T.C. Memo. 2004-196
UNITED STATES TAX COURT
AMARO A. TAIBO, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 17416-02. Filed August 31, 2004.
Steven T. Barta, for petitioner.
Jonathan J. Ono, for respondent.
MEMORANDUM OPINION
SWIFT, Judge: The sole issue for decision is whether
petitioner for 2000 is liable for an accuracy-related penalty
under section 6662(a) in the amount of $10,828.
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the year in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
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Background
The facts of this case were submitted fully stipulated under
Rule 122 and are so found.
Since 1991, petitioner has resided on Johnston Island, an
unincorporated U.S. Territory located approximately 700 nautical
miles southwest of Hawaii where petitioner has been employed as
an electrical engineer by Raytheon Demilitarization Co. or its
successor (Raytheon).
On April 30, 1991, petitioner signed an employment agreement
with Raytheon, which stated, among other things, that “Johnston
Island is not tax exempt; therefore, standard tax obligations
apply.”
For each of the years 1991 through 1996, on his Federal
income tax returns, the record herein does not indicate whether
petitioner treated the wages he received from Raytheon as taxable
or as nontaxable income.
On his timely filed 1997 joint Federal income tax return,
petitioner treated the $143,013 in Raytheon wages that he
received in 1997 as taxable income, and petitioner paid the
$44,629 in taxes relating thereto.
On his timely filed 1998 individual Federal income tax
return, petitioner treated the $156,741 in Raytheon wages that he
received in 1998 as nontaxable income, and petitioner did not pay
the Federal income taxes relating thereto.
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On July 6, 1999, a petition was filed in this Court by a
Raytheon employee who worked on Johnston Island (first Raytheon
employee) in which petition the taxability of wages earned by
U.S. citizens on Johnston Island was challenged. Specking v.
Commissioner, docket No. 12010-99. A regulation, which stated
that Johnston Island constituted a U.S. possession for purposes
of excluding from taxable income wages earned by U.S. citizens on
Johnston Island, formed the basis for the claim of nontaxability.
See sec. 1.931-1, Income Tax Regs.1 In subsequent similar cases
filed by Johnston Island employees, infra, other employees also
rely on this same regulation.
On July 12, 1999, another petition was filed in this Court
by another Raytheon employee who worked on Johnston Island
(second Raytheon employee) in which petition the taxability of
1
Sec. 1.931-1, Income Tax Regs., provides in part as
follows:
§ 1.931-1. Citizens of the United States and domestic
corporations deriving income from sources within a
possession of the United States.--(a) Definitions.--(1) As
used in section 931 and this section, the term “possession
of the United States” includes * * * Johnston Island * * *.
(2) As used in section 931 and this section, the
term “United States” includes only the States, the
Territories of Alaska and Hawaii, and the District of
Columbia.
(b) General rule--(1) Qualifications. In the case of a
citizen of the United States or a domestic corporation
satisfying * * * [certain] conditions, gross income means
only gross income from sources within the United States
* * *.
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wages earned on Johnston Island also was challenged. Umbach v.
Commissioner, docket No. 12348-99.
On July 30, 1999, petitioner filed an amended 1997 joint
Federal income tax return on which petitioner treated the
$143,013 in Raytheon wages that he received in 1997 as nontaxable
income and on which petitioner claimed a refund of the $44,629 in
taxes that he paid relating thereto.
On August 31, 1999, yet another petition was filed in this
Court by another Raytheon employee who worked on Johnston Island
(third Raytheon employee) in which petition the taxability of
wages earned on Johnston Island again was challenged. Haessly v.
Commissioner, docket No. 14496-99.
On September 28, 1999, respondent mailed to petitioner a
notice informing petitioner that respondent was formally
disallowing petitioner’s claim for refund of the $44,629 in taxes
petitioner paid on his Raytheon wages earned in 1997.
Respondent’s letter stated that “The Tax Reform Act of 1986 [Pub.
L. 99-514, sec. 1272, 100 Stat. 2085 (TRA 1986)] amended IRC 931.
Therefore, income from sources within the Johnston Islands does
not qualify for the possession exclusion.”2
On December 21, 1999, after an audit of petitioner’s 1998
Federal income tax return, respondent mailed to petitioner a
2
The record herein does not indicate whether petitioner
ever filed a refund suit in Federal district court with regard to
his disallowed 1997 claim for refund.
