Opinion
6819-20
05-31-2024
OTAY PROJECT LP, ORIOLE MANAGEMENT LLC, TAX MATTERS PARTNER, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
ORDER
Christian N. Weiler, Judge.
This case is calendared for a two week special trial session of the Court commencing on October 15, 2024, in Washington, D.C. On April 24, 2024, the Commissioner of Internal Revenue (respondent) filed a Motion for Leave to File First Amendment to First Amended Answer (Motion for Leave to Amend). On May 17, 2025, petitioner filed a response to respondent's Motion for Leave to Amend. Having considered the parties' arguments, the Court is now prepared to rule on respondent's Motion for Leave to Amend.
Background
The following facts are drawn from the parties' pleadings and motion papers. The facts stated are not findings of fact by this Court and are stated herein solely for the purpose of ruling on respondent's Motion for Leave to Amend.
Oriole Management, LLC (petitioner) is the "tax matters partner" of Otay Project, LP (the "Partnership"). The Partnership is a limited partnership formed under the laws of the State of California. At relevant times, petitioner was a general partner of the Partnership, and Otay Project. LLC (OPLLC) and Otay Ranch Development, LLC (ORD) were limited partners of the Partnership. OPLLC's partners were Oriole and ORD, and ORD was owned by 34 separate limited liability companies which were ultimately owned by Al Baldwin and Jim Baldwin-brothers and business partners-and their family members. In 1999, the Partnership acquired Otay Ranch, a real estate project consisting of 22,000 acres of land in San Diego County, California, and developed Otay Ranch from 2000 through 2005. The property was held in the Partnership.
While developing Otay Ranch, the Partnership sold tracts of land to third parties and other entities owned by Al and Jim Baldwin. The sales involved a contract for land sale by the Partnership and an unsecured promissory note to complete the construction of improvements on the land. The sales ultimately generated over $1,000,000,000 in gross revenue, and the total face value of the promissory notes received by the Partnership was about $921,000,000.
At least some of the contracts prevented buyers from rescinding the contracts even if the Partnership failed to complete its obligations. Instead, remedy under the contracts was limited to damages.
Based on these obligations to complete construction on the land, the Partnership accounted for the majority of the land sales under the completed contract method (CCM) of accounting under Treas. Reg. § 1.460-4(d). Under the CCM, the Partnership recognized income on a sale only after the construction obligations in the contract were completed. The Partnership accounted for the construction obligations as partnership liabilities under section 752 in the total amount of $175,000,000, and these liabilities were allocated to petitioner, the Partnership's general partner.
Around 2002, Al and Jim Baldwin decided to divide Otay Ranch pursuant to a handwritten memorandum of understanding. In 2005, the Partnership formed two additional lower-tier partnership entities, AB Finco, LLC and JB Finco, LLC (collectively the "Fincos"). Shortly after the formation of the Fincos, the Partnership contributed the promissory notes it held from land sales to the Fincos. According to petitioner, the legal rights to collect on the promissory notes were transferred to the Fincos; however, the obligations to perform the construction improvements to the land remained with the Partnership.
In 2007, Al and Jim Baldwin started forming additional partnerships, whereby Al and Jim Baldwin, along with their respective spouses, transferred (or donated) interests in several upper-tier partnerships (namely some 34 LLCs, collectively holding interests in the Partnership) to newly formed family partnerships which were indirectly owned by their children and grandchildren. Together with the Fincos transactions, these transactions resulted in a basis step-up of some $867 million under section 743(b) to the Partnership property, solely with respect to OPLLC.
More specifically, the Partnership's 2007 tax return reported a positive $866,981,686 step-up for partner OPLLC and a negative adjustment of $283,395 for partner ORD.
In 2012, the Partnership was terminated under section 708 for Federal income tax purposes. At this time, the Partnership had not yet completed its construction obligations. The termination triggered all remaining income deferred under the CCM to be recognized under the "constructive completion rules" of Treas. Reg. § 1.460-4(k), and the Partnership recognized all of its deferred income of $717,916,957. The vast majority of this income was allocated to OPLLC, which held a 99.9 percent interest in the Partnership. However, OPLLC's previously stepped-up basis under section 743(b) offset this deferred income.
On or about July 8, 2014, respondent notified the Partnership that its 2012 tax return was selected for examination. After issuing several Information Document Requests and holding conferences over a span of four years, respondent issued the FPAA on March 18, 2020. In the FPAA, respondent disallowed the reported stepped-up basis and adjusted the Partnership's 2012 ordinary income by $713,759,615.
On July 10, 2020, petitioner timely filed a Petition for Readjustment of Partnership Items with the Court. On June 16, 2021, Respondent's Amended and Restated Answer was filed asserting additional legal theories in further support of the FPAA, including the common law lack of economic substance doctrine, the codified lack of economic substance doctrine under section 7701(o) , and the substance over form doctrine (collectively the "Answer Theories"). In addition, respondent set forth facts supporting the Answer Theories as well as additional penalties.
