T.C. Memo. 2003-327
UNITED STATES TAX COURT
WATERFALL FARMS, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
RODNEY F. HUBER AND POLLY HUBER, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 5363-01, 5365-01. Filed November 25, 2003.
Douglas Bleeker, for petitioners.
Douglas Polsky and Charles Berlau, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
JACOBS, Judge: These cases have been consolidated for
trial, briefing, and opinion. In separate notices of deficiency,
respondent determined deficiencies in petitioners’ Federal income
- 2 -
tax and accuracy-related penalties under section 66621 for 1995,
1996, and 1997 as follows:
Waterfall Farms, Inc., Docket No. 5363-01:
Penalty
Year Deficiency Sec. 6662(a)
1995 $184 $37
1996 195 39
1997 2,507 501
Rodney F. and Polly Huber, Docket No. 5365-01:
Penalty
Year Deficiency Sec. 6662(a)
1995 $1,706 --
1996 855 --
1997 2,505 --
The issues for decision are:
(1) Whether amounts paid by Waterfall Farms, Inc. (Waterfall
Farms or the corporation), to provide medical care, food, and
lodging to its shareholders, Rodney F. Huber (Mr. Huber) and
Polly Huber (Mrs. Huber) (collectively the Hubers), and their
daughter are (a) constructive dividends, as respondent maintains,
or (b) employee medical care expenses and/or reimbursed employee
expenses that are excluded from the Hubers’ gross income and
deductible by Waterfall Farms as ordinary and necessary business
expenses, as petitioners maintain; and
1
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.
- 3 -
(2) whether Waterfall Farms is liable for the accuracy-
related penalty under section 6662(a) for the taxable years ended
November 30, 1995, 1996, and 1997.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulation of facts and the attached exhibits are
incorporated herein by this reference.
When the petitions were filed in these cases, the residence
of the Hubers, as well as the principal place of business of
Waterfall Farms, was in Fulton, South Dakota.
A. The Hubers
The Hubers are husband and wife; they have three daughters.
The Hubers live in a house (the farmhouse) on 6 acres (the
homestead) that, until 1997, they leased from Emma Rose (Ms.
Rose). Between November 1989 and August 1992, the Hubers
acquired four contiguous lots totaling 330 acres (the Huber
farm). The Huber farm consists of farmland and pasture on which
the Hubers raise corn and livestock. There are no houses on the
Huber farm.
B. Waterfall Farms
The Hubers executed articles of incorporation for Waterfall
Farms on March 11, 1994.2 The articles were filed with the
2
Douglas Bleeker, counsel for petitioners, prepared the
articles of incorporation, minutes of meetings, and other
(continued...)
- 4 -
secretary of state of South Dakota on March 22, 1994. The Hubers
conveyed the Huber farm to Waterfall Farms by deed, dated March
10, 1994, that was filed in the Hanson County register of deeds
on March 28, 1994.
The Hubers have been the sole shareholders, officers, and
directors of Waterfall Farms since its incorporation. Mr. Huber
has been president, treasurer, and a director, and Mrs. Huber has
been vice president, secretary, and a director, of Waterfall
Farms.
Article IV, section 10, of the bylaws of Waterfall Farms
provides:
SECTION 10. Repayment of Disallowed Expenses.
Any expense paid by the Corporation which is finally
determined as a personal expense of any officer or
employee and disallowed as Corporation expense shall be
repaid by the officer or employee to the Corporation
within Twenty-four (24) months of the final
determination by the Internal Revenue Service with
interest at Three (3%) below the New York Prime Rate on
the date of final determination.
The first meeting of the board of directors of Waterfall
Farms was held on March 18, 1994. At that meeting, the directors
adopted a medical reimbursement plan covering all “employees and
officers executing management responsibilities” and their spouses
and dependents. The medical reimbursement plan provides for the
payment of all medical care costs that would be “deductible on
2
(...continued)
corporate documents for Waterfall Farms.
- 5 -
Form 1040” (before considering limitations). Under the plan,
each participant is entitled to a maximum reimbursement of
$10,000 per year.
