Opinion
6225-16 16847-16
02-04-2022
MICHAEL R. KELLY, ET AL., Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
ORDER
Joseph Robert Goeke Judge
On December 3, 2021, the parties each filed a computation for entry of decision under Rule 155, and on January 31, 2022, each filed a memorandum in response to our order dated December 7, 2021, to address their disagreement or agreement with specific items in the opposing parties' computations and to explain the basis for any disagreement.
Unless otherwise indicated, all statutory references are to the Internal Revenue Code, Title 26 U.S.C. (Code) and all regulation references are to the Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all relevant times, and all Rule references are to the Tax Court Rules of Practice and Procedure.
The parties have agreed that there is no deficiency or overpayment for 2007 and 2008 and have agreed that there is a deficiency of $313,444 and a § 6662 accuracy-related penalty of $62,688.80 for 2009.
The parties disagree over the computation for 2010 and 2011. Petitioner has agreed to respondent's computation with respect to the net operating loss for 2010. Petitioner has stated that disputes remain with respect to 4 issues for the computation for 2010. For 2011 it appears that the disagreement arises only from Schedule C deductions relating to Kelly Hospitality, which are also at issue for 2010.
Capital Gain or Loss
Respondent computed an adjustment to capital gain of $46,545,051, and petitioner computed an adjustment of $2,527,695. Respondent's computation includes gain from distributions from NSI of $38,981,696, including a loan balance as of December 31, 2007, of $35,500,000 owed to NSI, which NSI discharged in 2010, and $3,451,696, that NSI transferred during 2010, which we held was not properly characterized as debt. Petitioner agrees to the $3,451,696 but disagrees that the discharged debt is capital gain because he was insolvent at year-end 2010. In the memoranda, respondent addressed 7 other components of the capital gain adjustment; petitioner addressed only the NSI distribution component.
Inclusion of the NSI debt in gross income depends on whether petitioner was insolvent at year-end 2010 pursuant to § 108(a)(1)(B). We directed the parties to include a revised insolvency calculation as part of the Rule 155 computation in accordance with the findings in our opinion. Petitioner's computation includes such a calculation; respondent did not provide a revised calculation. Respondent has maintained that petitioner had liabilities of approximately $88.5 million, which we stated conformed more closely to the record and should be used as the starting point for the revised calculation of petitioner's liabilities. Kelly, at 64. We find that petitioner has established that he had assets of approximately $71 million and, with liabilities of $88.5 million, he was insolvent.
In his memorandum, respondent appears to take the position that petitioner's insolvency is immaterial, citing a part of our opinion that addressed petitioner's argument that the amount of the cancellation of debt (COD) income should be the fair market value of the discharged debt instead of its face value; an issue separate from § 108(a)(1)(B). Kelly v. Commissioner, T.C. Memo. 2021-76, at 63. We held that COD income would be valued at the face amount of the debt under Treas. Reg. § 1.301-1(m). However, discharged debt that a shareholder had owed to an S corporation is excluded from gross income if the discharge occurs when the shareholder is insolvent. See Toberman v. Commissioner, 294 F.3d 985 (8th Cir. 2002). Accordingly, the NSI debt discharged in 2010 is properly excluded from petitioner's gross income.
Schedule C Adjustment
Respondent's computation includes Schedule C adjustments of $1,855,647. Petitioner agrees to this amount but asserts that he is entitled to deduct an additional $10,310,995 for expenses purportedly paid by Kelly Hospitality on behalf of Ivy Hotel San Diego, LLC (Ivy Hotel) for 2010. He also asserts that he is entitled to such a deduction for 2011 of $5,525,150. A partnership audit of Ivy Hotel increased its rental income by these amounts.
Petitioner asserts that no new evidence need be considered for deduction of Kelly Hospitality's expenses. The deductions are not flow-through adjustments from the partnership audit, and petitioner must establish that he is entitled to the deductions. Assertion of a new issue at this stage of the proceeding would be prejudicial. See Smalley v. Commissioner, 116 T.C. 450, 456 (2001). Accordingly, we direct petitioner to identify the part of the record where he raised this issue in a timely manner and to identify evidence in the record that supports his entitlement to the deductions.
Greenback and FCC COD Income
Respondent's computation included an adjustment for COD income for Greenback Entertainment and FCC of $2,014,081 and $11,157,337, respectively. These entities were S corporations in which petitioner was a shareholder, and each entity reported COD income which they excluded from the gross income pursuant to § 108(a)(1)(B).
FCC reported COD income of approximately $21.2 million and excluded approximately $21 million from its gross income. Petitioner also included $17.9 million from FCC in the computation of the short-term capital losses, which we disallowed.
Petitioner also reported COD income from Greenback and FCC of approximately $2.6 and $4.2 million, respectively, as part of the $145 million in reported COD income. Kelly, at 39-40. To the extent that petitioner as a shareholder is allocated part of any COD income from these entities, he may properly exclude such allocation on the basis of his insolvency, making respondent's asserted adjustment improper.
Furthermore, petitioner included discharged debt from these entities in the claimed $86,979,956 and $1,854,905 short-term capital loss for 2010, which we have held he is not entitled to. Kelly, at 37-38. We understand that these two holdings resolve this issue and render the need to compute any COD income from these entities moot.
Upon due consideration of the foregoing, it is hereby
ORDERED that petitioner is directed on or before March 7, 2022, to file with the Court a report that demonstrates where in the record he raised the 2010 and 2011 deductions for Kelly Hospitality as an issue before trial and to identify evidence in the record that establishes he is entitled to the deductions. It is further
ORDERED that the parties are directed on or before March 21, 2022, to provide to the Court computations that are in accordance with this Order, including that the COD income is excluded from petitioner's gross income on the basis of his insolvency. The parties should also include a schedule that identifies any disagreed amounts that we have not addressed in this Order.