Respondent's Amended and Restated Answer filed on June 16, 2021 which, according to respondent, was filed solely to combine his Answer, First Amendment to Answer and Second Amendment to Answer into a single pleading. See Motion for Leave to File First Amended Answer filed on June 10, 2021. Respondent lodged his First Amended and Restated Answer on June 10, 2021, which was later filed with the Court on June 16, 2021.
All section references are to the Internal Revenue Code in effect at all relevant times, and all Rule references are to the Tax Court Rules of Practice and Procedure. We round all monetary amounts to the nearest dollar.
On April 24, 2024, respondent filed his Motion for Leave to Amend pursuant to Rule 41 and now seeks leave to file a First Amendment to his Amended Answer, which seeks to add the additional defense that the step-up in basis attributable to the Partnership property under section 743(b) should be disallowed pursuant to the anti-abuse rule of Treas. Reg. § 1.460-4(k)(4). Petitioner opposes respondent's Motion for Leave to Amend.
Discussion
I. Summary of Respondent's Argument
Respondent, in his Motion for Leave to Amend, contends petitioner will not be prejudiced if respondent is allowed to amend his answer to assert the anti-abuse rule of Treas. Reg. § 1.460-4(k)(4). Respondent goes on to note that the evidence required to invoke the anti-abuse rule is "co-extensive with the evidence required to test the Restructuring's economic substance" and the partnership anti-abuse rule of Treas. Reg. § 1.701-2(a); and therefore there is no prejudice to petitioner through the granting of this motion.
II. Summary of Petitioner's Argument
Petitioner opposes the relief being sought by respondent. First, petitioner contends respondent's attempt to inject a brand-new matter into this case more than three years since filing his amended answer by now challenging the CCM of tax accounting used by petitioner since its inception in year 1999, and only some five months prior to trial. Moreover, petitioner contends how the Motion for Leave to Amend is not timely, how granting the motion would unfairly prejudice petitioner, how respondent has not been diligent in seeking the amendment, and how respondent has failed offer justification for the delay in filing this amendment.
III. Analysis
A party may amend a pleading once as a matter of course at any time before a responsive pleading is served. Rule 41(a). After pleadings are closed, a party may amend a pleading "only by leave of Court or by written consent of the adverse party, and leave shall be given freely when justice so requires." Id.; Foman v. Davis, 371 U.S. 178, 182 (1962). Whether to permit such an amendment is a matter within the sound discretion of the Court. Estate of Quick v. Commissioner, 110 T.C. 172, 178 (1998); Law v. Commissioner, 84 T.C. 985, 990 (1985). The touchstone in evaluating whether to allow an amendment is the existence of unfair surprise or prejudice to the nonmoving party. Estate of Quick v. Commissioner, 110 T.C. at 178-80; Law v. Commissioner, 84 T.C. at 990.
Rule references are to the Tax Court Rules of Practice and Procedure.
The question of prejudice under Rule 41(a) is not simply whether an amended pleading that includes the proposed new issues would make the case harder or more expensive for the other party, since this is likely to occur in any amendment to the pleadings. Ax v. Commissioner, 146 T.C. 153, 168-69 (2016). Rather, the question of prejudice is whether the addition of those new issues by a later amendment, rather than by inclusion in the initial pleading, creates an unfair disadvantage to the other party. Id.
Respondent moved to amend his answer, some five months in advance of trial. While not ideal timing, we cannot say that the First Amendment to the Amended Answer will create unfair surprise or prejudice to petitioner, should the Court grant respondent's Motion for Leave to Amend. The issue seems to be a legal dispute, relating the application of the anti-abuse rule of Treas. Reg. § 1.460-4(k)(4) and the Partnership's use of the CCM accounting method. We also accept respondent's premise that evidence required to invoke the CCM anti-abuse rule is coextensive with the evidence required to test the economic substance of petitioner's restructuring and/or the partnership anti-abuse rule of Treas. Reg. § 1.701-2(a). See Treas. Reg. § 1.701-2(b)(3).
Finally - and to negate the potential for prejudice - should petitioner need additional time to conduct discovery or a delay (in completion) of trial in light of respondent's First Amendment, the Court is inclined to grant such a request, if made, by petitioner. See Church of Scientology of Cal. v. Commissioner, 83 T.C. 381, 469 (1984) aff'd 823 F.2d 1310 (9th Cir. 1987).
Considering the foregoing, it is
ORDERED that respondent's Motion for Leave to File First Amendment to First Amended Answer, filed on April 24, 2024, is granted. It is further
ORDERED that the Clerk of the Court is directed to file respondent's First Amendment to First Amended Answer, which was lodged on April 24, 2024, into the record of this proceeding.