T.C. Memo. 2008-171
UNITED STATES TAX COURT
LARRY J. AND SHERILYN WADSWORTH, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 10823-05. Filed July 21, 2008.
Lillian W. Wyshak, for petitioners.
Valerie L. Makarewicz, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
KROUPA, Judge: Respondent determined a $147,708 deficiency
for 2001 and a $56,958 deficiency for 2002 in petitioners’
Federal income tax based on petitioners’ amended returns for
those years. Respondent also determined accuracy-related
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penalties under section 6662(a)1 of $29,541.60 for 2001 and
$11,125.60 for 2002.
After concessions,2 the only remaining issue is whether
petitioners are liable for the accuracy-related penalties for
2001 and 2002.3 We hold that petitioners are liable for the
accuracy-related penalties.
FINDINGS OF FACT4
Some of the facts have been stipulated and are so found.
The stipulation of facts and the accompanying exhibits are
incorporated by this reference. Petitioners resided in
California at the time they filed the petition.
1
All section references are to the Internal Revenue Code in
effect for the years at issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure, unless otherwise
indicated.
2
This Court issued an order denying petitioners’ amended
motion to dismiss for lack of jurisdiction, amended motion to
strike, and motion to shift the burden of proof, pursuant to
Wadsworth v. Commissioner, T.C. Memo. 2007-46. Petitioners renew
their objection to our jurisdiction. We reject their position,
for the reasons stated in Wadsworth v. Commissioner, supra.
3
Petitioners conceded at trial and on brief that the amounts
of income tax they originally reported on the returns for 2001
and 2002 were accurate and that the amended returns were
inaccurate. Petitioners nevertheless maintain that the
deficiencies are still at issue. We find petitioners’ position
inexplicable and completely at odds with their concession and
actions.
4
Petitioners’ briefs failed to comply with Rule 151(e).
They failed to include a statement of the nature of the
controversy, the tax involved, and the issues to be decided.
They also failed to include proposed findings of fact and a
concise statement of the points upon which they rely.
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Larry Wadsworth (petitioner) was a general partner of Gold
Coast Medical Services (GCMS), a partnership with gross receipts
exceeding a million dollars, in 2001 and 2002. GCMS operated a
pharmacy that provided medical products and services to eligible
beneficiaries of the California Medical Assistance Program during
2001 and 2002.
Petitioners timely filed Federal income tax returns for 2001
and 2002 and attached a Schedule E, Supplemental Income and Loss,
to each return. Petitioners reported $534,424 of total income on
the Schedule E for 2001 and $345,546 of total income on the
Schedule E for 2002, both amounts consisting solely of non-
passive income from GCMS. GCMS also timely filed Forms 1065,
U.S. Return of Partnership Income, for 2001 and 2002.5
DHS Audit
The California Department of Health Services (DHS) audited
GCMS’s books after petitioners’ original returns were filed. DHS
issued its audit report on August 19, 2003, for the period from
January 1, 2001, through February 28, 2002. DHS concluded that
GCMS had been overpaid for those periods and directed GCMS to
remit $2,311,634.39 within 60 days of the issuance of the audit
report or be subject to interest and an offset of 100 percent
withholding on current billings.
5
The returns filed by GCMS are not at issue except to the
extent that petitioner reported his distributive share of the
partnership’s income and loss. Sec. 702.
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Amended Returns
Keith Borges prepared the original GCMS partnership returns
for 2001 and 2002 and the original Federal income tax returns for
2001 and 2002 that petitioners filed. He had prepared returns
for petitioners since 1994. Mr. Borges received a bachelor of
science degree with an emphasis in accounting in 1979 and has
been an accountant ever since. He has been a certified public
accountant since 1981 and is a partner in the accounting firm of
Anderson Lucas Somerville & Borges. He is a member of the
American Institute of Certified Public Accountants and the
California Society of Certified Public Accountants.
Petitioner and Robert Rosenstein, the attorney representing
GCMS in its appeal of the DHS audit findings, contacted Mr.
Borges after the audit and asked if the partnership tax returns
could be amended to claim a deduction for the amount reflected in
the DHS audit as a contingent liability. Mr. Borges researched
whether the deduction was appropriate, decided that it was not,
and then declined to amend the returns. He requested that Mr.
Rosenstein send him any supporting information or legal authority
to justify claiming a deduction for a contingent liability. Mr.
Borges never received any additional information.
Petitioners and Mr. Rosenstein next looked to Douglas Huff
to amend the returns and claim the deduction. Mr. Huff had a
background in finance and had been preparing returns for Mr.
