Partnership Challenges Tax Treatment of Gains From Property Sale

TALLGRASS INVESTORS, LLC, by and through CHARLES BELLOCK, Tax Matters Partner,
Petitioners,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent.

UNITED STATES TAX COURT

PETITION FOR READJUSTMENT OF PARTNERSHIP ITEMS UNDER FORMER SECTION 6226 OF THE INTERNAL REVENUE CODE

Petitioner Tallgrass Investors, LLC, by and through Charles Bellock, its Tax Matters Partner, hereby petitions for a readjustment of the adjustments to partnership items set forth by the Commissioner of Internal Revenue (“Commissioner”) in the Commissioner's Notice of Final Partnership Administrative Adjustment with respect to the taxable year ending 2015, dated September 13, 2021 (the “FPAA”). As a basis for Petitioner's case, Petitioner alleges as follows:

1. Petitioners Tallgrass Investors, LLC, is a limited liability company organized on or about February 15, 2001, under the laws of the State of Colorado, with a principal place of business in Boulder, Colorado. The employment identification number of the Petitioner is set forth in the Statement of Taxpayer Identification Number, filed herewith.

2. Charles Bellock is the Tax Matter Partner for Petitioner, as this term is defined in Section 6231(a) of the Internal Revenue Code of 1986 and the regulations thereunder.

3. Petitioner's United States Partnership Return and accompanying schedules (together, “Form 1065”) for the taxable year ending December 31, 2015 was timely filed with the Internal Revenue Service Center located in Ogden, Utah.

4. The FPAA was mailed to Petitioner on or about September 13, 2021, and was issued by the Independent Office of Appeals, located at 4050 Alpha Road, Suite 517, Dallas, Texas, 75244. A copy of the FPAA is attached hereto as Exhibit A.

5. As determined by the Commissioner, the proposed adjustments to partnership items are as follows:

Adjustment	Amount
Gross Receipts from Property Held for Sale	2,298,907
Cost of Sales	(256,315)
Business Interest Income	70,506
Reclassify Inv Expense as Business	(17,204)
Portfolio Income Interest	(70,506)
Long Term Capital Gain	(2,042,592)
Investment Expenses rel to portfolio income	17,204
Net Earnings from Self Employment	1,953,373

6. The Commissioner's determination of the tax and penalties set forth in the Notice of Deficiency is based upon the following errors:

a. The Commissioner erred in determining that Tallgrass Investors, LLC held its land for sale to customers in its ordinary course of business and, as such, all gains from the sale of its property are ordinary income and not gains from the sale of capital assets. The Commissioner erred additionally in determining that related expenses were ordinary business expenses rather than investment expenses. The Commissioner erred in increasing gross receipts from property held for sale by $2,298,907 for the tax year ended December 31, 2015.

b. The Commissioner erred when he increased the cost of sales by $256,315 for the tax year ended December 31, 2015.

c. The Commissioner erred in when he determined that all expenses related to Petitioner's operations are considered ordinary business expenses and not investment expenses, and in increasing business interest income by $70,506.00 for tax year ended December 31, 2015.

d. The Commissioner erred when he determined that business expenses should be increased by $17,204.00 for tax year ended December 31, 2015.

e. The Commissioner erred when he determined that portfolio income — interest should be decreased by $70,506.00 for tax year ended December 31, 2015.

f. The Commissioner erred when he determined that long-term capital gains should be decreased $2,042,592.00 for tax year ended December 31, 2015.

g. The Commissioner erred when he determined that portfolio income should be decreased by $70,506.00 for tax year ended December 31, 2015.

h. The Commissioner erred when he determined that investment expenses related to portfolio income should be decreased by $17,204.00 for tax year ended December 31, 2015.

i. The Commissioner erred when he determined that, as a result of adjustments in this notice, the net earnings from self-employment are $1,953,373.00 rather than $0.00 as shown on Petitioner's return, and increased the net earnings from self-employment by $1,953,373.00.

j. The Commissioner erred when he determined that Petitioner was liable for the accuracy-related penalty imposed under section 6662(a) of the Internal Revenue Code for the tax year ended December 31, 2015, because there was (1) a substantial understatement of income tax, (2) there was a valuation misstatement, or (3) Petitioner was negligent or disregarded rules or regulations. The Commissioner erred when he determined that Petitioner had not shown that it had reasonable cause for the underpayment of tax or that any exceptions to the penalty apply.