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letter notifying petitioner that the $156,741 in Raytheon wages
that petitioner received in 1998 constituted taxable income with
respect to which $41,898 in taxes was due. Attached to the
letter was Form 886-A, Explanation of Items, which stated:
Since your home is not in a foreign country, but a territory
of the United States, your earned income is not excludable
under Internal Revenue Code 911. See 1.911-2([g]) & (h) for
the United States and foreign country defined. Also, since
you are not a bona fide resident of a specified possession
“as defined in Internal Revenue Code 931(c)”, you do not
qualify for the possession exclusion.
In early 2000, petitioner paid to respondent $49,285,
reflecting the full $41,898 tax deficiency for 1998 determined by
respondent, including interest, and no formal notice of
deficiency for 1998 was ever mailed to petitioner. With respect
to 1998, respondent did not impose a penalty against petitioner
relating to the treatment on petitioner’s 1998 Federal income tax
return of his Raytheon wages as nontaxable income.
On February 28, 2000, a complaint was filed in Federal
district court by a fourth Raytheon employee who worked on
Johnston Island in which complaint the taxability of wages earned
on Johnston Island was challenged. Farrell v. United States, No.
CV 00-00164SOM-KSC.
The record herein does not include a copy of petitioner’s
1999 Federal income tax return, apparently filed in April of
2000, and the record herein does not indicate whether petitioner
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treated thereon his Raytheon wages received in 1999 as taxable or
as nontaxable income.
On February 12, 2001, the District Court for the District of
Hawaii decided Farrell v. United States, 87 AFTR 2d 1159, 2001-1
USTC par. 50,279 (D. Haw. 2001), and held that Johnston Island
does not constitute a foreign country for purposes of section 911
and does not constitute a specified possession for purposes of
section 931.3 Therefore, the District Court, in spite of the
conflicting regulation, which listed Johnston Island as a
possession, concluded that wages earned on Johnston Island
constituted taxable income. Thereafter, the taxpayer in Farrell
filed a timely appeal to the Court of Appeals for the Ninth
Circuit of the District Court’s decision.
On his electronically filed 2000 individual Federal income
tax return, filed on approximately March 4, 2001, petitioner
treated the $185,048 in Raytheon wages that he received in 2000
as nontaxable income, and petitioner did not pay any Federal
income taxes relating thereto.
Petitioner’s retained copy of his electronically filed 2000
Federal income tax return, which is in evidence herein, reflected
3
All references herein to sec. 931 are to sec. 931 as
amended by the Tax Reform Act of 1986, Pub. L. 99-514, sec. 1272,
100 Stat. 2593 (TRA 1986), and all references to former sec. 931
are to such section prior to amendment by TRA 1986.
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the following information regarding the wages petitioner received
in 2000 relating to his work on Johnston Island:
(1) The amount -- $185,048;
(2) Their character -- petitioner’s wages from Raytheon;
(3) Raytheon’s treatment of the wages -- as petitioner’s
wages and as taxable income to petitioner;
(4) The fact that $50,109 in taxes were withheld by
Raytheon with regard thereto;
(5) The fact that petitioner on his Federal income tax
return was claiming an offsetting reduction to the full
$185,048 in disclosed wages and a refund of the $50,109
in withheld taxes relating thereto;
(6) The fact that petitioner worked on Johnston Island and
that petitioner’s Federal income tax return treated
Johnston Island as a “possession”; and
(7) The basis on which petitioner was relying for his
treatment of his Johnston Island wages as nontaxable
income, namely sec. 1.931-1(a) and (b)(i) and (ii),
Income Tax Regs.4
On March 5, 2001, a fourth petition was filed in this Court
by a fifth Raytheon employee who worked on Johnston Island in
which petition the taxability of wages earned on Johnston Island
was challenged. Jones v. Commissioner, docket No. 2970-01.
4
A partial copy of petitioner’s electronically filed 2000
Federal income tax return as printed out by respondent discloses
only the information in the first five numbered items in the
above list regarding petitioner’s wages earned on Johnston Island
and does not reflect the information in the last two above-
numbered items.
