T.C. Memo. 2003-161
UNITED STATES TAX COURT
ROBERT E. AND YVONNE R. KOVACEVICH, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 12815-99. Filed June 3, 2003.
Robert E. Kovacevich and Richard W. Kochansky, for
petitioners.
Milton B. Blouke and Roger P. Law, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
FOLEY, Judge: By notice of deficiency dated April 28, 1999,
respondent determined deficiencies, additions to tax, and
penalties relating to petitioners’ 1992 through 1994 Federal
income tax returns as follows:
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Addition to Tax Penalty
Year Deficiency Sec. 6651(a) Sec. 6662(b)(1)
1992 $18,232 $1,330 $3,176
1993 8,347 1,442 --
1994 13,074 -– 2,615
After concessions by both parties, the section 6651(a)(1)
addition to tax relating to 1992 and all issues relating to 1993
were settled. The remaining issues for decision are whether:
(1) Petitioners failed to report income that Robert E. Kovacevich
(petitioner) received from Western Management, Inc. (Western);
(2) income reported by petitioners is properly classified as
gross receipts from a Schedule C business rather than as wages;
(3) petitioners are entitled to certain business deductions; and
(4) petitioners are liable for section 66621 penalties.
FINDINGS OF FACT
Petitioner was admitted to practice law in the State of
Washington in 1959. In 1981, petitioner incorporated Robert E.
Kovacevich, P.S., a Washington C corporation, whose name was
subsequently changed to Western Management, Inc. From its
incorporation through 1994, Western’s only source of income was
from the provision of legal services, and petitioner was
Western’s sole shareholder, president, and secretary-treasurer.
In 1981, Western’s board of directors voted to pay petitioner
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
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$28,000 in 1982 and $60,000, annually, thereafter. Petitioner
designated Seattle First National Bank, Spokane and Eastern
Branch (Seafirst), as the depository for all of Western’s funds.
All moneys that were paid on Western’s accounts receivable were
deposited in the Seafirst account.
Petitioner worked 160 to 180 hours per month for Western and
performed all services necessary to generate Western’s gross
receipts. From 1992 through 1995, petitioner made all major
decisions for Western including: Paying creditors, hiring
employees, signing checks, determining employee compensation,
renewing Western’s malpractice insurance, and signing Western’s
Federal tax returns. No other person performed legal services on
behalf of Western.
Petitioner received funds from Western as his needs arose
and was not compensated for his services at predetermined
intervals. In 1992 and 1994, respectively, Western paid
petitioner $135,000 and $132,000. Western issued checks to
petitioners and their creditors (e.g., Nordstrom, Teneff Jewelry,
Fit and Hollywood, and National Golf), and petitioner informed
Western’s accountant and tax return preparer, Bob Moe and
Associates (Moe), that these payments were draws. Western
classified the payments as “loans” on its corporate ledgers and
did not file Forms 1099-MISC, Miscellaneous Income, relating to
the payments. Western also paid petitioner’s law license renewal
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fees, office expenses, bar dues, and health insurance premiums
and deducted most of these expenses on its corporate income tax
returns.
Petitioners maintained, at Farmers and Merchants Bank, a
personal line of credit. On the corporate ledgers, Moe listed
checks written to Farmers and Merchants Bank and MBNA in the
“Receivable from Officer” account. These checks had an “LN” memo
description, indicating that the payment related to a loan or the
“Receivable from Officer” account.
From 1982 through 1992, Western sponsored a defined benefit
plan for petitioner, its only participant. In 1982 and 1984,
respectively, Western contributed $46,473 and $81,822 to the
plan. In the early 1980s, petitioners and the pension plan
invested $160,000 (i.e., petitioners invested $70,000 and the
pension plan invested $90,000) in a business venture.
Petitioners and the pension plan later sued the venture’s
promoter and, in 1992, were awarded a $20,852 recovery of their
investment. Petitioners retained the pension plan’s portion of
the recovery (i.e., $11,677).
In 1984, petitioners bought a 1973 Rolls Royce for $27,000.
Petitioners used the Rolls Royce for business promotion in 1984
and 1985. In 1985, the automobile’s engine failed, and, as a
result, petitioners were not able to use the automobile for
approximately 2-1/2 years.
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With input from Moe, petitioners prepared and filed their
1992 and 1994 joint tax returns. On the Schedule C, Profit or
Loss From Business, attached to their 1992 individual income tax
return, they reported $103,046 in gross receipts relating to
Western’s law practice (i.e., $90,000 of compensation and $13,046
of rent payments from Western). On the Schedule C attached to
their 1994 individual income tax return, they reported $102,565
in gross receipts relating to Western’s law practice (i.e.,
$90,000 of compensation and $12,565 of rent payments from
Western) and a $1,475 depreciation deduction relating to the
automobile.