7. The facts upon which Petitioner relies, as the basis of Petitioner's case, are as follows:

The Acquisition of Surplus Property from Union Pacific, and the Establishment of Tallgrass Investors, LLC and Community Development Group of Erie, Inc.

a. In 1998, Community Development Group of Erie, LLC (“CDGE, LLC”) (an entity owned by some of the principals who are also members of Petitioner) entered into a purchase and sale agreement with Union Pacific to purchase 2,809 acres of the railroad's land located near Erie, Colorado for $6,500,000. This property encompassed seven separate parcels, labelled A through H (omitting F). Union Pacific was willing to dispose of the land at a very favorable price (less than $2,500/acre). The purchase and sale contract was extended twice, each time with the payment of additional non-refundable earnest money deposits to Union Pacific.

b. In 1999, while the land was under contract to CDGE, LLC, individuals who were later associated with Petitioner attempted to convince the Town of Erie to annex the entire Union Pacific property, which would have substantially increased the value of the property, and expended significant funds in an effort to achieve that objective. A consolidated annexation proposal for the development (then known as “Northfield”) was submitted and approved unanimously by both Erie's Planning Board and the Board of Trustees. However, the planned annexation was opposed by some residents. Ultimately, a referendum was held, and the voters of Erie rejected the annexation proposal in an election held on December 14, 1999.

c. After the failed annexation attempt, the Mayor of Erie suggested that there would be a better chance of annexation if the property were broken into multiple parcels and annexations were pursued piecemeal.

d. For the 1999 tax year, CDGE, LLC filed a final return, writing off the cost of the failed annexation attempt (but not the earnest money spent on the land contract). The rights under the contract were treated as having been distributed out to the members of the LLC in an amount equal to CDGE, LLC's payments of earnest money (approximately $325,000).

e. In November of 2000, CDGE, LLC transferred its rights under the Union Pacific purchase and sale contract to Weld County Land Company, LLC (“WCLC”), an entity formed and owned by the same principals as CDGE, LLC. The members of CDGE, LLC were treated as having received a “distribution” from CDGE, LLC (i.e., the rights under the contract), and then in turn making an initial capital contribution to WCLC, LLC of the self-same contract rights.

f. WCLC and Union Pacific subsequently entered into a modification of the purchase and sale contract, reducing the price from $6,500,000 to $6,022,000 to reflect the fact that portions of the property were determined to be undevelopable.

g. WCLC purchased the Union Pacific land on November 14, 2000. WCLC's purchase of the Union Pacific land was financed by two notes, one to KeyBank, N.A. for $3 million, and a second to the seller, Union Pacific, for $3,011,000.

h. On February 15, 2001, WCLC transferred portions, but not all, of the Union Pacific land to four newly formed LLCs (each of which had the same set of owners as WCLC), including Tallgrass Investors, LLC (“Tallgrass”). The transaction was treated as a distribution of LLC property to members, and then a recontribution of property by the members to the newly formed LLCs. Tallgrass's intention was to invest in real property for appreciation.

i. Subsequent to the transfer of portions of the Union Pacific property to the new LLCs, the loan agreement between WCLC and KeyBank, N.A. was amended to add the new LLCs (including Tallgrass) as “borrowers” in addition to WCLC.

j. The separation of the 2,809-acre Union Pacific property into five parcels and the placement of ownership of the parcels into separate LLCs accomplished two objectives. First, based on comments received from the Mayor of Erie, it was believed that pursuing annexation piecemeal, i.e., a parcel-by-parcel approach, might prove to be a more successful strategy. Second, it potentially limited cross-entity liability exposure.

k. It was the intent of Tallgrass to hold the parcel of property that it had received from WCLC for appreciation; neither entity planned to engage in any development activities with respect to the property that it received.

l. In early-2001, pursuant to Colorado law, CDGE, LLC, an entity that — at this point in time — held no interest in the Union Pacific land or any other assets, converted its status from a limited liability company to a corporation. The entity became Community Development Group of Erie, Inc. (“CDGE, Inc.” or “CDGE”), and elected S corporation status at that time.

m. CDGE's purposes were to 1) obtain the “entitlements” (annexation, zoning, and platting) for parcels that it purchased; 2) be responsible for the cost of bringing utilities — water and sewer — to the parcels; and 3) to do some onsite development, including roads, if necessary to support the entitlements. It was expected that CDGE would, at some later point in time, purchase the parcels from WCLC, Tallgrass and the other landholding entities, engage in development, and sell parcels to builders who would construct homes and sell them to the general public. While it was understood that the landholding entities, including Tallgrass, would report their gains on sales to CDGE as capital gains, it was anticipated that CDGE would report its profit on the later resale of parcels to third parties as ordinary income.

n. During the period between 2001 and 2005, CDGE entered into various purchase and sale contracts with the entities that held the former Union Pacific land, including Tallgrass. These purchase and sale agreements typically had a closing date set out several years into the future.

CDGE Purchases Property from Tallgrass

o. While the contract for the purchase of the Union Pacific property, entered into originally in 1998, contained a purchase price of less than $2,500/acre, the value of the property increased significantly over the following years, as the hot real estate market in ex-urban Denver was driving up the value of unimproved land. In late 2000, after the property had been transferred to Tallgrass, a portion of the former Union Pacific property was appraised on an “as is” basis at $15,000/acre, or about six times the 1998 contract purchase price.

p. In the 2000 to 2003-time frame, the value of properties near the Town of Erie was rapidly increasing as the probability of development increased, and other sales of undeveloped land in the area were occurring at prices between $18,000/acre and $31,000/acre.