At a special meeting of the directors held on November 1,
1994, the board of directors of Waterfall Farms adopted a
resolution setting forth a repayment obligation similar to that
set forth in the bylaws. At that meeting, the directors also
adopted the following resolution:
RESOLVED that the Corporation’s officers and
employees shall be required to live at the worksite of
the Corporation to ensure security for the Corporation
property and operations. The officers and employees
shall be required to live on the worksite to supervise
the care and feeding of the livestock of the
corporation. The Corporation shall supply said
officers and employees all of their food and lodging
while living at said worksite. That all of the
officers and employees shall be considered “on duty”
when at the worksite and therefore entitled to such
benefits.
C. Farm Lease
During the years at issue, Waterfall Farms leased the Huber
farm to Mr. Huber under a “share-crop” arrangement. Under a
written agreement titled “Farm Lease”, dated December 1, 1994
(the 1995 lease), effective for 1 year (to November 30, 1995),
Mr. Huber agreed to pay Waterfall Farms $15,000 plus one-third of
the proceeds from the sale of all crops grown on the farm. Mr.
Huber was to receive the other two-thirds of the proceeds from
the sale of the crops, as well as all payments received under
- 6 -
Federal conservation programs (or any other Federal, State, or
local governmental programs).
Mr. Huber agreed (1) to farm the land; (2) to provide all
labor and other items required in producing, harvesting, and
marketing the crops; (3) to furnish all tools, farm implements,
machinery, hired help, fertilizer, chemicals, and seed necessary
to cultivate and manage the farm; (4) to protect the crops from
injury and waste; (5) to till the land after harvesting the
crops; and (6) to rotate the crops from year to year. Waterfall
Farms agreed to furnish all necessary materials, and Mr. Huber
agreed to supply all necessary labor, to maintain all fences and
other improvements.
Mr. Huber and Waterfall Farms entered into a second 1-year
farm lease (the 1996 lease), dated December 1, 1995 (ending
November 30, 1996). The provisions of the 1996 lease were
identical to those contained in the 1995 lease except that Mr.
Huber was not required to pay any amount to Waterfall Farms and
the proceeds from the sale of the crops were to be divided three-
fifths to Mr. Huber and two-fifths to Waterfall Farms.
Mr. Huber entered into a third farm lease with Waterfall
Farms, dated December 1, 1996 (the 1997 lease). The 1997 lease
was identical to the 1995 lease except that Mr. Huber agreed to
pay $5,000 to Waterfall Farms plus one-fourth of the proceeds
from the sale of all crops grown on the farm. The term of the
- 7 -
1997 lease was 1 year; it continued in effect year to year until
otherwise canceled.
In 1996, Waterfall Farms acquired 10 cows in order to start
a herd. Mr. Huber, as an employee of Waterfall Farms, was
responsible for the care of the corporation’s livestock.
D. Mr. Huber’s Separate Business Activity
During the years at issue, Mr. Huber (as a self-employed
farmer) farmed properties that were not owned by Waterfall Farms.
These other farms were located 2 to 20 miles from the homestead.
In addition, Mr. Huber worked part time for other employers.
Specifically, he worked for Alexandria Grain and Oil in 1996 and
for Spencer Quarries, Inc., in 1997.
In 1997, Mr. Huber purchased a one-half interest in a race
car. He attended races most Saturday and Sunday nights.
In 1995 and 1996, Mrs. Huber worked full time as a secretary
for the police department of the City of Mitchell, South Dakota,
and part time for Davison County. The Hubers were covered by a
health insurance policy that was obtained through Mrs. Huber’s
employment with the police department. The insurance premium was
paid partly by Mrs. Huber and partly by her employer.
Waterfall Farms reimbursed the Hubers for Mrs. Huber’s share of
the insurance premium.
- 8 -
E. Compensation and Payment of Food, Lodging, and Medical
Expenses
Mr. Huber was the sole employee of Waterfall Farms. He kept
the corporate books and paid its bills. For his services, Mr.