Western’s fiscal year ends on March 31. On its 1992, 1993,
1994, and 1995 corporate income tax returns, Western deducted
officers’ compensation expenses in the amounts of $135,000,
$144,000, $132,000, and $133,000, respectively. Petitioner
amended Western’s 1991 Form 941, Employer's Quarterly Federal Tax
Return, with the following statement:
The amount of earnings of Employee Robert E. Kovacevich
was not clear, hence was left off. The Employee paid
all Income Tax due, hence the withholding is
unnecessary. However the Social Security Tax is due.
A completed W-2(c) term is included.
On September 30, 1995, Western made a payment of $22,583 in
income tax withholding relating to petitioners’ 1992 and 1993
employment taxes.
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In 1991, a former client, Terry Stokke, sued petitioner for
allegedly committing fraud with respect to a pooled investment.
Petitioner settled the lawsuit in 1992 for $39,000 and reported
this amount as a Schedule C expense on their 1992 tax return.
At the time the petition was filed, petitioners resided in
Spokane, Washington.
OPINION
I. Jurisdiction
On October 18, 2000, the Court filed petitioners’ Motion To
Dismiss “Wages” Issue In 1992 For Lack Of Jurisdiction, in which
petitioners contended that Western’s 1995 payment of $22,583.20
in income tax withholding discharged petitioners’ tax liability
relating to petitioners’ 1992 unreported wages. We disagree.
Congress has specifically given this Court jurisdiction to
redetermine a deficiency if a valid notice of deficiency has been
issued and a petition has been timely filed. Secs. 6212(a),
6213(a), and 6214(a); Rule 13(a), (c); Monge v. Commissioner, 93
T.C. 22, 27 (1989); Normac, Inc. v. Commissioner, 90 T.C. 142,
147 (1988). Therefore, petitioners’ motion will be denied.
Petitioners further contend that the notice of deficiency is
invalid because respondent did not make a determination. In
support of their position, petitioners state that “the
unexplained arrows and rounding of * * * [the amounts of the
deficiencies] indicate vagueness.” In the notice, respondent
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determined deficiencies in the amounts of $18,232 and $13,074
relating to 1992 and 1994, respectively. See Perlmutter v.
Commissioner, 44 T.C. 382, 400 (1965)(holding that a valid notice
of deficiency indicates that the respondent has determined a
deficiency in tax in a definite amount for a particular taxable
year and intends to assess the tax in due course), affd. 373 F.2d
45 (10th Cir. 1967). A notice of deficiency is not invalid for
failure to explain the adjustments or to cite statutory
provisions on which respondent relied. See, e.g., Henry Randolph
Consulting v. Commissioner, 113 T.C. 250, 253 (1999); Campbell v.
Commissioner, 90 T.C. 110 (1988); Mayerson v. Commissioner, 47
T.C. 340, 348-349 (1966); St. Paul Bottling Co. v. Commissioner,
34 T.C. 1137 (1960). Accordingly, we reject petitioners’
contention.
II. Unreported Income
Petitioners contend that it was inappropriate for respondent
to use the “specific item” method to determine petitioners’
deficiencies. The “specific item” method is an indirect method
of income reconstruction, which consists of evidence of specific
amounts of income received by a taxpayer and not reported on the
taxpayer’s return. Estate of Beck v. Commissioner, 56 T.C. 297,
361 (1971). It is well settled that taxpayers are required to
report every item of income received and maintain records to
establish the correct amount of income, deductions, and credits
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required to be shown on their tax returns. Petzoldt v.
Commissioner, 92 T.C. 661, 687 (1989). Petitioners failed to
keep sufficient records. Thus, respondent was justified in using
the “specific item” method of proof to determine petitioners' tax
liabilities relating to 1992 and 1994. See Estate of Beck v.
Commissioner, supra at 353-354 (“there is no restriction on the
method or theories by which respondent may test his views that
unreported income exists provided they are reasonably calculated
to disclose the presence or absence of unreported income”).
Accordingly, we reject petitioners’ contention.2
Petitioner received $135,000 and $132,000 relating to 1992
and 1994, respectively. Petitioners, however, reported only
$90,000 in compensation in each year. Petitioners failed to
establish that the checks written for petitioners’ benefit
(e.g., checks written to petitioners’ creditors) were not
includable in their gross income and failed to adequately rebut
respondent’s determination of unreported income. Therefore, we
conclude that petitioners failed to report additional income in
the amounts of $45,000 (i.e., $135,000 income received minus
2
The burden of proof is on petitioners to show that
respondent’s deficiency determination is incorrect. Rule 142(a);
Welch v. Helvering, 290 U.S. 111 (1933). Sec. 7491 is
inapplicable because the examination began before July 22, 1998,
the section’s effective date. Internal Revenue Service
Restructuring & Reform Act of 1998, Pub. L. 105-206, sec.
3001(c), 112 Stat. 685, 726.
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$90,000 income reported) and $42,000 (i.e., $132,000 income
received minus $90,000 income reported) relating to 1992 and
1994, respectively.