q. On May 16, 2005, after Tallgrass had held its portion of the Union Pacific property for more than four years, CDGE entered into a contingent contract with Tallgrass to purchase the Tallgrass property, providing for a payment of 75% of the net profit (after taking into account expenses at both the landholding entity level and the CDGE level) to Tallgrass and 25% of the net profit to CDGE. Subsequently, in 2005, CDGE lined up a potential buyer for the property, and the amount which would have been received by Tallgrass would have been about $42,500/acre, a price consistent with what similar parcels in the area were selling for in 2005. However, because of the onset of the Great Recession, the anticipated sale never occurred.

r. In 2007, CDGE and Tallgrass amended their purchase and sale agreement, providing for a fixed purchase price, rather than a percentage purchase price. The purchase price in the amended agreement was based on an appraisal by National Valuation Consultants of $19.8 million, or approximately $21,000/acre.

s. CDGE, as the developer of the Tallgrass property, negotiated with the Town of Erie regarding the annexation of the property, and, in 2007, the Town of Erie approved the annexation of the Tallgrass property into Erie.

t. While the Town of Erie had given its approval to the development of the property in 2007, little was done in the following few years in light of the collapse in the housing market caused by the Great Recession.

u. In 2013, the housing market had rebounded, and approximately two thirds of the Tallgrass property was acquired by CDGE from Tallgrass and sold to third party home builders in that year. As the market price of the property had risen substantially, the per-acre price on the sale to third parties was substantially higher than the acquisition price set out in the 2007 contract.

v. In 2015, CDGE purchased an additional portion of the Tallgrass Investors, LLC property for approximately $2.3 million. Tallgrass reported over $2 million in capital gains with respect to this transaction, and its owners paid tax on this gain. CDGE resold this property to a third party for approximately $11 million.

The IRS Proposed Adjustments

w. The IRS audited CDGE and Tallgrass for the years 2014-2016. Based on adjustments to the tax returns of CDGE, the IRS proposed deficiencies against the shareholders of that entity for the years 2014-2016. The CDGE shareholders have each filed petitions in the Tax Court, contesting the proposed deficiencies.

x. In Notices of Deficiency issued to CDGE's shareholders, the IRS sought to ignore the 2007 contract between CDGE and Tallgrass and treated CDGE as having purchased the property directly from Union Pacific back in 2000. The IRS accordingly adjusted CDGE's basis in this property downward by over $1.9 million, without taking into account the substantial income and tax reported by Tallgrass and its members/owners.

y. In the FPAA issued to Tallgrass, the IRS seeks a “whipsaw” adjustment, again ignoring the sale from Tallgrass to CDGE, but treating Tallgrass (rather than CDGE) as it had owned the property from 2001 to 2015, and acted as the developer of the property. The adjustments to the Tallgrass return treat the full amount of gain recognized on Tallgrass' return as ordinary income, subject to self-employment tax.

z. The IRS's efforts to collapse and ignore transactions between commonly owned entities, one of which invests in real property, and another which is involved in the development of the real property, has been rejected in cases such as Bramblett v. Comm'r, 960 F.2d 526 (5th Cir. 1992), rev'g T.C. Memo 1990-296; Paullus v. Comm'r, T.C. Memo. 1996-419; Phelan v. Comm'r, T.C. Memo. 2004-206, and Sugar Land Ranch Development, LLC v. Comm'r, T.C. Memo. 2018-21. The facts in this case do not warrant the collapsing of the transactions, and the transaction between the investment entity (Tallgrass) on the one hand, and the development entity (CDGE) on the other, should be respected.

Facts Regarding Penalties

aa. There was no substantial understatement of income tax pursuant to Section 6662(b)(2) and 6662(d).

bb. Petitioners were not negligent in the preparation of the income tax returns, nor did they disregard the rules and regulations within the meaning of Sections 6662(b)(1) and 6662(c).

cc. There was no substantial valuation misstatement (overstatement) pursuant to Sections 6662(b)(3) and 6662(e).

dd. In connection with the structuring of the arrangements at issue in this case, Petitioner and its principals were advised by Robert Guerra, a CPA with a tax practice specializing in real estate investment and development.

ee. Petitioner relied on Mr. Guerra for the preparation of its 2014-2016 income tax returns. Petitioner and its principals provided Mr. Guerra with all of the information they had regarding the transactions between the commonly controlled entities.

ff. Petitioner acted with reasonable cause and good faith as those terms are defined for purposes of section 6664.

WHEREFORE, Petitioner prays that this Court may hear this case and determine that:

1. There are no adjustments to Petitioner's 2015 partnership income tax return;

2. The Commissioner erred in the FPAA as alleged in each assignment of error set forth in this Petition;

3. The penalties under section 6662 of the Internal Revenue Code as asserted in the FPAA should not be imposed; and

4. The Court grant such other and further relief to which the Petitioner may be entitled.

DATED this 28th day of October, 2021.

John M. Colvin, U.S. Tax Court No. CJ1464
Colvin & Hallett, P.S.
719 Second Ave., Suite 711
Seattle, WA 98104
Telephone: (206) 223-0800

Attorney for Petitioner