Huber received $1,000 in 1995, $600 in 1996, and $1,000 in 1997.
In addition, Waterfall Farms paid all of the Hubers’ medical care
expenses.
In 1997, Waterfall Farms leased the homestead from Ms. Rose;
the rent was $7,500 per annum. The original term of the lease
was 1 year beginning January 1, 1997, and ending December 31,
1997; the agreement continued in effect year to year until
otherwise canceled. The Hubers (and one of their daughters)
continued to use the homestead as their residence after
Waterfall Farms leased the homestead from Ms. Rose. In addition
to the rent for the homestead, Waterfall Farms paid for
the food consumed by the Hubers and their daughter.
Waterfall Farms did not pay dividends for fiscal years ended
November 30, 1995, 1996, and 1997.
- 9 -
F. Income Tax Returns
Mr. Bleeker (petitioners’ counsel) prepared the Hubers’
joint Forms 1040, U.S. Individual Income Tax Return, and
Waterfall Farms’ Forms 1120, U.S. Corporation Income Tax Return,
for the years at issue.
1. Waterfall Farms
Waterfall Farms filed timely its Forms 1120 for the taxable
years ended November 30, 1995, 1996, and 1997. On these returns,
Waterfall Farms reported total income and total deductions as
follows:
11/30/95 11/30/96 11/30/97
Total income $27,500 $20,172 $30,132
Total deductions 24,769 18,404 29,699
Taxable income 2,731 1,768 433
Included in the total expenses deducted by Waterfall Farms
were the following items for food, lodging, and medical expenses
provided to the Hubers:
11/30/95 11/30/96 11/30/97
Food & lodging
Food for employees $4,290 $4,395 $4,709
Rent –- –- 7,500
Food & lodging expenses 4,290 4,395 12,209
Medical
Medical insurance $1,224 $1,297 $3,048
Medical expenses -- –- 1,456
Total medical 1,224 1,297 4,504
Waterfall Farms filed Forms 1120X, Amended U.S. Corporation
Income Tax Return, for its fiscal years ended November 30, 1995
and 1996, that were received by the Internal Revenue Service in
- 10 -
March 1998. In the amended returns, Waterfall Farms eliminated
the deduction for food for employees. As a result, the
corporation reported taxable income of $7,021 for 1995 and $6,163
for 1996.
2. The Hubers
The Hubers timely filed their joint income tax returns for
1995, 1996, and 1997. On these returns, the Hubers reported Mr.
Huber’s wages from Waterfall Farms. They reported farming income
(including Mr. Huber’s share of the proceeds from the sale of
crops grown on the Huber farm) as self-employment income. They
did not report any income attributable to their food, lodging-
related, and medical expenses paid by Waterfall Farms.
The Hubers filed a Form 1040X, Amended U.S. Individual Income
Tax Return, for 1995. On the amended return, the Hubers elected
to defer crop insurance proceeds. The amended return did not
include the $4,290 paid by Waterfall Farms for the Hubers’ food
in 1995. The Hubers did not amend their 1996 return to include
the $4,395 paid by Waterfall Farms for their food in 1996.
On Schedule F, Profit or Loss from Farming, Mr. Huber
reported gross income, total expenses, and net profit or loss
from his separate farming activities for 1995, 1996, and 1997 as
follows:
- 11 -
19951 1996 1997
Gross income $85,151 $112,626 $126,764
Total expenses 96,344 112,589 128,520
Net profit/loss (11,193) 37 (1,756)
1
As amended.
G. Notices of Deficiency
On January 31, 2001, respondent timely mailed to the Hubers
a statutory notice of deficiency for 1995, 1996, and 1997 (the
Huber notice of deficiency). Also on January 31, 2001,
respondent timely mailed to Waterfall Farms a statutory notice of
deficiency for its fiscal years ended November 30, 1995, 1996,
and 1997 (the Waterfall Farms notice of deficiency).