III. Employment Status
Respondent determined in the notice of deficiency that
payments from Western, reported on petitioners’ Schedule C, are
wage compensation and the business expenses deducted by
petitioners are miscellaneous itemized deductions. Respondent
contends that petitioner was an employee of Western because he
was an officer who performed substantial services. Petitioner,
relying on several contentions that have been rejected in similar
circumstances, contends that he was not an employee of Western.
Pursuant to section 3121(d)(2), the term “employee” includes
any individual who has the status of an employee under the
applicable common law rules. Paragraphs (1), (3), and (4) of
section 3121(d) delineate “statutory employees”. These
individuals are considered employees regardless of their status
under the common law. See Joseph M. Grey Pub. Accountant, P.C.
v. Commissioner, 119 T.C. 121, 126 (2002). Any officer of a
corporation is a statutory employee, if such officer performs
substantial services for a corporation and receives remuneration
for those services. See Veterinary Surgical Consultants, P.C. v.
Commissioner, 117 T.C. 141 (2001), affd. sub nom. Yeagle Drywall
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Co. v. Commissioner, 54 Fed. Appx. 100 (3d Cir. 2002); sec.
31.3121(d)-1(b), Employment Tax Regs. Petitioner was a statutory
employee because at all relevant times he served as Western’s
president, worked in all significant aspects of Western’s
business, performed substantial services for Western in his
capacity as an officer, and obtained remuneration for such
services from Western as his needs arose.
IV. Pension Plan Recovery
Petitioners received and retained an $11,677 recovery that
belonged to the pension plan. Petitioners contend that these
funds were rolled over into an Individual Retirement Account, but
their testimony on this issue was unconvincing, and they did not
present any supporting documentation. Accordingly, the $11,677
must be included in income.
V. Schedule C Expenses
For depreciation purposes, automobiles are classified as 3-
year property. Rev. Proc. 83-35, 1983-1 C.B. 745. The period
for depreciation of an asset begins when the asset is placed in
service and ends when the asset is retired from service. Sec.
1.167(a)-11(e)(1), Income Tax Regs. Petitioners contend that the
automobile was not placed in service until 1990 because the
engine failed in 1985, and the automobile could not be used for a
few years. Petitioners further contend that, pursuant to section
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280F, which limits the deduction of luxury automobiles, they are
entitled to a $1,417 deduction relating to 1994.
Petitioners bought the Rolls Royce for $27,000 in 1984 and
placed it in service that year. Once placed in service
depreciation continues until the cost basis of the property has
been either recovered through previously allowed or allowable
depreciation deductions or the property is retired from service
(i.e., sold, abandoned, or destroyed). Sec. 1.167(a)-10, Income
Tax Regs.; Rev. Proc. 87-57, sec. 2.05, 1987-2 C.B. 687, 688.
Petitioners’ automobile was not retired from service prior to the
years in issue. Thus, pursuant to section 280F(a), the
automobile would have been fully depreciated well before
petitioners filed their 1994 return, on which they deducted the
$1,475. Sec. 280F(a)(2)(B)(iv); sec. 1.167(a)-10(a), Income Tax
Regs. Accordingly, their deduction is disallowed. Because
petitioner is an employee of Western, we also hold that the
$39,000 expense is deductible as a miscellaneous itemized
deduction. Sec. 67(a).
VI. Penalties
Section 6662(a) imposes a 20-percent accuracy-related
penalty on the portion of an underpayment of tax which is
attributable to a taxpayer’s negligence or disregard of rules or
regulations. Sec. 6662(b)(1). Section 6664(c)(1) provides that
no penalty shall be imposed if it is shown that there was
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reasonable cause for the underpayment and that the taxpayer acted
in good faith. The determination of whether a taxpayer acted
with reasonable cause and in good faith depends upon the facts
and circumstances. See sec. 1.6664-4(b)(1), Income Tax Regs.
Reliance on the advice of an accountant may demonstrate
reasonable cause and good faith. See id. Petitioners contend
that they relied in good faith on the advice of Moe, but
petitioners did not provide Moe with accurate information (e.g.,
mischaracterizing payments made by Western to various creditors
of petitioners as loans instead of wages). Under such
circumstances, reliance on an accountant's advice is not in good
faith and does not establish that the taxpayer acted with
reasonable cause. See Paula Constr. Co. v. Commissioner, 58 T.C.
1055, 1061 (1972), affd. without published opinion 474 F.2d 1345
(5th Cir. 1973). Moreover, petitioner is an experienced tax
lawyer who manipulated income received from Western. Petitioner
did not exercise due care in the filing of his return and thus is
liable for the section 6662(a) penalty. Welch v. Helvering, 290
U.S. 111, 115 (1933).
Contentions we have not addressed are irrelevant, moot, or
meritless.
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To reflect the foregoing,
An order denying
petitioners’ motion to dismiss
will be issued, and decision
will be entered under Rule
155.