Moore v. Commissioner: Tax Court Finds Cost Basis of Stock Limited to Value as Set Forth in Agreed Judgment

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By David I. Kempler, Esq., Elizabeth Carrott
Minnigh, Esq., and Christine Bowers, Esq.

Buchanan Ingersoll & Rooney PC, Washington, DC

In Moore v. Commissioner, T.C. Memo 2013-249, the Tax
Court held that a married couple's basis in an S corporation stock
was limited to its value as agreed to in a judgment in the
husband's prior suit to rescind the loan agreement with the
corporation pursuant to which he purchased stock from a related
party. The Tax Court, however, declined to uphold the
accuracy-related penalty under §6662(d) on the grounds that
taxpayers had reasonable cause for claiming the inflated basis on
their return where their tax preparers were competent professionals
with sufficient expertise to justify reliance, and were fully aware
of all facts relating to the transactions.

Under §1001(a), gain or loss from the sale or other disposition
of property reflects the difference between the amount realized and
the property's adjusted basis. Adjusted basis is generally basis
determined under §1012, adjusted as determined under §1016. Regs.
§1.1012-1(a) provides that basis is generally the property's cost,
which is any "amount paid for such property in cash or other
property." Cost generally includes promissory notes issued in
exchange for property.1 Although cost
basis generally equals the price paid for property, irrespective of
its actual value, this general rule may not apply "where a
transaction is based upon `peculiar circumstances' which influence
the purchaser to agree to a price in excess of the property's fair
market value."2 In the case of stock
in an S corporation, §1016(a)(17) provides that adjustments to
basis include any adjustments required under §1367.

Husband owned 5% of the stock of ATS, an S corporation, and had
a basis of $212,334 in this stock. Thereafter, at the request of
ATS, Husband entered into an agreement to purchase an additional
1,477,859 shares from an existing shareholder for $5,842,606,
payable in four installments. Husband financed the purchase by
borrowing the funds from ATS, and ultimately paid a total of
$5,353,624 to the existing shareholder. A year after the sale,
Husband sued ATS in the District Court of Dallas County claiming
that the stock purchased was only worth $1 million and that he
should only be liable for $1 million not $5,353,624. The court
ultimately agreed with Husband and entered an "Agreed Judgment"
reducing the amount of the note receivable from Husband from
$5,842,606 to $1 million.

Two years later, Husband sold all of his ATS shares for $3
million. On his joint income tax return, he reported a capital loss
of $1,502,519 from the sale of the ATS stock. In calculating the
capital loss, Husband reported a basis of $4,502,519 in the ATS
shares. This basis was calculated using the original $5,353,624
paid less certain S corporation adjustments reducing his basis. The
IRS issued a notice of deficiency determining that Husband and Wife
had a long-term capital gain of $2 million from the sale.

Taxpayers asserted that Husband's cost basis in his ATS shares
was $6,054,940, representing (i) the $212,334 that he paid in
exercising his option to purchase 5% interest, plus (ii) the
$5,842,606 that Taxpayers asserted represent the total payments
that Husband made pursuant to the agreement to purchase the
additional shares. Conversely, the IRS contended that Husband's
cost basis in the ATS shares was only $1 million because, as a
result of the agreed judgment, his ultimate cost and economic
outlay for the ATS shares was only $1 million, because the lawsuit
resulted in a return of Husband's capital with respect to the
shares that lowered his basis to $1 million.  This contention
ignored the 5% of the ATS stock purchased for $212,334.

First, the Tax Court concluded that the IRS had failed to
advance in the notice of deficiency or in the proceeding any reason
for excluding the $212,334 that Husband paid the 5% of the ATS
stock. Accordingly, the Tax Court held that this amount should be
included in his cost basis.

The Tax Court then considered whether Husband's basis in the
additional stock purchased should be limited to the amount in the
agreed judgment because Husband's agreement to purchase ATS shares
was integrally related to the loan from ATS to pay for these shares
and the agreed judgment that relieved him of all but $1 million of
the principal amount of that loan. Taxpayers asserted that the
IRS's position incorrectly collapsed two transactions, and that
Husband's purchase of the ATS stock for $5,842,606 and Husband's
loan arrangement with ATS to pay for these shares should be viewed
as two separate transactions. The Tax Court, however, sided with
the IRS on the grounds that while the two transactions might be
separate as a matter of form, "taking economic realities into
account" Husband was not obligated to repay the entire debt. The
Tax Court analyzed the economic reality of the transactions in
their totality, concluding that Husband's agreement to purchase the
additional shares was done as an accommodation to ATS, with an
understanding that ATS's funds would be used to pay the nominal
purchase price.

