Arnold v. Comm'r

T.C. Memo. 2005-256

UNITED STATES TAX COURT

EDWARD W. AND EDITH M. ARNOLD, ET AL.,1 Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 13292-03, 13293-03, Filed October 31, 2005.
1096-04.

Edward W. Arnold and Edith M. Arnold, pro se.

Thomas J. Travers and Kelley A. Blaine, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

COLVIN, Judge: Respondent determined deficiencies in

petitioners’ income tax of $3,038 for 1999, $3,178 for 2000, and

$27,549 for 2001 and accuracy-related penalties under section

1
The cases of the following petitioners are consolidated
for trial, briefing, and opinion: Edward & Edith M. Arnold,
docket No. 13293-03, and Edward & Edith M. Arnold, docket No.
1096-04.
 - 2 -

6662(a) of $607.60 for 1999, $635.60 for 2000, and $69,217.40 for

2001.

After concessions,2 the issues for decision are:

1. Whether petitioners may deduct losses from Western

Timber Farms, Inc., for 1999, 2000, and 2001. We hold that they

may not.

2. Whether petitioners are liable for self-employment tax

for 2001. We hold that they are.

3. Whether petitioners may deduct $28,067 in expenses for

“leased payroll” for 2001. We hold that they may not.

4. Whether petitioners are liable for accuracy-related

penalties under section 6662(a) for 1999, 2000, and 2001. We

hold that they are.

FINDINGS OF FACT

A. Petitioners

Petitioners resided in Portland, Oregon, when they filed

their petition. In 1999, 2000, and 2001, Edward W. Arnold (Mr.

Arnold) was an accountant and Edith M. Arnold (Mrs. Arnold) was a

real estate agent. Mr. Arnold has been suspended from practice

before the Internal Revenue Service since 1981.

2
At trial, respondent reduced the claim for the accuracy-
related penalty under sec. 6662(a) to $5,509.80 for 2001.

Section references are to the Internal Revenue Code as
amended and in effect for the years in issue. Rule references
are to the Tax Court Rules of Practice and Procedure.
 - 3 -

B. Western Timber Farm, Inc.

Petitioners organized Western Timber Farm, Inc. (Western),

on February 4, 1993. Petitioners alternately served as president

of Western during the years in issue.

On April 20, 1993, Mrs. Arnold signed a Form 2553, Election

by a Small Business Corporation, for Western in which she stated

that Western wanted to adopt a tax year ending January 31. Mrs.

Arnold stated on the form that the year ending January 31 was

Western’s natural business year as provided in Rev. Proc. 87-32,

secs. 4.01 and 4.02(a), 1987-2 C.B. 396, 399.3

In a letter to Western dated February 12, 1996, respondent

acknowledged receipt of the Form 2553 and stated that the

acknowledgment was not an acceptance of the election. In a

letter to petitioners dated December 21, 1998, respondent said

that Western’s S corporation election was not valid. In a letter

to respondent dated July 28, 1999, Mr. Arnold protested

respondent’s denial of Western’s S corporation election and

argued that Western was entitled to adopt a fiscal year ending

January 31.

In a letter to Mr. Arnold dated March 19, 2001, respondent

stated that respondent had reviewed Western’s Form 1120S, U.S.

Income Tax Return for an S Corporation, for 1998. According to

3
Rev. Proc. 87-32, 1987-2 C.B. 396, was in effect in 1999
and 2000. It was superseded by Rev. Proc. 2002-38, 2002-1 C.B.
1037, effective for tax years ending on or after May 10, 2002.
 - 4 -

that form, Western’s 1998 tax year ended on November 30, 1998.

In the March 19, 2001, letter, respondent stated that Western was

not an S corporation. In a letter to Mrs. Arnold dated June 5,

2002, respondent noted that Western had filed an S corporation

return for 1999 even though respondent told petitioners before

they filed that return that Western did not qualify as an S

corporation. In that letter, respondent referred to two revenue

rulings which provide relief to some corporations which make a

late S corporation election or an inadvertent termination.

Respondent asked petitioners to respond if they believed that

Western qualified under either revenue ruling.

In a letter to the Taxpayer Advocate Service dated December

26, 2003, Mr. Arnold asserted that petitioners’ original S

corporation election for Western was valid.

C. Mr. Arnold’s Accounting and Tax Preparation Activities and
Pacific Controller, Inc.

On a date not stated in the record, Mr. Arnold organized

Pacific Controller, Inc. (Pacific), an S corporation he owned.

