T.C. Summary Opinion 2005-159
UNITED STATES TAX COURT
MATTHEW HUDACK AND KRISTEN HUDACK, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 3432-04S. Filed November 2, 2005.
Matthew Hudack, pro se.
Michael S. Hensley, for respondent.
PANUTHOS, Chief Special Trial Judge: This case was heard
pursuant to the provisions of section 7463 of the Internal
Revenue Code in effect at the time that the petition was filed.1
1
Unless otherwise indicated, all subsequent section
references are to the Internal Revenue Code (Code) in effect at
relevant times, and all Rule references are to the Tax Court
Rules of Practice and Procedure. All monetary amounts are
rounded to the nearest dollar.
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The decision to be entered is not reviewable by any other court,
and this opinion should not be cited as authority.
Respondent determined deficiencies in petitioners’ Federal
income taxes as well as accuracy-related penalties as follows:
Penalty
Year Deficiency Sec. 6662(a)
1999 $17,096 $3,419
2000 16,469 3,294
After petitioners’ concessions,2 the issues for decision
are: (1) Whether Matthew Hudack (petitioner) was a statutory
employee for 1999 and 2000 (years in issue); and (2) whether
petitioners are liable under section 6662(a) for accuracy-related
penalties for the years in issue.
Adjustments to the amounts of petitioners’ itemized
deductions and the alternative minimum tax are purely
computational matters, the resolution of which depends on our
disposition of the first disputed issue.
Background
Some of the facts have been stipulated, and they are so
found. We incorporate by reference the parties’ stipulation of
facts and the accompanying exhibits.
At the time that the petition was filed, petitioners resided
in Santa Ana, California.
2
For 1999, petitioners concede that they are not entitled
to claimed “business promotion” expenses of $974 and “client
costs” expenses of $402.
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In 1986, petitioner received his license to sell life
insurance products in the State of California. From 1986 to June
1990 and from June 1993 to at least the date of trial, petitioner
worked for the Manufacturers Life Insurance Co. (USA) (Manulife)
selling life insurance products. Manulife is a Toronto-based
insurance company that sells annuities, group pensions, insurance
policies, and college savings plans and provides investment
account management services.
On January 1, 1999, petitioner executed a “Regional Director
Employment Agreement” (agreement) with Manulife, which was in
effect during the years in issue.3 The agreement required
petitioner to serve Manulife full time as a primary
representative and an integral part of Manulife’s sales service
for an indefinite period. The agreement also required petitioner
to “agree not to sell, solicit, market or otherwise promote
financial products for any company other than” Manulife and its
subsidiaries without Manulife’s written consent and to adhere to
all policies, procedures, and written rules and regulations of
Manulife including Manulife’s codes of conduct.
Under the agreement, petitioner was an at-will employee.
The agreement provided that petitioner was “attached” to
Manulife’s Orange County Sales Office in Irvine, California
(Irvine office), and assigned him the southern California sales
3
Manulife has 29 regional directors nationwide.
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territory. The agreement set petitioner’s compensation on a
commission schedule based on the business category for the
products that he sold.4 In addition, Manulife provided
petitioner with an annual reimbursement allocation, which
petitioner could use for any business-related expense.5
Petitioner, however, was responsible for business expenses
exceeding his reimbursement allocation. Manulife did not pay
petitioner for vacation days, but Manulife provided that
petitioner was eligible to enroll in its benefit and retirement
plans.
Petitioner’s responsibilities were to identify sales
opportunities for insurance agents, brokers, financial planners,
and stockbrokers and to provide financial plans for their
clients. As the regional director, petitioner reported his goals
and objectives to the western regional manager. In his sales
presentations, petitioner used financial planning information
packets that were preapproved by Manulife.6 Petitioner’s only
office location was the Irvine office. Petitioner purchased his
4
Although not further explained in the record, it appears
that petitioner received an annual base salary of $60,000 for old
sales commissions as evidenced in his 1999 monthly compensation
statements.
5
The record does not disclose the amount of petitioner’s
reimbursement allocation, nor does it explain Manulife’s
reimbursement procedures.
6
For 1999, petitioner led the company in sales for life
insurance products.
