Daniel J. Culnen v. COMMISSIONER OF INTERNAL REVENUE On Appeal from the Decision of the United States…

NOT PRECEDENTIAL
UNITED STATES COURT OF APPEALS
FOR THE THIRD CIRCUIT
__________
NO. 01-1138
__________
DANIEL J. CULNEN,
Appellant
v.
COMMISSIONER OF INTERNAL REVENUE
_________
On Appeal from the Decision
of the United States Tax Court
at Tax Court Nos. 94-06496 and 92-25551
Tax Court Judge: Honorable James S. Halpern
__________
Argued November 7, 2001
Before: BECKER, Chief Judge, McKEE and RENDELL, Circuit Judges
(Filed: January 7, 2002)
_______________
Frank Agostino, Esq. [ARGUED]
Susan M. Flynn, Esq.
Calo Agostino, Esq.
27 Warren Street
Hackensack, NJ 07601
Counsel for Appellant
Teresa E. McLaughlin, Esq.
Andrea R. Tebbets, Esq. [ARGUED]
United States Department of Justice
Tax Division
P. O. Box 502
Washington, DC 20044
Counsel for Appellee
__________
OPINION OF THE COURT
__________
RENDELL, Circuit Judge.
Daniel J. Culnen was a 73% stockholder in Wedgewood Associates, a
subchapter (s) corporation in the restaurant business. When Wedgewood ceased doing
business, it made an assignment for the benefit of creditors, abandoned its furniture and
fixtures, and reported a net loss of $2,410,941. Culnen’s tax return for the same year
showed his 73% share of the Form 4797 loss to be $1,759,987. The Commissioner
disallowed Culnen’s deduction of the loss. On appeal, the Tax Court ruled not that the
loss was improperly deducted by Culnen, but, rather, that Wedgewood’s loss for tax
purposes was not the amount claimed, but was, instead, $515,243. We will REVERSE
the Tax Court’s ruling.
The deficiency notice sent by the IRS to Culnen disallowed Culnen’s pro rata
share of Wedgewood’s loss:

-- 1 of 4 --

It has been determined that you did not sustain the $1,759,987.00 loss,
allegedly derived from your ownership interest in Wedgewood Associates
Inc., reported on your return for the 1990 taxable year. In the event that a
court of competent jurisdiction determines that you did sustain, all or a
portion of such reported loss, you are not entitled to a deduction for such
loss for the following reasons: (1) you have failed to establish that you have
adequate basis in your interest in Wedgewood Associates Inc. to deduct
any of this reported loss amount; (2) the amount of this reported loss
exceeds your basis in the stock and debt of Wedgewood Associates Inc.
pursuant to the provisions of I.R.C. Section 1366(d)(1); (3) such reported
loss exceeds the amount for which you were at risk during the 1990 taxable
year under the provisions of I.R.C. Section 465; (4) the reported loss is not
deductible since such loss is considered a passive activity loss which is not
deductible under the provisions of I.R.C. Section 469; and (5) the reported
loss is not deductible under the provisions of I.R.C. Section 267(a) since
the parties to the transaction(s) which generated such loss are related
parties under provisions of I.R.C. Section 267(b).
Culnen was, therefore, put on notice that he had the burden to establish his basis
in his stock and establish its deductibility, meeting the challenge that it was passive
activity loss, and its disallowance based on the theory that the parties to the transactions
were related parties. The deficiency notice did not challenge Wedgewood’s loss, but
only Culnen’s ability to deduct his pro rata share of the loss. The pleadings, pretrial
motions, status reports, trial memoranda, and trial transcripts all focus on the amount of
his loss and his pro rata share.
At trial, Wedgewood’s tax preparer testified as to the nature and amount of the
loss, specifically, that it consisted of the acquisition price of furniture and fixtures less
depreciation based upon the fact that the corporation had essentially abandoned the
furniture and fixtures to an assignee for the benefit of creditors. Culnen offered evidence
to prove his basis, specifically the nature and amount of his investments over time, many
of which were made through his partnership, Culnen & Hamilton, and he offered
evidence to refute the IRS’ contention regarding the related party and passive activity
issues.
At the conclusion of the trial, the government argued for the first time, and the
Tax Court considered, whether Wedgewood correctly calculated the losses resulting from
the assignment pursuant to I.R.C. Section 1001. Culnen objected to the consideration of
this issue, since it had never been raised in the deficiency notice, or raised in the course
of pre-trial proceedings. It is undisputed that the government produced no evidence
relating to the corporate-level loss issue.
In its opinion, the Tax Court framed the issue as follows:
Respondent disallowed petitioner’s pro rata share of Wedgewood’s
ordinary losses for 1987, 1989, and 1990 because petitioner failed to
convince respondent that he had an adequate basis with respect to his
investment in Wedgewood. We must determine that basis. Respondent
disallowed petitioner’s share of the Form 4797 loss (the $1,759,987 loss)
for the same reason and because petitioner failed to convince respondent
that Wedgewood suffered the $1,759,987 loss. We must determine both
his basis and whether Wedgewood suffered any loss. (emphasis added)
The Tax Court then proceeded to review the evidence offered, and concluded that
Culnen had indeed proven that he had an adequate basis with respect to his investment in
Wedgewood. The Tax Court then turned its attention to the issue of the Form 4797 loss
and embarked upon a discussion of Section 1001 of the Internal Revenue Code and its
definition of "amount realized," noting that the regulations provide that, for purposes of
that section, the sale or the disposition of property that secures a nonrecourse liability
discharges that liability, and that, according to the regulations, the "amount realized"
from the sale or disposition of the property includes the amount of liabilities from which
the transferor is discharged as a result of the disposition. The court then noted,
"Respondent’s position is that Wedgewood did not realize any loss."
The court then criticized Culnen’s failure to adduce proof regarding the amount
realized on the sale of the furniture and fixtures, and his failure to show that the