During the years in issue Pacific used Controller International,

Inc.’s employer identification number. Controller International,

Inc., is the same entity as or the predecessor entity to Pacific.

The last tax return filed by Pacific was for a tax year ending

January 31, 1997.

Mr. Arnold assigned to Pacific the payments he received from

customers for his personal accounting services. Pacific has
 - 5 -

never paid wages or a salary to Mr. Arnold. Petitioners treated

all of the amounts distributed to Mr. Arnold from Pacific as

loans. Mr. Arnold signed a promissory note in the amount of the

balance due at the end of each year. Pacific did not withhold

payroll taxes on payments to Mr. Arnold. Petitioners reported

$41,544 of income as flowthrough from Pacific on the Schedule E,

Supplemental Income and Loss, attached to their Form 1040, U.S.

Individual Income Tax Return, for 2001.

D. Mrs. Arnold’s Real Estate Activities and Edith Arnold, P.C.

Mrs. Arnold held a license to sell real estate in 2000 and

2001. In those years, Mrs. Arnold was a real estate agent for

the Coldwell Bank Barbara Sue Seal Agency (Seal), a real estate

brokerage. Mrs. Arnold signed a Form W-9, Request for

Identification Number and Certification, on January 10, 1999, and

wrote on the bottom of the form: “Please do not issue a 1099 for

me.”

Seal and Mrs. Arnold signed an addendum to an independent

contractor agreement on October 30, 2000, and another independent

contractor agreement in January 2001. Seal made payments to Mrs.

Arnold in her name.

Edith Arnold, P.C. (EAPC), is an S corporation owned by Mrs.

Arnold and incorporated on a date not stated in the record. Mrs.

Arnold was president of EAPC. Mrs. Arnold assigned the

commissions and income she received from Seal to EAPC during the
 - 6 -

years EAPC existed, including 2001. EAPC has never paid wages or

a salary to Mrs. Arnold. Petitioners treated amounts EAPC

distributed to Mrs. Arnold as loans from EAPC. Mrs. Arnold

signed a promissory note in the amount of the balance due at the

end of each year. EAPC did not withhold payroll taxes on any

payments to Mrs. Arnold.

E. Petitioners’ Income Tax Returns

Mr. Arnold prepared the income tax returns for petitioners,

Western, EAPC, and Pacific. Western reported its income and

expenses on the basis of a taxable year ending November 30 for

the years ending in 1994-2000. EAPC reported $65,509 of income

from trade or business activities for the fiscal year ended

January 31, 2001.

Petitioners’ tax years ended on December 31. On their

individual income tax returns for 1999, 2000, and 2001,

petitioners deducted nonpassive S corporation losses from Western

of $10,093 for 1999, $10,579 for 2000, and $14,544 for 2001.

Petitioners reported $65,509 of income from EAPC on the Schedule

E attached to their Form 1040 for 2001.

On their Form 1040 for 2001, petitioners reported on

Schedule E, Part I, Income from Rental Real Estate and Royalties,

income from “leased payroll” of $17,995. Petitioners deducted in

Part I of Schedule E a total of $28,067, consisting of $3,200 for

repairs and improvements, $10,471 for interest expense, and
 - 7 -

$14,396 for labor. Petitioners subtracted $28,067 from $17,995

of income and reported a loss of $10,072 for that activity.

OPINION

A. Whether Petitioners May Deduct Losses From Western in 1999,
2000, and 2001

1. Petitioners’ Contentions and Background

Petitioners contend that (1) they properly elected S

corporation status for Western, (2) Western was an S corporation,

(3) they substantiated the losses they deducted, (4) respondent

erroneously determined before 1999 that Western’s S corporation

election was invalid, and (5) they may deduct Western’s losses

for 1999, 2000, and 2001.4 We disagree.

An election of a corporation to be an S corporation under

sections 1361(a) and 1362(a)(1) must be complete, properly filed,

and made in accordance with regulations prescribed by the

Secretary. Sec. 1377(c); Pestcoe v. Commissioner, 40 T.C. 195,

197 (1963). A corporation electing S corporation status must

file a properly completed Form 2553 containing the information

required by that form. Sec. 1.1362-6, Income Tax Regs.

4
Respondent’s determination is presumed to be correct and
petitioners bear the burden of proof on all issues in this case.
See Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115 (1933).
Petitioners do not contend that respondent bears the burden of
proof under sec. 7491(a). However, respondent bears the burden
of production under sec. 7491(c) as to the accuracy-related
penalty under sec. 6662(a).
 - 8 -

2. Whether Western Used a Permitted Tax Year

An S corporation may use only a permitted year as its

taxable year. Sec. 1378(a). A permitted year is a year ending

December 31, or any other accounting period for which the

corporation establishes a business purpose to the satisfaction of

the Secretary. Sec. 1378(b).