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own computer, fax machine, and cellular phone for use in his
sales activities, but he paid no rent or other business expenses
(e.g., utilities, office supplies and equipment, furniture, and
copier) in connection with the Irvine office. Those expenses
were paid by Manulife. In the Irvine office, Manulife employed
two support staff employees to assist petitioner.
Manulife issued Forms W-2, Wage and Tax Statement, to
petitioner reporting wages or other compensation of $496,053 and
$436,891 for 1999 and 2000, respectively. The Forms W-2 also
reported that Manulife withheld the applicable payroll taxes.
The Forms W-2 further indicated that petitioner participated in
Manulife’s health insurance program, pension plan, and deferred
compensation plan. Manulife did not check box 15 for statutory
employee.7
Petitioners timely filed a Form 1040, U.S. Individual Income
Tax Return, for each of the years in issue. Petitioners attached
to each return, inter alia, a Schedule C, Profit or Loss From
Business. On each Schedule C, petitioner identified his
principal business or profession as life insurance sales and his
business address as the Irvine office. Petitioner reported the
following on the Schedules C:
7
We note that the 2000 Form W-2 box 15 for statutory
employee contained a handwritten “X”.
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Year Gross Receipts1 Total Expenses Net Profit
2
1999 $526,773 $98,890 $427,883
2000 441,898 76,540 365,358
1
Gross receipts included the amounts reflected on the
respective Forms W-2 issued by Manulife as well as self-
employment income from other sources.
2
In 1999, petitioner received self-employment income of
$3,400 from Manulife, which was reported on a Form 1099-MISC,
Miscellaneous Income.
Expenses consisted of advertising, automobile expenses,
commissions and fees, depreciation, insurance, legal and
professional services, office expenses, rent or lease of
equipment, supplies, travel, meals and entertainment, utilities,
and other expenses.8
Petitioner consulted with his return preparer, W.R. Frey
(Mr. Frey), and discussed the nature of his work. Following the
consultation, Mr. Frey advised petitioner to file as a statutory
employee.
In the notice of deficiency, respondent determined that
petitioner was a common law employee and, therefore, not
permitted to report income and expenses on Schedule C.
Respondent further determined that petitioners are liable for the
accuracy-related penalty under section 6662(a).
8
We note that petitioner did not report on his return any
reimbursement income or its associated expense because he
considered it a “wash”.
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Discussion
A. Petitioner’s Employment Status9
Generally, adjusted gross income means gross income less
trade or business expenses, except in the case of the performance
of services by an employee. Sec. 62(a)(1). As relevant herein,
an individual performing services as an employee may deduct
expenses incurred in the performance of services as an employee
only as miscellaneous itemized deductions on Schedule A, Itemized
Deductions, and then only to the extent such expenses exceed 2
percent of the individual’s adjusted gross income. Secs.
62(a)(2); 63(a), (d); 67(a) and (b); 162(a). In contrast, an
individual who qualifies as a statutory employee as defined under
section 3121(d)(3) is not subject to the section 67(a) 2-percent
limitation for expenses incurred in the performance of services
as an employee. Rev. Rul. 90-93, 1990-2 C.B. 33.10 Thus, a
statutory employee under section 3121(d)(3) is allowed to deduct
expenses from gross income on Schedule C that otherwise would be
9
We render a decision on the merits based on the
preponderance of the evidence, without regard to the burden of
proof under sec. 7491(a).
10
Rev. Rul. 90-93, 1990-2 C.B. 33, provides that an
individual treated as a statutory employee under sec. 3121(d)(3)
for employment tax purposes who would otherwise be characterized
as an independent contractor is not considered an employee for
purposes of secs. 62 and 67, and, therefore, may deduct business
expenses on Schedule C.
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subject to the 2-percent limitation of section 67(a). See sec.
62(a)(1).
Petitioner contends that he was a statutory employee under
section 3121(d)(3)(B) and, therefore, that he may report his
business-related income and expenses on Schedule C.