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Rosenstein’s clients for some time. He amended the GCMS returns
after discussions with Mr. Rosenstein but without consulting tax
cases or any other information. Mr. Huff had several
conversations with Mr. Rosenstein about the amended returns
because Mr. Borges’ refusal to amend the returns concerned Mr.
Huff, yet he went ahead with amending the returns. Mr. Huff
described Mr. Rosenstein as a “bankruptcy-tax attorney” who had
been preparing returns for many years. Mr. Huff amended
petitioners’ returns based on what he described as a “possible
contingent liability.”
GCMS filed amended partnership returns after DHS issued its
audit report but before learning the result of GCMS’s appeal.
The amended partnership returns reported that GCMS reduced its
gross receipts for “returns and allowances” by $1,981,401 for
2001 and by $330,555 for 2002 to correspond to the amounts
identified in the DHS audit report.
Petitioners filed amended individual returns in March 2004
reflecting the changes in GCMS’s partnership income. Petitioners
attached an amended GCMS Schedule K-1, Partner’s Share of Income,
Credits, Deductions, etc., to each amended return and reported a
decrease in partnership income and a loss from the partnership
activity on each return. The changes reflected the amounts
identified in the DHS audit report. Those changes resulted in
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petitioners’ claiming and receiving a $147,708 refund for 2001
and a $56,958 refund for 2002.
Appeal of DHS Audit Findings
GCMS appealed the DHS audit findings. After GCMS amended
its returns to pass through to petitioner the “possible
contingent liabilities” arising from that audit, the results of
the DHS audit were overturned. The DHS Office of Administrative
Hearings and Appeals concluded on September 7, 2004, that GCMS
did not engage in discriminatory billing and had not been
overpaid. Consequently, GCMS made no reimbursement payments to
DHS.
Petitioners’ amended returns prompted respondent’s
examination of petitioners’ returns. Respondent examined
petitioners’ returns for each of the years at issue and
determined deficiencies in the amounts allowed as refunds of the
overpayments claimed on the amended returns. Petitioners timely
filed the petition.
OPINION
Petitioners have paid and conceded the deficiencies
resulting from the amended returns. The issue remaining is
whether petitioners are liable for the accuracy-related penalties
with respect to the deficiencies attributable to claiming the
contingent liabilities.
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Accuracy-Related Penalty
Respondent determined that petitioners are liable for
accuracy-related penalties for substantial understatements of
income tax under section 6662(b)(2) for 2001 and 2002.6 A
taxpayer is liable for an accuracy-related penalty of 20 percent
for any part of an underpayment attributable to, among other
things, a substantial understatement of income tax. See sec.
6662(a) and (b)(2); sec. 1.6662-2(a)(2), Income Tax Regs. There
is a substantial understatement of income tax if the amount of
the understatement exceeds the greater of either 10 percent of
the tax required to be shown on the return, or $5,000. Sec.
6662(d)(1)(A); sec. 1.6662-4(b)(1), Income Tax Regs.
Respondent has the burden of production under section
7491(c) and must come forward with sufficient evidence that it is
appropriate to impose the penalty. See Higbee v. Commissioner,
116 T.C. 438, 446-447 (2001). Petitioners reported $23,986 of
tax due for 2001 when $171,694 was required. Petitioners
reported $38,265 of tax due for 2002 when $95,233 was required.
These understatements exceed the section 6662 threshold
6
Respondent determined in the alternative that petitioners
were liable for accuracy-related penalties for negligence or
disregard of rules or regulations under sec. 6662(b)(1) for the
years at issue. Because respondent has proven that petitioners
substantially understated their income tax for the years at
issue, we need not consider whether petitioners were negligent or
disregarded rules or regulations.
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for both years. We find respondent has satisfied his burden of
production.
Disclosure of a Position and Reasonable Basis for Treatment
No accuracy-related penalty may be imposed for a substantial
understatement of income tax, however, when the taxpayer
adequately discloses the relevant facts affecting the tax
treatment of an item and there existed a reasonable basis for the
treatment of that item. Sec. 6662(d)(2)(B); sec. 1.6662-4(e),
Income Tax Regs. A taxpayer may disclose on a Form 8275,
Disclosure Statement, a Form 8275-R, Regulation Disclosure
Statement, or on the return itself. Sec. 1.6662-4(f)(1) and (2),
Income Tax Regs. The Commissioner has prescribed other
circumstances in which information provided on a return is
adequate. Sec. 1.6662-4(e)(1) and (f)(2), Income Tax Regs. A
Schedule K-1 is not listed as a proper form for disclosure. Rev.