Western stated in its S corporation election that a tax year

ending January 31 was its natural business year as provided in

Rev. Proc. 87-32, secs. 4.01 and 4.02(a). Rev. Proc. 87-32,

supra, provides a procedure under which a corporation electing S

corporation status may have a tax year ending on a date other

than January 31 that coincides with its natural business year.

Generally, a 12-month period is a taxpayer’s natural business

year if at least 25 percent of the gross receipts of the

enterprise are regularly earned in the last two months of the

annual period. Id.

A taxpayer cannot establish a natural business year under

Rev. Proc. 87-32, sec. 4.01(1)(d), if the taxpayer (and any

predecessor organization) has not had gross receipts for a period

of at least 47 months. Petitioners did not offer evidence

showing the amount of Western’s gross receipts from sales and

services for any period. Thus, petitioners have not established

that Western may use a tax year other than a calendar year. We
 - 9 -

conclude that Western did not use a permitted year as defined in

section 1378(b) for any year before or during the years in issue.

3. Whether Western Is an S Corporation

Petitioners contend that under Rev. Proc. 97-48, 1997-2 C.B.

521, Western was an S corporation during the years in issue

because Western followed procedures required to qualify as an S

corporation, including filing Forms 1120S for 1994-2002. We

disagree. Corporations which file a late election for S

corporation status may be eligible for relief under Rev. Proc.

97-48, supra. As previously discussed, Western failed to qualify

as an S corporation because it did not use a tax year permitted

under section 1378(a), not because it filed its S corporation

election late. Thus, Western is not eligible for relief under

Rev. Proc. 97-48, supra.

Petitioners contend that respondent failed to act on their

election of S corporation status for Western and that this

failure resulted in deemed approval. We disagree that respondent

failed to act. By letter to petitioners dated December 21, 1998,

respondent stated that respondent had rejected S corporation

status for Western before the returns for the years in issue were

due.

4. Whether Petitioners Substantiated Their Claimed
Flowthrough Losses From Western

Petitioners contend that they substantiated the amounts of

Western’s losses they deducted (as flowthrough) on their income
 - 10 -

tax returns for 1999, 2000, and 2001. We disagree. Petitioners

offered no evidence substantiating Western’s losses.

5. Conclusion

Petitioners may not deduct any losses from Western in 1999,

2000, and 2001.

B. Whether Petitioners Are Liable for Self-Employment Tax for
2001 on Income From Their Accounting and Real Estate
Activities

1. Contentions of the Parties and Background

Petitioners contend that they are not liable for self-

employment tax for 2001 because they performed services as

employees of their respective corporations in 2001. Respondent

contends that petitioners improperly assigned their personal

service income to their S corporations in 2001 and thus the

income at issue was petitioners’ income from self-employment in

2001.

The tax on income from self-employment is imposed on net

earnings of $400 or more derived by an individual from a trade or

business. Sec. 1402(a) and (b); sec. 1.1401-1(c), Income Tax

Regs.; see also Parrish v. Commissioner, T.C. Memo. 1997-474,

affd. 168 F.3d 1098 (8th Cir. 1999). The performance of services

as an employee is generally not subject to self-employment tax.

Sec. 1402(c)(2) and (3).
 - 11 -

2. Whether Petitioners Improperly Assigned Income From
Accounting and Real Estate Services to Their
Corporations

Petitioners contend that they did not improperly assign Mr.

Arnold’s accounting income to Pacific and Mrs. Arnold’s real

estate commissions to EAPC. Petitioners contend that their

corporations earned that income. Petitioners contend that the

income at issue is not taxable to them under the assignment of

income doctrine because the income was earned by their validly

organized and operated corporations. We disagree.

The existence of a validly organized and operated

corporation does not preclude taxation of income to the service

provider instead of the corporation. Wilson v. United States,

530 F.2d 772, 777-778 (8th Cir. 1976), Haag v. Commissioner, 88

T.C. 604, 610-611 (1987), affd. without published opinion 855

F.2d 855 (8th Cir. 1988); see also Commissioner v. Culbertson,

337 U.S. 733, 739-740 (1949). Deciding whether the corporation

or the service provider earned the income requires that we decide

whether the corporation or its service-performing agent or

shareholder controls the earning of the income. Johnson v.