Section 3121(d) defines “employee” for employment tax
purposes as follows:
SEC. 3121(d). Employee.--For purposes of this
chapter, the term “employee” means--
(1) any officer of a corporation; or
(2) any individual who, under the usual
common law rules applicable in determining
the employer-employee relationship, has the
status of an employee; or
(3) any individual (other than an
individual who is an employee under paragraph
(1) or (2)) who performs services for
remuneration for any person--
* * * * * * *
(B) as a full-time life
insurance salesman;
Under section 3121(d)(3), however, the provisions of section
3121(d)(3)(B) apply only if a full-time life insurance salesman
does not have the status of an employee under the usual common
law rules applicable in determining the employer-employee
relationship. Lickiss v. Commissioner, T.C. Memo. 1994-103.
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Therefore, we must first determine whether petitioner was a
common law employee during the years in issue.11
For purposes of section 62(a), subtitle A of the Code does
not define “employee”. Under these circumstances, we apply
common law rules to determine whether an individual is an
employee. Nationwide Mut. Ins. Co. v. Darden, 503 U.S. 318, 323-
325 (1992); Weber v. Commissioner, 103 T.C. 378, 386 (1994),
affd. 60 F.3d 1104 (4th Cir. 1995). Whether an individual is a
common law employee is a question of fact. Profl. & Executive
Leasing, Inc. v. Commissioner, 862 F.2d 751, 753 (9th Cir. 1988),
affg. 89 T.C. 225 (1987); Simpson v. Commissioner, 64 T.C. 974,
984 (1975). Among the relevant factors in determining the nature
of an employment relationship are the following: (1) The degree
of control exercised by the principal over the details of the
work; (2) the taxpayer’s investment in the facilities used in the
work; (3) the taxpayer’s opportunity for profit or loss; (4) the
permanency of the relationship between the parties; (5) the
principal’s right of discharge; (6) whether the work performed is
an integral part of the principal’s business; (7) what
relationship the parties believe they are creating; and (8) the
provision of employee benefits. NLRB v. United Ins. Co., 390
U.S. 254, 258 (1968); Profl. & Executive Leasing, Inc. v.
11
The parties agree that petitioner otherwise qualifies as
a full-time life insurance salesman pursuant to sec.
3121(d)(3)(B).
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Commissioner, supra; Simpson v. Commissioner, supra. No one
factor is determinative; rather, all the incidents of the
relationship must be assessed and weighed. NLRB v. United Ins.
Co., supra.
1. Degree of Control
The crucial test to determine the nature of a working
relationship is the employer’s right to control the manner in
which the taxpayer’s work is performed. Weber v. Commissioner,
supra at 387. It is not necessary for the employer to exercise
control over the details of the taxpayer’s work; rather, all that
is necessary is that the employer have the right to control the
details of the taxpayer’s work. Profl. & Executive Leasing, Inc.
v. Commissioner, supra at 754; McGuire v. United States, 349 F.2d
644, 646 (9th Cir. 1965); Weber v. Commissioner, supra at 388.
To retain the requisite control over the details of an
individual’s work, the employer need not stand over the
individual and direct every move made; it is sufficient that the
employer has the right to do so. Weber v. Commissioner, supra at
388. Similarly, the employer need not set the individuals’s
hours or supervise every detail of the work environment to
control the individual. Gen. Inv. Corp. v. United States, 823
F.2d 337, 342 (9th Cir. 1987).
While petitioner had control over his own sales performance,
Manulife had the right to control the manner in which he
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performed his work. Manulife set petitioner’s sales commission
schedule, his sales territory, and his annual reimbursement
allocation. Moreover, Manulife restricted petitioner’s ability
to sell or promote other company’s financial products without
Manulife’s consent and required petitioner to use preapproved
financial information packets to market Manulife’s life insurance
products. In addition, Manulife required petitioner to use the
Irvine office to conduct business and to use Manulife’s support
staff to assist him in his sales activities. These facts suggest
that Manulife generally retained the right to regulate and direct
petitioner’s business activities.
We give little or no weight to the fact that the agreement
merely required petitioner to adhere to Manulife’s policies,
procedures, written rules, and codes of conduct and that Manulife
required petitioner to report his goals and objectives to the
western regional manager because the record does not identify the
procedures for enforcement of the rules and for reporting
requirements.
The totality of the evidence on this factor supports a
finding that Manulife had the right to control the manner in
which petitioner performed his work and that petitioner therefore
was an employee of Manulife.