In the Waterfall Farms notice of deficiency, respondent
disallowed the food, lodging, and medical expenses deducted by
Waterfall Farms, totaling $1,224 for 1995, $1,297 for 1996, and
$16,713 for 1997. Respondent determined that (1) Waterfall Farms
failed to establish that the food and lodging expenses were
ordinary and necessary business expenses under section 162 and
(2) those items are the Hubers’ personal expenses. Respondent
further determined that Waterfall Farms was liable for the
accuracy-related penalty under section 6662(a).
In the Huber notice of deficiency, respondent determined
that payments by Waterfall Farms of the Hubers’ food, lodging,
and medical expenses resulted in constructive dividends as
follows:
- 12 -
11/30/95 11/30/96 11/30/97
Food & lodging $4,290 $4,395 $12,209
Medical 1,224 1,297 4,504
Total dividends 5,514 5,692 16,713
OPINION
Issue 1. Expenses Incurred by Waterfall Farms To Provide Medical
Benefits, Food, and Housing to the Hubers in 1995,
1996, and 1997
A. Positions of the Parties3
Respondent disallowed deductions taken by Waterfall Farms
for medical costs (health insurance premiums and other medical
care expenses), food, and lodging (rent for the homestead).
Respondent asserts that the medical costs, food, and lodging
expenses are the Hubers’ personal, family, and living expenses
and that payments of these expenses by Waterfall Farms constitute
constructive dividends to the Hubers. On the other hand,
petitioners assert that all the expenditures are reasonable and
3
Under certain circumstances, sec. 7491 places the burden of
proof or production on the Commissioner. Sec. 7491 applies to
court proceedings arising in connection with tax examinations
beginning after July 22, 1998. Internal Revenue Service
Restructuring and Reform Act of 1998, Pub. L. 105-206, sec.
3001(a), 112 Stat. 726. Petitioners timely filed their returns
for the years at issue. Hence, all of the returns were filed on
or before Apr. 15, 1998. The record does not disclose when the
examination of petitioners’ tax returns began, and it is possible
that the examination began before July 23, 1998. Petitioners do
not contend that sec. 7491 applies in these cases, and they have
not otherwise asserted that respondent has the burden of proof or
production with respect to any issue presented in these cases.
We therefore conclude that sec. 7491 does not apply, and
petitioners have the burden of proof and production.
- 13 -
necessary business expenses, deductible by Waterfall Farms and
excluded from the Hubers’ income.
Petitioners contend that the medical costs are employee
benefits, deductible by the employer and excludable from the
employee’s income under sections 105 and/or 106. Petitioners
further maintain that Waterfall Farms provided food and lodging
to Mr. Huber in his capacity as an employee and that such was
done for the convenience of Waterfall Farms. Consequently,
petitioners assert that the food and lodging expenses are
employer-provided “meals and lodging”, the costs for which are
excluded from the Hubers’ income under section 119 and deductible
by Waterfall Farms.
B. Medical Expenses
We first shall decide whether the payments by Waterfall
Farms of the medical expenses are excludable from the Hubers’
gross income under sections 105 and 106 and deductible by the
corporation as ordinary and necessary business expenses under
section 162(a).
Under section 106, “an employee’s gross income does not
include employer-provided coverage (e.g., accident and health
insurance premiums) under an accident and health plan.” Rugby
Prods. Ltd. v. Commissioner, 100 T.C. 531, 535 (1993). The
employer may provide coverage under an accident or health plan by
paying the premium (or a portion of the premium) on an accident
- 14 -
or health insurance policy covering one or more employees or by
contributing to a separate trust or fund. Sec. 1.106-1, Income
Tax Regs.
Under the general rule of section 105(a), amounts received
by an employee through accident and health insurance for personal
injury or sickness, to the extent attributable to nontaxed
employer contributions, are includable in the employee’s gross
income. Amounts received under an accident or health plan for
employees are treated as amounts received through accident or
health insurance. Sec. 105(e). An exception to the general rule
allows an employee to exclude from gross income amounts received
to reimburse the employee for expenses incurred by the employee
for the medical care (as defined in section 213(d)) of the
employee and the employee’s spouse and dependents. Sec. 105(b).