Commissioner, 78 T.C. 882, 891 (1982) (and cases cited therein),

affd. without published opinion 734 F.2d 20 (9th Cir. 1984).

A corporation earns the income if: (a) The service provider

is an employee of a corporation which has the right to direct or

control that employee in some meaningful sense; and (b) there
 - 12 -

exists a contract or similar arrangement between the corporation

and the person or entity using the services which recognizes the

corporation’s right to direct or control the work of the service

provider. Haag v. Commissioner, supra at 611; Johnson v.

Commissioner, supra at 891; see also Leavell v. Commissioner, 104

T.C. 140, 151-152 (1995). We discuss these requirements next.

a. Whether Petitioners Were Employees of Their
Corporations

Petitioners were employees of their corporations because

they were officers of those corporations. See secs. 3121(d)(1),

1401, 1402; Robinson v. Commissioner, 117 T.C. 308, 320-322

(2001).

b. Whether Contracts Existed Between Petitioners
and Their Corporations Recognizing the Rights of
the Corporations To Direct or Control Their
Performance of Services

Petitioners make no argument on this point. There is no

evidence of a contract or similar arrangement between Mr. Arnold

and Pacific or between Pacific and its clients. Thus,

petitioners have not shown that Pacific controlled Mr. Arnold’s

performance of services.

Similarly, there is no evidence that Mrs. Arnold contracted

with her corporation to perform real estate services or that EAPC

contracted with clients to perform real estate services. The

contracts between Mrs. Arnold and Seal and Seal’s records with

respect to Mrs. Arnold’s real estate sales and commissions show
 - 13 -

that Seal paid Mrs. Arnold, not EAPC. We conclude that EAPC did

not control Mrs. Arnold’s performance of real estate services.5

c. Conclusion

We sustain respondent’s determination that petitioners are

subject to self-employment tax in 2001 on income from their

accounting and real estate activities.

C. Whether Petitioners’ Tax Treatment of “Leased Payroll” Is
Correct

1. Whether the $17,995 of “Leased Payroll” Income That
Petitioners Reported on Their 2001 Return Is Self-
Employment Income

Mr. Arnold testified that: (a) He personally obtained and

contracted with employees and independent contractors to provide

services to Pacific; (b) he charged Pacific 25 percent more than

the workers were paid; and (c) the 25 percent difference was

rental income to him and not subject to self-employment tax.

Generally, income from the rental of property is not self-

employment income. Sec. 1402(a)(1). Petitioners reported that

they received $17,995 of “leased payroll income” as rental

income. Petitioners contend that the $17,995 of “leased payroll

income” is not self-employment income. We disagree.

Mr. Arnold’s testimony establishes that the $17,995 that

petitioners reported as leased payroll income: (a) Was not

5
We do not consider respondent’s argument based on Mrs.
Arnold’s Web site because evidence about the Web site is not from
2001.
 - 14 -

income from real estate rentals; and (b) was derived from Mr.

Arnold’s personal services. Thus, petitioners received $17,995

in self-employment income that Pacific paid to Mr. Arnold in 2001

for labor provided by Mr. Arnold. We sustain respondent’s

determination that the $17,995 that petitioners reported as

leased payroll income is self-employment income.

2. Whether Petitioners May Deduct $28,067 As Leased
Payroll Expenses

Petitioners contend that they may deduct the following

$28,067 in expenses related to their leased payroll activity:

(a) $14,396 for labor; (b) $10,471 for interest; and (c) $3,200

for repairs and improvements. We disagree for reasons stated

below.

a. Labor Expenses

Petitioners contend that Mr. Arnold paid $14,396 for labor

in 2001. Petitioners rely on Forms W-2, Wage and Tax Statement,

and Forms 1099-MISC, Miscellaneous Income, showing payments made

to various individuals in 2000. A taxpayer may deduct ordinary

and necessary expenses paid or incurred during the taxable year

in carrying on any trade or business. Sec. 162(a).