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2. Investment in Facilities
During the years in issue, petitioner worked out of
Manulife’s Irvine office, which was his only work location.
Indeed, petitioner’s business contact information listed the
Irvine office as his business address.
Moreover, Manulife employed at its Irvine office two support
employees to assist petitioner in his sales activities. Manulife
was responsible for hiring, supervising, and paying these
employees. Although petitioner provided his own computer and fax
machine, he was not otherwise responsible for any business
expenses associated with this office, including rent, office
supplies, equipment, and furniture.
This factor strongly suggests that petitioner was an
employee of Manulife.
3. Opportunity for Profit or Loss
Petitioner received commissions based on his sales
performance. Manulife also reimbursed petitioner for his
business expenses up to an annual limit.
Compensation on a commission basis is entirely consistent
with an employer-employee relationship. Tex. Carbonate Co. v.
Phinney, 307 F.2d 289, 292 (5th Cir. 1962); Capital Life & Health
Ins. Co. v. Bowers, 186 F.2d 943 (4th Cir. 1951). While
petitioner conceivably could have suffered some loss as a result
of his sales activities, he may still be an employee under the
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common law test if his risk of loss was negligible. Lewis v.
Commissioner, T.C. Memo. 1993-635; Radovich v. Commissioner, T.C.
Memo. 1954-220. Moreover, the risk that he would not receive any
commissions because of low sales performance is common to both
employees and statutory employees.
Other than his computer, fax machine, cellular phone, and
business expenses that exceeded his annual reimbursement
allocation, petitioner did not have any capital investments or
bona fide liability for expenses (such as salary payments to
unrelated employees) in his sales activities such that he would
be subject to a real risk of economic loss.
This factor supports a finding that petitioner was an
employee of Manulife.
4. Permanency of Relationship
Since becoming a licensed life insurance salesman in 1986,
petitioner has worked for Manulife from 1986 to June 1990 and
again from June 1993 to at least the date of trial. Moreover,
under the agreement, petitioner was hired to work for an
indefinite period of time.
This factor supports a finding that petitioner was an
employee of Manulife.
5. Principal’s Right To Discharge
The relationship between petitioner and Manulife was
terminable at the will of either party without any further
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compensation. With respect to a statutory employee, the parties
would likely have this same right. Therefore, we accord this
factor little or no weight.
6. Integral Part of Business
Manulife is in the business of selling its products. Sales
representatives, such as petitioner, are Manulife’s key
connection with its customers. This factor supports a finding
that petitioner was an employee of Manulife. See Lewis v.
Commissioner, supra.
7. Relationship Parties Believe They Created
Petitioner contends that he was a statutory employee. On
the Forms W-2, however, Manulife did not mark the statutory
employee box. Further, Manulife paid the applicable payroll
taxes and did not issue a Form 1099. The withholding of such
taxes by Manulife is consistent with a finding that petitioner
was an employee. See Azad v. United States, 388 F.2d 74, 78 (8th
Cir. 1968); Weber v. Commissioner, 103 T.C. at 392.
This factor would support a finding that petitioner was an
employee.
8. Employee Benefits
Petitioner participated in Manulife’s pension plan and
deferred compensation plan. Moreover, petitioner received health
benefits through Manulife’s group health insurance plan.
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Typically, statutory employees are not entitled to
participate in employee benefit plans. There is an exception,
however, for full-time life insurance salespeople who are treated
as employees for purposes of certain employee benefit programs
maintained by a business. Sec. 7701(a)(20). We find this factor
is neutral.
9. Conclusion as to Employment Status
On balance, considering the record and weighing all of the
factors, we conclude that during the years in issue petitioner
was a common law employee, rather than a statutory employee under
section 3121(d)(3)(B). Therefore, petitioner is not entitled to
report gross income and expenses on Schedule C. Accordingly, we
sustain respondent’s determination on this issue.
B. Section 6662(a) Accuracy-Related Penalty
The final issue for decision is whether petitioners are
liable for accuracy-related penalties under section 6662(a) for
the years in issue.