For the reasons set forth below, we agree with petitioners
that pursuant to sections 105 and/or 106 payments by Waterfall
Farms for reimbursement of medical care costs (including
reimbursement for the health insurance premiums) need not be
included in the Hubers’ income for 1995, 1996, and 1997.
Section 105(e) requires first, that the benefits be received
under a “plan”, and second, that the plan be “for employees”,
rather than for some other class of persons such as shareholders
and their relatives. Larkin v. Commissioner, 48 T.C. 629, 635
(1967), affd. 394 F.2d 494 (1st Cir. 1968). After giving due
- 15 -
consideration to the record before us, we conclude that Waterfall
Farms’ medical reimbursement plan satisfies both the “plan” and
“for employees” requirements of section 105(e).
Section 1.105-5(a), Income Tax Regs., provides guidelines as
to what constitutes an accident or health plan. A plan may cover
one or more employees, and different plans may be established for
different employees or classes of employees. Id. Income Tax
Regs. The regulations do not require that there be a written
plan or that there be enforceable employee rights under the plan,
so long as the participant has notice or knowledge of the plan.
Wigutow v. Commissioner, T.C. Memo. 1983-620.
In the instant case, a plan (as defined in section
1.105-5(a), Income Tax Regs.) existed. Waterfall Farms adopted a
written medical reimbursement plan identifying who was eligible
to participate, what expenses would be reimbursed, and how
participants were to make claims for reimbursement. The plan was
adopted at the first meeting of the board of directors.
Mr. Huber had knowledge of the medical reimbursement plan.
Moreover, the medical reimbursements provided under the written
plan included reimbursement for all “medical care” costs
deductible on Form 1040, which includes health insurance costs.
Sec. 213(d)(1)(D). And finally, we are satisfied that the
corporation’s medical plan was for Mr. Huber as an employee of
- 16 -
Waterfall Farms, and not for his benefit as one of the
corporation’s shareholders.
Plans limited to employees who are also shareholders are not
per se disqualified under section 105(b). Larkin v.
Commissioner, supra at 635 n.5. In this regard, we have
sustained plans for corporate officers who were also shareholders
because those officers had central management roles in conducting
the business of the corporation. Wigutow v. Commissioner, supra;
Epstein v. Commissioner, T.C. Memo. 1972-53; Seidel v.
Commissioner, T.C. Memo. 1971-238; Smith v. Commissioner, T.C.
Memo. 1970-243; Bogene, Inc. v. Commissioner, T.C. Memo.
1968-147.
Respondent has stipulated that during the years at issue Mr.
Huber was an employee of Waterfall Farms. Indeed, Mr. Huber was
the corporation’s only employee. And without Mr. Huber’s
involvement, Waterfall Farms could not have conducted its farming
operations.
Mr. Huber’s compensation for services rendered to Waterfall
Farms was his salary and employee benefits. Respondent does not
contend that Mr. Huber received excessive compensation. Indeed,
respondent contends that Mr. Huber was undercompensated for his
services.
Although Mrs. Huber did not work for Waterfall Farms,
payment of her medical expenses was based on her status as Mr.
- 17 -
Huber’s spouse. Likewise, payment of the medical expenses for
the Hubers’ daughter was based on her status as Mr. Huber’s
dependent. The derivative participation of Mr. Huber’s spouse
and dependent is plainly contemplated both by the medical plan
and by section 105(b).
On the basis of the record before us, we conclude that
medical payments made for the benefit of the Hubers and/or their
daughter were made under a plan for employees and not for
shareholders. Accordingly, during the years at issue, the
medical payments made by Waterfall Farms pursuant to its medical
plan (the insurance premiums and other medical care expenditures)
are excludable from the Hubers’ gross income under section
105(b).
Section 162(a) permits a taxpayer to deduct all ordinary and
necessary expenses incurred during the taxable year in carrying
on a taxpayer’s trade or business. An expense is ordinary if it
is customary or usual within a particular trade, business, or
industry or relates to a transaction “of common or frequent
occurrence in the type of business involved.” Deputy v. du Pont,
308 U.S. 488, 495 (1940). An expense is necessary if it is
appropriate and helpful for the development of the business. See
Commissioner v. Heininger, 320 U.S. 467, 471 (1943).