-- 2 of 4 --

indebtedness secured by the liens on those assets was nonrecourse. The court then made
an assumption that the debt was nonrecourse and that the "amount realized" for tax
purposes would include the amount of the liens, namely $1,865,000. After making other
mathematical calculations, the court concluded that the "amount realized" was
$1,991,001, and, since the adjusted basis was $2,506,244, Wedgewood’s loss was
$515,243, and petitioner’s pro rata share was therefore $376,127.
Culnen contends that we should either reverse the ruling of the Tax Court based
upon the theory of "meet the hold," or should remand for a determination regarding the
section 1001 issue, since the Tax Court ruled without any evidentiary basis. We hold
that, whether based on "meet the hold," or simply notice principles of due process, we
will reverse because the Tax Court improperly ruled against Culnen based on an issue as
to which Culnen was never advised - namely a last minute challenge to the amount of
Wedgewood’s loss. The Court did determine, however, that Culnen did prevail on the
issues raised in the deficiency notice. Accordingly, Culnen is entitled to prevail on the
claims raised in the deficiency notice, and judgment should be entered in his favor.
At oral argument, counsel for the Commissioner urged that the deficiency notice’s
reference to "adequate basis in your interest" and "reported loss exceeds your basis" were
sufficient to put Culnen on notice that the amount of the corporate loss was under attack.
We disagree. To the contrary, the deficiency notice was addressed to Culnen, and never
referenced Wedgewood except as it related to Culnen’s stock or interest in the
corporation. The notice stated, "It has been determined that you did not sustain the
$1,759,987 loss allegedly derived from your ownership interest in Wedgewood
Associates, Inc. reported on your return for the 1990 taxable year." The emphasis on
"you" and "your" clearly communicates that the notice was addressed to Culnen’s loss,
not Wedgewood’s. We note that Wedgewood’s loss, and its amount, has never been
challenged by the IRS, and there is no evidence that its loss was ever determined to be an
amount other than the amount used by Culnen in calculating the amount of his deduction
for purposes of the Form 4797. While the IRS would be free to attack the amount of
Wedgewood’s loss in a deficiency notice addressed to it, or as part of an attack on
Culnen’s deduction of a percentage thereof, this challenge was never made since the
corporate loss issue was never raised in the deficiency notice, or in any of the pretrial
proceedings. Rather, it appears to have surfaced only when it appeared that Culnen
could in fact trace his investments and show his basis in the stock he owned and, thus,
prove the allowability of the deduction he claimed.
Among the principles animating our conclusion is the "meet the hold" doctrine
Culnen suggests. That doctrine prohibits a party from changing his ground and "putting
his conduct upon another and different consideration." Ohio & Mississippi Railway Co.
v. McCarthy, 96 U.S. 258, 267 (1878). The fairness concerns that underlie this principle
are consistent with the most elementary requirements of due process. Here, we are
troubled by the total lack of notice of the nature of the IRS’s claim so as to inform
Culnen of the proof he must present, given his burden in a proceeding to challenge the
deficiency notice. More than an inequitable change of position, the Commissioner
essentially asserted an entirely new claim. Perhaps the situation would be different if the
notice of deficiency had consisted of a vague challenge to the loss, but later proceedings
had made clear the nature of the IRS’s theory. However, here, the numerous stipulations
and record statements regarding the issues are devoid of any mention of attack on
Wedgewood’s loss, let alone specific contention that the "amount realized" was being
challenged based on the provisions and regulations under section 1001 regarding
recourse debt and dischargeability. The stipulations and various statements of the issues
say nothing remotely touching on this issue. Further, the surprise and disadvantage to
Culnen are obvious from the record and result. In Commissioner v. Transport Mfg. &
Equip. Co., 478 F.2d 731 (8th Cir. 1973) the court noted that the taxpayer must be
advised of the theory being advanced by the Commissioner: "The failure to advise the
taxpayer of such information is extremely prejudicial. Deficiency assessments are
usually presumptively correct, and the taxpayer has the burden to prove them wrong.
The taxpayer works at an extreme disadvantage in trying to invalidate deficiency
assessments if he does not specifically know why the Commissioner is challenging the
taxpayer." Id at 735.
Here the theories set forth in the notice of deficiency were successfully rebutted by
Culnen’s evidence. Accordingly, we will reverse the Tax Court’s order and remand for

-- 3 of 4 --

entry of judgment in favor of Culnen.
________________________
________________________
TO THE CLERK OF COURT:
Please file the foregoing Not Precedential Opinion.
/s/Marjorie O. Rendell
Circuit Judge

-- 4 of 4 --