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On August 28, 2001, we decided Specking v. Commissioner,
117 T.C. 95 (2001), affd. sub nom. Haessly v. Commissioner, 68
Fed. Appx. 44 (9th Cir. 2003), affd. sub nom. Umbach v.
Commissioner, 357 F.3d 1108 (10th Cir. 2003), representing a
consolidated group of cases involving three of the above
petitions filed in the Tax Court. In our decision in Specking v.
Commissioner, supra, we held that Johnston Island does not
constitute a foreign country for purposes of section 911 and does
not constitute a specified possession for purposes of section
931. We concluded that section 931 applies to income earned on
Johnston Island for years beginning after December 31, 1986, and,
therefore, that wages earned on Johnston Island constituted
taxable income.
Three months after Specking was decided by this Court, on
November 13, 2001, in response to a letter request from a
Raytheon employee on Johnston Island, respondent mailed to the
employee a letter and a copy of section 1.931-1, Income Tax
Regs., in which letter such regulation was described as “current
as of October 24, 2001”, and in which regulation Johnston Island
was listed as a possession.
On November 30, 2001, after an audit of petitioner’s 2000
Federal income tax return, respondent mailed to petitioner a
letter notifying petitioner that the $185,048 in Raytheon wages
that petitioner received in 2000 constituted taxable income with
respect to which $54,139 in taxes was due. This letter stated
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that Johnston Island was not a specified possession for purposes
of the income exclusion allowed under section 931. Respondent
did not assert any penalty relating thereto.
A month thereafter, on December 28, 2001, petitioner mailed
to respondent a personal check in the amount of $57,709,
reflecting payment of the full $54,139 tax deficiency for 2000
determined by respondent, including interest. In an e-mail sent
to respondent on the same day, petitioner reserved his right to
file a claim for refund if the pending litigation regarding the
taxability of Johnston Island wages was eventually resolved in
the taxpayers’ favor.
On February 26, 2002, respondent mailed to petitioner
another letter relating to petitioner’s 2000 Federal income tax
return in which letter respondent proposed against petitioner for
2000 a $10,828 accuracy-related penalty under section 6662(a)
relating to petitioner’s claim that his $185,048 in 2000 wages
constituted nontaxable income.
On May 9, 2002, each of the three taxpayers in Specking v.
Commissioner, supra, filed appeals of our decision therein, two
to the Court of Appeals for the Tenth Circuit and one to the
Court of Appeals for the Ninth Circuit.
On June 4, 2002, a fifth petition was filed in this Court by
a sixth Raytheon employee who worked on Johnston Island in which
petition the taxability of wages earned on Johnston Island was
challenged. Hautzinger v. Commissioner, docket No. 9501-02.
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On August 23, 2002, respondent mailed a notice of deficiency
to petitioner with respect to the $10,828 accuracy-related
penalty for 2000 which petitioner had not yet paid.
On November 7, 2002, petitioner became the sixth Raytheon
employee to file a petition in this Court in which petition
petitioner challenges not the taxability of his Johnston Island
wages but only the imposition by respondent of the $10,828
accuracy-related penalty.
On December 24, 2002, the Court of Appeals for the Ninth
Circuit in Farrell v. United States, 313 F.3d 1214 (9th Cir.
2002), affirmed the District Court’s decision in Farrell v.
United States, 87 AFTR 2d 1159, 2001-1 USTC par. 50,279 (D. Haw.
2001). The Court of Appeals held that Johnston Island does not
constitute a foreign country for purposes of section 911 and does
not constitute a specified possession for purposes of section
931. In addition, the Court of Appeals held that section 931
controls over the conflicting regulation at section 1.931-1,
Income Tax Regs. Therefore, the Court of Appeals concluded that
wages earned on Johnston Island by U.S. citizens constituted
taxable income.
On January 14, 2003, we decided Jones v. Commissioner, T.C.
Memo. 2003-14, involving the fourth petition filed in the Tax
Court involving Johnston Island wages. In our decision in Jones,
we held that Johnston Island does not constitute a foreign
country for purposes of section 911 and that Johnston Island does
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not constitute a specified possession for purposes of section
931. We also held that section 931 controls over the conflicting
regulation at section 1.931-1, Income Tax Regs., and that, for
years beginning after December 31, 1986, section 931 applies to
income earned by U.S. citizens on Johnston Island, making the
wages taxable income.