When payments for medical care are properly excludable from
an employee’s income because they are made under a “plan for
- 18 -
employees,” they are deductible by the employer as ordinary and
necessary business expenses under section 162(a). Sec.
1.162-10(a), Income Tax Regs. Consequently, Waterfall Farms is
entitled to deduct the insurance premiums and medical
reimbursement payments under section 162(a).
C. Food and Rent
1. Section 119: Employer-Provided Meals and Lodging
We next decide whether the food and rent are employer-
provided meals and lodging expenses, excludable from the Hubers’
income under section 119 and deductible by Waterfall Farms under
section 162.
Meals and lodging furnished to an employee by his employer
are excluded from the employee’s gross income under section 119
if the meals and lodging are provided for the convenience of the
employer on the premises of the employer. In the case of
lodging, the employee must be required to accept the lodging on
the business premises of his employer as a condition of
employment.
The term “‘business premises of the employer’ generally
means the place of employment of the employee.” Sec.
1.119-1(c)(1), Income Tax Regs. They are the premises where the
employee performs a significant portion of his duties or where
the employer conducts a significant portion of its business.
McDonald v. Commissioner, 66 T.C. 223 (1976). The extent or
- 19 -
boundaries of the business premises is a factual question that
considers the employee’s duties as well as the nature of the
employer’s business. Lindeman v. Commissioner, 60 T.C. 609, 615
(1973).
During the years at issue, Waterfall Farms paid for the
Hubers’ food (which they consumed on the homestead) and deducted
the cost of the food on the corporation’s Forms 1120 filed for
fiscal years ending November 30, 1995, 1996, and 1997. In 1995
and 1996, the Hubers rented the homestead from Ms. Rose.
Waterfall Farms filed amended returns for 1995 and 1996
eliminating the deduction for the food because the homestead was
not its business property. In 1997, Waterfall Farms rented the
homestead from Ms. Rose. Although Waterfall Farms rented the
homestead, there is no evidence that any business activity (aside
from record keeping) took place on the homestead. Thus, the food
and lodging were not provided on the business premises of
Waterfall Farms.
Moreover, section 119 requires that meals and lodging be
furnished for the “convenience of the employer”. Meals and
lodging are furnished for the “convenience of the employer” if
there is a direct nexus between the meals and lodging furnished
and the asserted business interests of the employer served
thereby. McDonald v. Commissioner, supra at 230. Petitioners
- 20 -
assert that Mr. Huber, as the corporation’s sole employee, was
required to be available for duty 24 hours a day.
Waterfall Farms leased the Huber farm to Mr. Huber.
Waterfall Farms contracted with Mr. Huber as a tenant, not as its
employee, to perform all necessary work on the Huber farm.
It is well settled that “Ordinarily, taxpayers are bound by
the form of the transaction they have chosen; taxpayers may not
in hindsight recast the transaction as one that they might have
made in order to obtain tax advantages.” Framatome Connectors
USA Inc. v. Commissioner, 118 T.C. 32, 70 (2002) (citing Estate
of Leavitt v. Commissioner, 875 F.2d 420, 423 (4th Cir. 1989),
affg. 90 T.C. 206 (1988), and Grojean v. Commissioner, 248 F.3d
572, 576 (7th Cir. 2001), affg. T.C. Memo. 1999-425). Here,
inasmuch as Mr. Huber farmed the Huber farm as a tenant, and not
as an employee of Waterfall Farms, the food and lodging in
question were not furnished to Mr. Huber as a corporate employee
for the convenience of his employer. Thus, the food and rent at
issue are not section 119(a) meal and lodging expenses.
2. Inclusion of Payments in the Hubers’ Gross Income
When a corporation makes an expenditure that primarily
benefits the corporation’s shareholders, the amount of the
expenditure may be taxed to the shareholder as a constructive
dividend. Hood v. Commissioner, 115 T.C. 172 (2000); Magnon v.
