lacked jurisdiction. The Tax Court did not make a factual finding of whether the FPAA was arbitrary, but held instead that Sealy continued to bear the burden of going forward with the evidence because the FPAA did not involve unreported illegal income. This presents a question of law which we review de novo.

The FPAA sent to Sealy noted that the Commissioner had determined adjustments to the partnership's 1983 and 1984 returns. The Commissioner listed the adjustments, specifying the items on the returns which were affected for the tax years in question. In an attachment to the schedule of adjustments, the FPAA noted that the Commissioner was disallowing the claimed deductions and credits because Sealy had not established that its activity had any economic substance, was engaged in for profit, constituted a trade or business, or involved property held for the production of income.

As the prerequisite for litigation over disputed items on a partnership's return, an FPAA is the functional equivalent of a notice The Internal Revenue Code does not specify the form or content of a valid notice of deficiency. Courts have held, however, that the notice generally must advise the taxpayer that the Commissioner has determined a deficiency for a particular year and must specify the amount of the deficiency or provide the information necessary to compute the deficiency. ⁷ A determination of deficiency issued by the Commissioner is generally given a presumption of correctness, which operates to place on the taxpayer the burden of producing evidence showing that the Commissioner's determination is incorrect. ⁸ Several courts have recognized, however, that they need not give effect to the presumption of correctness and may instead shift the burden from the taxpayer to the Commissioner when the notice of deficiency is determined to be arbitrary or excessive. ⁹ In these cases, the notice of deficiency involved a determination of unreported income, whether from legal sources, as in Portillo ¹⁰, or from illegal sources, as in Jackson ¹¹.

                of deficiency. 5  Both the FPAA and the notice of deficiency serve to notify affected taxpayers that the Commissioner has made a final administrative determination of their liability for particular tax years. 6  We therefore analyze the FPAA here the same way that we would analyze a notice of deficiency
                

We have previously recognized that the reason behind the burden-shifting principle in an unreported income case is that the taxpayer bears the difficult burden of proving the non-receipt of income. ¹² The Commissioner's determination in such a case necessarily involves reconstructing income that should have been reported, potentially leading to questionable results. ¹³ If the Commissioner does not substantiate the notice's determination with some predicate evidence, therefore, the taxpayer should be relieved of the burden of going forward with the evidence. The issue we must decide in the instant case is whether the same principle applies when the notice of deficiency involves not unreported income but a taxpayer's entitlement to deductions and credits.

In Gatlin v. Commissioner ¹⁴, the Eleventh Circuit considered whether the burden-shifting We agree with these courts that the burden-shifting principle for...