The forms have several different employer identification

numbers (EIN), none of which match petitioners’ Social Security

numbers. The forms do not show that either petitioner paid

$14,396 for labor or that the payments relate to Mr. Arnold’s

leased payroll activity. Petitioners do not explain why 2000
 - 15 -

expenses are deductible for 2001. Petitioners may not reduce the

$17,995 received in 2001 by amounts they claim to have paid for

labor.

b. Interest Expense

Petitioners reported interest income totaling $10,491 for

2001 as follows: (1) $1,253 from Western; (2) $7,387 from EAPC;

(3) $1,831 from Pacific; and (4) $20 from “other”. Petitioners

contend that they had interest expenses in that amount. We

disagree. The interest was not an expense of petitioners if it

was paid to them by their S corporations. Statements in a tax

return are admissions and are not overcome without cogent

evidence that they are wrong. Waring v. Commissioner, 412 F.2d

800, 801 (3d Cir. 1969), affg. per curiam T.C. Memo. 1968-126;

Estate of Hall v. Commissioner, 92 T.C. 312, 337-338 (1989); Lare

v. Commissioner, 62 T.C. 739, 750 (1974), affd. without published

opinion 521 F.2d 1399 (3d Cir. 1975). There is no evidence that

petitioners had $10,471 of interest expenses in 2001.

Petitioners’ Schedule B is inconsistent with their claim for

a $10,471 interest deduction because it states that petitioners’

corporations paid $10,471 to petitioners. Thus, Mr. Arnold did

not make these interest payments, and apparently, these payments

do not relate to Mr. Arnold’s leased payroll activity.
 - 16 -

c. Repairs and Improvements

Petitioners contend that they may deduct from the $17,995

amount $3,200 for repairs and improvements. We disagree.

Petitioners have failed to show that they paid those amounts or

that those amounts were ordinary and necessary expenses of Mr.

Arnold’s leased payroll activity.6

d. Conclusion

Petitioners have not shown that they are entitled to deduct

any amount from the $17,995 they received from Pacific because of

Mr. Arnold’s leased payroll activity.

D. Whether Petitioners Are Liable for the Accuracy-Related
Penalty

Petitioners contend that they are not liable for the

accuracy-related penalty under section 6662(a) because they

6
In their reply brief, petitioners request that we reopen
the record to admit into evidence (1) documents stating that they
paid $3,200 for repairs and improvements and (2) schedules
relating to their claims of double taxation of income, illegal
seizures, and failure to issue refunds.

A court generally will not reopen the record unless the
evidence relied on probably would change the outcome of the case.
Butler v. Commissioner, 114 T.C. 276, 287 (2000). The documents
stating that petitioners paid $3,200 for repairs and improvements
would probably not change the outcome of these cases because they
do not purport to show that they were ordinary and necessary
expenses of Mr. Arnold’s leased payroll activity. The schedules
probably would not change the outcome of these cases because the
data in the schedules is uncorroborated. Petitioners do not
explain why they did not offer these documents into evidence at
trial. It is not appropriate to reopen the record under these
circumstances.
 - 17 -

followed regulations and procedures when preparing records and

the returns at issue in these cases. We disagree.

1. Burden of Production

Section 7491(c) places on the Commissioner the burden of

producing evidence that it is appropriate to impose a particular

penalty. To meet that burden, the Commissioner need not produce

evidence relating to defenses such as reasonable cause or

substantial authority. Higbee v. Commissioner, 116 T.C. 438, 446

(2001); H. Conf. Rept. 105-599, at 241 (1998), 1998-3 C.B. 747,

995. Once the Commissioner meets the burden of production, in

order to not be found liable for the penalty the taxpayer must

produce evidence showing that the Commissioner’s determination is

incorrect. Higbee v. Commissioner, supra at 447.

Respondent has met the burden of production under section

7491(c) with respect to the accuracy-related penalty under

section 6662(a) by showing: (a) Western did not report its

income on a permitted tax year; (b) respondent notified

petitioners in writing that Western was not an S corporation; (c)

petitioners disregarded statutes and the regulations thereunder

in claiming losses from Western for 1999, 2000 and 2001; (d)

petitioners performed personal services and claimed that their

corporations earned the income received for personal services

provided for tax year 2001; and (e) Mr. Arnold and not Pacific

earned the $17,995 that petitioners reported as leased payroll
 - 18 -

income on their 2001 return and that the $17,995 is self-

employment income.

2. Whether Petitioners Have Shown They Were Not Negligent

Petitioners argue that they were not negligent because they

are correct on the merits of this case and they followed the

Secretary’s regulations and procedures. We disagree. As

discussed above, we conclude that petitioners are incorrect on

the merits of this case. Petitioners did not comply with Rev.

Proc. 87-32, 1987-2 C.B. 396. Petitioners make no argument and

offered no evidence to show that they had reasonable cause. We

conclude that petitioners are liable for the accuracy-related

penalty under section 6662(a) for 1999, 2000, and 2001.

To reflect concessions and the foregoing,

Decisions will be

entered under Rule 155.