Commissioner, 73 T.C. 980, 993-994 (1980); Am. Insulation Corp.
- 21 -
v. Commissioner, T.C. Memo. 1985-436. We have found that
expenses for food and rent paid by Waterfall Farms are the
Hubers’ expenses. Petitioners contend that the payments are not
constructive dividends because Mr. Huber was required to repay
any amounts that Waterfall Farms could not deduct for Federal
income tax purposes. Petitioners cite Cepeda v. Commissioner,
T.C. Memo. 1993-477, to support their position. Cepeda, however,
is inapposite. In that case, the taxpayers claimed that advances
made by the corporation were loans rather than employee
compensation or constructive dividends. Here, petitioners do not
contend that the corporate payments of the Hubers’ expenses were
loans.
For Federal income tax purposes, a transaction will be
characterized as a loan if there was “an unconditional obligation
on the part of the transferee to repay the money, and an
unconditional intention on the part of the transferor to secure
repayment.” Haag v. Commissioner, 88 T.C. 604, 616 (1987), affd.
without published opinion 855 F.2d 855 (8th Cir. 1988). In the
instant case, when the payments were made there was no
unconditional obligation on the part of the Hubers to repay a
specific dollar amount to the corporation. Their obligation to
repay any of the payments was in general terms. The amount of
repayment could not be determined when the payments were made.
Any obligation to repay any amount could not arise before
- 22 -
respondent disallowed the deduction for the expenses; i.e, when
the Waterfall Farms notice of deficiency was issued in January
2001. Thus, the payments were not loans. Since the payments
when made by Waterfall Farms did not constitute business expenses
of the corporation or loans to the Hubers, the conclusion is
inescapable that the payments constituted distributions by
Waterfall Farms to the Hubers.
In N. Am. Oil Consol. v. Burnett, 286 U.S. 417, 424 (1932),
the Supreme Court stated:
If a taxpayer receives earnings under a claim of right
and without restriction as to its disposition, he has
received income which he is required to return, even
though it may still be claimed that he is not entitled
to retain the money, and even though he may still be
adjudged liable to restore its equivalent. * * *
It is clear, therefore, under the claim of right doctrine, the
amounts paid by Waterfall Farms in 1995, 1996, and 1997 were
taxable to the Hubers in those years. See Pahl v. Commissioner,
67 T.C. 286, 289 (1976).
If a taxpayer is required to repay income recognized under
the claim of right doctrine in an earlier tax year, section 1341
permits the taxpayer, in effect, to elect to compute his taxes
for the year of repayment in a manner that gives the taxpayer the
equivalent of a refund (without interest) of tax for the earlier
year. Specifically, section 1341(a)(5) permits the tax for the
year of repayment to be reduced by the amount of the tax paid for
the year of receipt that was attributable to the inclusion of the
- 23 -
repaid amount of that year’s gross income. United States v.
Skelly Oil Co., 394 U.S. 678, 682 (1969). Section 1341, however,
requires actual repayment, restoration, or restitution. Chernin
v. United States, 149 F.3d 805, 816 (8th Cir. 1998); Kappel v.
United States, 437 F.2d 1222, 1226 (3d Cir. 1971); Estate of
Smith v. Commissioner, 110 T.C. 12 (1998).
Although the bylaws of Waterfall Farms require the Hubers to
repay amounts for which the corporation is disallowed a
deduction, the Hubers do not claim that they have repaid the
disallowed amounts. Indeed, there is no evidence in the record
to show that they did. Therefore, section 1341 does not apply.
We hold that Waterfall Farms’ payment of the Hubers’ food and
rent constitutes income to the Hubers.
Petitioners argue that the expenses are meals and lodging
expenses excludable under section 119. We have found to the
contrary.