In reaching its conclusion, the Tax Court reasoned that the
non-arm's-length nature of the loan agreement between Husband and
ATS strongly suggested that it did not represent absolute
indebtedness.  The Tax Court also noted that, while ATS lent
the funds to Husband, they paid the seller directly, so Husband had
no ability to use the loan for any other purpose. The Tax Court
further noted that for a long time, Husband's outstanding balance
on his loan from ATS significantly exceeded the $4 million credit
limit indicated by the promissory note and that at the time of the
agreed judgment, Husband had repaid none of the money that ATS had
lent him to purchase the shares some 18 months earlier. Therefore,
the Tax Court agreed with the IRS and concluded that Husband's cost
basis in these additional shares was $1 million.3
Accordingly, taking into account the $212,334 paid for the initial
shares, the Tax Court concluded that Husband's cost basis in his
ATS stock was $1,212,334.

The Tax Court then turned to the imposition by the IRS of an
accuracy-related penalty. Under §6662, a taxpayer may be liable for
a penalty of 20% on any portion of an underpayment of tax: (i) due
to negligence or disregard of rules or regulations or (ii)
attributable to an understatement of income tax that exceeds the
greater of 10% of the tax required to be shown on the tax return or
$5,000. Under §6664(c)(1), as a general rule, the §6662
accuracy-related penalty will not be imposed with respect to any
portion of an underpayment if the taxpayer can show that there was
reasonable cause for that portion and that he acted with good faith
with respect to that portion. Regs. §1.6664-4(b)(1) provides that a
taxpayer may be able to establish reasonable cause and good faith
by showing reliance on professional advice. Generally, a taxpayer
must show that: (i) the adviser was a competent professional who
had sufficient expertise to justify the reliance; (ii) the taxpayer
provided necessary and accurate information to the adviser; and
(iii) the taxpayer actually relied in good faith on that adviser's

Taxpayers contended that they relied on the advice of their tax
advisors at a top 10 accounting firm. The Tax Court concluded that
the tax advisors were competent professionals with sufficient
expertise to justify reliance. The Tax Court further found credible
Husband's testimony and the documentary evidence that showed that
the tax advisers were fully aware of all the facts relating to the
transactions in question. Accordingly, the Tax Court found that,
taking into account all the facts and circumstances, Taxpayers had
reasonable cause and acted in good faith in reporting their basis
in the ATS shares, and, therefore were not subject to the accuracy
related penalty.

Arguably, even if Taxpayer had been successful in his argument,
Taxpayer's basis in the additional stock still would have been
reduced to $1 million. If the total loan had been upheld, when
Taxpayer's obligation to repay any amounts over $1 million was
forgiven pursuant to the agreed judgment, that would arguably be
treated as a constructive distribution from the S corporation to
Taxpayer as a shareholder. Under §1368, the constructive
distribution would have reduced Taxpayer's cost basis in that stock
to $1 million.

For more information, in the Tax Management Portfolios, see
Maule, 560 T.M.
, Income Tax Basis: Overview and Conceptual
Aspects,  and in Tax Practice Series, see ¶4280, Basis of
Stock and Debt



  1 See, e.g., Commissioner v.
, 461 U.S. 300, 307-308 (1983); Crane v.
, 331 U.S. 1 (1947); Regs. §1.1012-1(g).

  2 Lemmen v. Commissioner, 77 T.C. 1326,
1348 (1981) (holding that a taxpayer's basis in a cattle herd was
limited to its fair market value at the time of purchase where
excess purchase price was allocable to maintenance contracts)
(quoting Bixby v. Commissioner, 58 T.C. 757, 776

  3 See Bridges v. Commissioner, 39 T.C.
1064, 1077 (1963) ("While it is true that technically petitioner
was personally obligated on his not … there was no reason to think
that petitioner could or would have been called upon to pay the
note out of his own funds[.]"), aff'd, 325 F.2d 180 (4th Cir.
1963); Roe v. Commissioner, T.C. Memo 1986-510 (discussing
cases in which recourse notes have been held not to be genuine
indebtedness for purposes of determining basis in acquired
property), aff'd without publ. opin. sub nom. Haag v.
, 855 F.2d 855 (8th Cir. 1988), and aff'd without
publ. opin. sub nom. Sincleair v. Commissioner, 841 F.2d
394 (5th Cir. 1988).

  4 See  Neonatology Assocs.,
P.A. v. Commissioner
, 115 T.C. 43, 99 (2000), aff'd, 299 F.3d
221 (3d Cir. 2002).