On June 16, 2003, the Court of Appeals for the Ninth Circuit
decided Haessly v. Commissioner, 68 Fed. Appx. 44 (9th Cir.
2003), affg. Specking v. Commissioner, 117 T.C. 95 (2001), and
held that Johnston Island does not constitute a foreign country
for purposes of section 911 and, following its opinion in Farrell
v. United States, supra, that Johnston Island does not constitute
a specified possession for purposes of section 931. The Court of
Appeals affirmed our opinion in Specking v. Commissioner, supra,
and concluded that wages earned on Johnston Island constituted
taxable income.
On June 24, 2003, the taxpayer in Jones v. Commissioner,
T.C. Memo. 2003-14, filed an appeal of our decision therein to
the Court of Appeals for the Eleventh Circuit, which appeal is
still pending.
In the above deficiency determinations by respondent, and in
the above court opinions regarding the taxability of Johnston
Island wages by the District Court, the Tax Court, and the Courts
of Appeals, no penalties were asserted against the taxpayers, and
none was imposed by the courts.
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On August 8, 2003, we decided Hautzinger v. Commissioner,
T.C. Memo. 2003-236, involving the fifth petition filed in the
Tax Court involving Johnston Island wages. In our decision in
Hautzinger, consistent with the above court opinions, we held
that Johnston Island does not constitute a specified possession
for purposes of section 931 and that section 931 controls over
the conflicting regulation at section 1.931-1, Income Tax Regs.
Therefore, we concluded that wages earned on Johnston Island
constituted taxable income.
In addition, however, in Hautzinger, we decided that the
taxpayer was negligent in falsely reporting on his Federal income
tax return that his Raytheon wages were earned by him on American
Samoa, a specified possession for purposes of section 931, and
not on Johnston Island, where the wages in fact were earned.
Because of such false reporting of the source of the wages, we
sustained respondent’s determination of a section 6662(a)
accuracy-related penalty. The taxpayer in Hautzinger did not
file an appeal of our decision.
On December 11, 2003, the Court of Appeals for the Tenth
Circuit in Umbach v. Commissioner, 357 F.3d 1108 (10th Cir.
2003), affg. Specking v. Commissioner, 117 T.C. 95 (2001),
representing the consolidated cases of Umbach v. Commissioner,
supra, and Specking v. Commissioner, supra, affirmed our decision
in Specking. The Court of Appeals held that Johnston Island does
not constitute a foreign country for purposes of section 911 and
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does not constitute a specified possession for purposes of
section 931. The Court of Appeals held that section 931 applies
to income earned on Johnston Island, noting its agreement with
the decision of the Court of Appeals for the Ninth Circuit in
Farrell v. United States, 313 F.3d at 1219, and that the wages
earned by U.S. citizens on Johnston Island constituted taxable
income. In Umbach v. Commissioner, supra, with regard to the
taxpayer’s treatment of his Johnston Island wages as nontaxable
income, no penalty was asserted by respondent and none was
imposed by the Court of Appeals for the Tenth Circuit.
Discussion
Under section 6662, an accuracy-related penalty is to be
added to the portion of an underpayment of tax attributable to
negligence, to a disregard of rules or regulations, or to a
substantial understatement of income tax.
Generally, for purposes of the accuracy-related penalty,
negligence includes a failure to make a reasonable attempt to
comply with the tax laws. Sec. 6662(c). Negligence is indicated
where a taxpayer fails to make a reasonable attempt to ascertain
the correctness of the claimed tax treatment of an item, does not
have a reasonable basis for such tax treatment, and does not act
with reasonable cause and in good faith with respect to such tax
treatment. Secs. 1.6662-3(b)(1)(ii), 1.6662-3(b)(3), 1.6664-
4(a), Income Tax Regs.
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A substantial understatement of income tax is defined as an
understatement constituting the greater of 10 percent of the tax
required to be shown on a Federal income tax return or $5,000.