Personal, family, or living expenses are not deductible
except as otherwise expressly permitted. Sec. 262. A taxpayer’s
expenses for his or her own meals and lodging are personal
because they would have been incurred whether or not the taxpayer
had engaged in any business activity. Christey v. United States,
841 F.2d 809, 814 (8th Cir. 1988); Moss v. Commissioner, 80 T.C.
1073, 1078 (1983), affd. 758 F.2d 211 (7th Cir. 1985). In order
for personal living expenses to qualify as a deductible business
- 24 -
expense under section 162(a), the taxpayer must demonstrate that
the expenses were different from, or in excess of, what he would
have spent for personal purposes. Sutter v. Commissioner, 21
T.C. 170, 173 (1953). Petitioners did not produce any evidence
that the food and the rent for the homestead were other than
ordinary living expenses. Thus, petitioners have failed to
establish that the Hubers are entitled to a deduction for any
portion of the expenses under section 162.4
Issue 2. Accuracy-Related Penalty Under Section 6662(a)
Respondent determined that Waterfall Farms is liable for the
accuracy-related penalty under section 6662(a). As pertinent
here, section 6662(a) imposes a 20-percent penalty on the portion
of an underpayment attributable to negligence or disregard of
rules or regulations. Sec. 6662(b)(1). Negligence includes any
failure to make a reasonable attempt to comply with the
provisions of the Internal Revenue Code. Sec. 6662(c); sec.
1.6662-3(b)(1), Income Tax Regs.
4
Except as otherwise provided, an individual is not allowed
a deduction with respect to the use of a dwelling unit that is
used by the individual as a residence. Sec. 280A(a). The
individual, however, may deduct expenses allocable to portions of
the dwelling that are exclusively used for business purposes.
Sec. 280A(c). In the case at bar, the Hubers did not argue that
their housing expenses are deductible under sec. 280A.
Therefore, we do not address the question of whether certain
portions of their expenses may be deductible under that section.
We note, however, that the Hubers have made no showing that the
farmhouse, or any portion thereof, was used exclusively for
business purposes.
- 25 -
The penalty under section 6662(a) does not apply to any
portion of an understatement of tax if it is shown that there was
reasonable cause for the taxpayer’s position and that the
taxpayer acted in good faith with respect to that portion. Sec.
6664(c)(1). The determination of whether a taxpayer acted with
reasonable cause and in good faith is made on a case-by-case
basis, taking into account all the pertinent facts and
circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs. The most
important factor is the extent of the taxpayer’s effort to assess
his/her proper tax liability for the year. Id. The good faith
reliance on the advice of an independent, competent professional
as to the tax treatment of an item may meet this requirement.
Sec. 1.6664-4(b), Income Tax Regs.
Despite the fact that petitioners have the burden of proof,
see supra note 3, petitioners have made no showing that they made
an attempt to comply with the tax rules and regulations with
regard to those deductions taken by Waterfall Farms for the years
at issue which have been disallowed. Hence, with respect to
those deductions, petitioners have failed to show that Waterfall
Farms was not negligent. Nor have petitioners showed that they
acted in good faith with respect to, or that there was reasonable
cause for, the position they took.
Further, petitioners do not claim that they relied on Mr.
Bleeker or any other professional as to the tax treatment of the
- 26 -
expenses for food and lodging.5 Petitioners simply assert that
the accuracy-related penalty does not apply because Waterfall
Farms properly claimed the deductions under section 162(a) and
the Hubers properly excluded the payments under section 119. We
have found to the contrary.
Under these circumstances, we are compelled to hold that
Waterfall Farms is liable for the accuracy-related penalty for
the years at issue.
To reflect the foregoing,
Decisions will be
entered for respondent.
5
Before the trial in these cases, respondent filed a motion
to disqualify Mr. Bleeker from his representation of petitioners.
Respondent’s motion was based, in part, on the premise that, if
petitioners contend that they reasonably relied on Mr. Bleeker’s
advice with respect to the proper tax treatment of the payments
at issue, then Mr. Bleeker would be required to testify as a
witness in the trial of these cases. The Court held a telephone
conference call with Mr. Bleeker and counsel for respondent to
discuss respondent’s motion. During that call, Mr. Bleeker
informed the Court that petitioners did not intend to raise
reasonable reliance on a tax professional as a defense to the
accuracy-related penalties.