Section 6662(a) imposes a penalty equal to 20 percent of any
underpayment of tax that is attributable to either negligence or
disregard of rules or regulations, or a substantial
understatement of income tax. See sec. 6662(a) and (b)(1) and
(2).
The term “negligence” includes any failure to make a
reasonable attempt to comply with the provisions of the internal
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revenue laws. Sec. 6662(c); sec. 1.6662-3(b)(1), Income Tax
Regs. The term “disregard” includes any careless, reckless, or
intentional disregard. Sec. 6662(c); sec. 1.6662-3(b)(2), Income
Tax Regs.
An understatement of income tax is “substantial” if it
exceeds the greater of 10 percent of the tax required to be shown
on the return, or $5,000. Sec. 6662(d)(1)(A). An
“understatement” is defined as the excess of the tax required to
be shown on the return over the tax actually shown on the return.
Sec. 6662(d)(2)(A).
Whether the accuracy-related penalty is applied because of
negligence or disregard of rules or regulations, or a substantial
understatement of tax, section 6664 provides an exception to
imposition of the accuracy-related penalty if the taxpayer
establishes that there was reasonable cause for the
understatement and that the taxpayer acted in good faith with
respect to that portion. Sec. 6664(c)(1); sec. 1.6664-4(b),
Income Tax Regs.; see United States v. Boyle, 469 U.S. 241, 242
(1985). Although not defined in the Code, “reasonable cause” is
viewed in the applicable regulations as the “exercise of ordinary
business care and prudence”. Sec. 301.6651-1(c)(1), Proced. &
Admin. Regs.; see United States v. Boyle, supra at 246. The
determination of whether a taxpayer acted with reasonable cause
and in good faith is made on a case-by-case basis, taking into
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account all the pertinent facts and circumstances. Sec. 1.6664-
4(b)(1), Income Tax Regs. Generally, the most important factor
is the extent of the taxpayer’s effort to assess the proper tax
liability, including reliance on the advice of a tax return
preparer. Id.
By virtue of section 7491(c), respondent has the burden of
production with respect to the accuracy-related penalty. To meet
this burden, respondent must produce sufficient evidence
indicating that it is appropriate to impose the penalty. See
Higbee v. Commissioner, 116 T.C. 438, 446 (2001). Once
respondent meets this burden of production, petitioner must come
forward with persuasive evidence that respondent’s determination
is incorrect. Rule 142(a); see Higbee v. Commissioner, supra.
As a defense to the penalty, petitioner bears the burden of
proving that he or she acted with reasonable cause and in good
faith. See sec. 6664(c)(1); see also Higbee v. Commissioner,
supra; sec. 1.6664-4(b)(1), Income Tax Regs.
Respondent satisfied his burden of production under section
7491(a)(1) because the record shows that petitioners
substantially understated their income tax for the years in
issue. See sec. 6662(d)(1)(A)(ii); Higbee v. Commissioner, supra
at 442. Accordingly, petitioners bear the burden of proving that
the accuracy-related penalty should not be imposed with respect
to any portion of the understatement for which they acted with
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reasonable cause and in good faith. See sec. 6664(c)(1); Higbee
v. Commissioner, supra at 446. The mere fact that we held
against petitioners with respect to petitioner’s employment
status does not, in and of itself, require holding for respondent
on the accuracy-related penalty. See Hitchins v. Commissioner,
103 T.C. 711, 719 (1994).
Petitioners contend that they are not liable for accuracy-
related penalties because they reasonably relied on their tax
return preparer. On the basis of the entire record in this case
and in light of the nature of petitioner’s occupation as a life
insurance salesperson, we find that petitioners’ reliance on
their tax return preparer that petitioner was a statutory
employee was reasonable. Therefore, petitioners are not liable
for the accuracy-related penalties for the years in issue.
Accordingly, respondent’s determination on this issue is not
sustained.
We have considered all of the other arguments made by the
parties, and, to the extent that we have not specifically
addressed them, we conclude that they are without merit.
Reviewed and adopted as the report of the Small Tax Case
Division.
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To reflect our disposition of the disputed issues, as well
as petitioners’ concessions,
Decision will be entered
for respondent as to the
deficiencies in taxes and for
petitioners as to the penalties.