Sec. 6662(d)(1)(A). An understatement is reduced by that portion
of the understatement which is attributable to either substantial
authority for the claimed tax treatment of the item or adequate
disclosure of and reasonable basis for the claimed tax treatment
of the item. Sec. 6662(d)(2)(B).
Under section 7491(c), respondent has the burden of
production with respect to any penalty. Once respondent meets
the burden of production, the taxpayer, however, continues to
have the burden of proof with respect to whether respondent’s
determination of the penalty is correct. Rule 142(a); Higbee v.
Commissioner, 116 T.C. 438 (2001).
Petitioner argues that, with respect to his 2000 Federal
income tax return and his treatment of Johnston Island wages
reported thereon as nontaxable income, his reliance on section
1.931-1, Income Tax Regs., was reasonable and the pending
litigation was in good faith. Petitioner argues that the
regulation and the pending litigation, combined with the
disclosure petitioner made on his 2000 individual Federal income
tax return, establish a reasonable basis for his tax treatment of
his Raytheon wages as nontaxable income.
Respondent seems to argue that the existence of section 931
(in which Johnston Island is not listed as a specified possession
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for purposes of excluding from taxable income wages earned
therein) precludes any reasonable reliance by petitioner on
section 1.931-1, Income Tax Regs. (in which regulation Johnston
Island was and is still listed as a possession of the United
States). Respondent contends that petitioner should have known
that his interpretation was “too good to be true”. Respondent
also contends that regardless of whether petitioner made an
adequate disclosure on his 2000 Federal income tax return of
facts relating to his Johnston Island wages, petitioner did not
have a reasonable basis for the nontaxable treatment thereof.
We believe that for 2000 imposition on petitioner of the
accuracy-related penalty with regard to the nontaxable treatment
of his Johnston Island wages is inappropriate.
Although the District Court case and all five Tax Court
cases regarding the taxability of Johnston Island wages have
since been decided in favor of respondent, the question of
whether petitioner had a reasonable basis for the nontaxability
of his Johnston Island wages is to be evaluated as of March 4,
2001, the day petitioner filed his 2000 individual Federal income
tax return. We note particularly respondent’s letter of
November 13, 2001, in which respondent continued to refer
Johnston Island employees to section 1.931-1, Income Tax Regs.,
and to describe the regulation as “current”. We also note
respondent’s failure, as of March 2001, to assert any accuracy-
related penalty against any of the taxpayers who were litigating
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the issue as to the taxability of Johnston Island wages. We do
not regard petitioner’s treatment on his 2000 individual Federal
income tax return of his Johnston Island wages as negligent.
We turn to the question of whether petitioner’s tax return
treatment of his Johnston Island wages constituted a substantial
understatement giving rise to the accuracy-related penalty. The
grounds on which a substantial understatement may be reduced
include tax treatments that are based on adequate disclosure and
a reasonable basis. Sec. 6662(d)(2)(B)(ii).
The disclosure made on petitioner’s 2000 Federal income tax
return, as reflected on petitioner’s retained copy of such
return, constitutes adequate disclosure for purposes of
section 6662(d)(2)(B)(ii). Respondent provides no explanation
for the incomplete nature of respondent’s printout of
petitioner’s 2000 individual Federal income tax return. In
deciding this disclosure issue, particularly in light of
respondent’s burden of production on this penalty, we believe it
appropriate to rely on the information reflected on petitioner’s
retained copy of his 2000 individual Federal income tax return.
On the facts of this case, the disclosure issue is resolved in
favor of petitioner.
With regard to reasonable basis, we incorporate our
discussion above and conclude that petitioner, on his 2000
individual Federal income tax return, had a reasonable basis for
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his tax treatment of his Johnston Island wages as nontaxable income.
In Hautzinger v. Commissioner, T.C. Memo. 2003-236, decided
by this Court on August 8, 2003, respondent did assert and we did
sustain imposition of an accuracy-related penalty, but, as
stated, such penalty related to the false reporting by the
taxpayer that his wages were earned in American Samoa rather than
in Johnston Island, where the wages in fact were earned.
Petitioner herein is not liable for the section 6662(a)
accuracy-related penalty with respect to his tax understatement
relating to his Johnston Island wages.
To reflect the foregoing,
Decision will be entered
for petitioner.