Proc. 2001-52, 2001-2 C.B. 491; Rev. Proc. 2002-66, 2002-2 C.B.
724.
Petitioners argue that attaching the amended Schedule K-1 to
the amended returns was sufficient to alert respondent of
petitioners’ position. We disagree. Petitioners failed to
attach a Form 8275 or explain the basis of their changes when
they amended the returns.
Disclosure will not have an effect, moreover, where the
position on the return has no reasonable basis. Sec. 1.6662-
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4(e)(2)(i), Income Tax Regs. The reasonable basis standard is
not satisfied by a return position that is merely arguable.
Secs. 1.6662-4(e)(2)(i), 1.6662-3(b)(3), Income Tax Regs.
Petitioners essentially argue that they elected the
“modified cash” method of accounting, yet fail to explain what
that is or how it absolves them from the penalty. The
partnership, if on the cash method of accounting, would have been
entitled to a deduction for a liability to the State of
California for the year in which the liability was paid. See
sec. 1.461-1, Income Tax Regs. Petitioners presented no evidence
that the partnership paid any portion of the $2,311,634.39 during
2001 or 2002 to the State of California. Nor was the partnership
entitled to a deduction for “returns and allowances” in 2001 or
2002 under the accrual method of accounting. An accrual basis
taxpayer generally cannot accrue a deduction for a contested
liability unless conditions of section 461(f) are met. The
partnership contested DHS’s report and made no transfer within
the meaning of section 461(f) to provide for the satisfaction of
the liability. An accrual method taxpayer who fails to satisfy
the conditions of section 461(f) ordinarily is not entitled to
claim a deduction for a contested liability before the year in
which the contest is eliminated by compromise or settlement or
through a final disposition. Dixie Pine Prods. Co. v.
Commissioner, 320 U.S. 516 (1944). We find that petitioners had
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no reasonable basis for their position, and accordingly the
adequate disclosure exception does not apply.
Petitioners’ Receipt of Refunds Produced Deficiencies
Petitioners also argue that because the amount of income tax
they originally reported was correct, they are not liable for
penalties. Again, we disagree. The crucial question is whether
the refunds of the overpayments claimed on their amended returns
were rebate refunds, subject to recovery by the deficiency
procedures. If the refunds were made on the ground that the
income tax imposed for each year was less than the amount shown
as tax on petitioners’ return for that year, then the refunds
constitute rebates. See sec. 6211(b)(2); see also Clayton v.
Commissioner, T.C. Memo. 1997-327, affd. without published
opinion 181 F.3d 79 (1st Cir. 1998). If the refunds were
unrelated to a recalculation of their tax liabilities, however,
then they would be characterized as non-rebate refunds. Clark v.
United States, 63 F.3d 83, 86-87 (1st Cir. 1995); O'Bryant v.
United States, 49 F.3d 340, 342 (7th Cir. 1995). The refunds
here are rebates within the meaning of sections 6211(b)(2) and
6664(a) because they were made on the ground that petitioners’
tax liabilities were less than the amounts shown as tax on their
original returns. Accordingly, the refunds are subject to the
deficiency regime of sections 6211 through 6216 and result in
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underpayments, within the meaning of section 6664(a), on which
the accuracy-related penalties may be imposed.
Petitioners Did Not Have Reasonable Cause or Act in Good Faith
The accuracy-related penalty is not imposed with respect to
any portion of an underpayment if a taxpayer shows that there was
reasonable cause for, and that the taxpayer acted in good faith
with respect to, that portion of the underpayment. Sec.
6664(c)(1); sec. 1.6664-4(a), Income Tax Regs. Petitioners have
the burden of proving that the accuracy-related penalty does not
apply. See Higbee v. Commissioner, 116 T.C. at 446. The
determination of whether a taxpayer acted with reasonable cause
and in good faith depends on the pertinent facts and
circumstances, including the taxpayer’s efforts to assess his or
her proper tax liability, the knowledge and experience of the
taxpayer, and the taxpayer’s reliance on the advice of a
professional. Sec. 1.6664-4(b)(1), Income Tax Regs. Reliance on
the advice of a professional tax adviser constitutes reasonable
cause and good faith if, under all the circumstances, such
reliance was reasonable and the taxpayer acted in good faith.
Id. To prove reasonable cause due to reliance on the advice of a
tax adviser, however, the taxpayer must show that the adviser was
a competent professional with sufficient expertise to justify
reliance. Neonatology Associates, P.A. v. Commissioner, 115 T.C.
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43, 99 (2000), affd. 299 F.3d 221 (3d Cir. 2002); Ellwest Stereo
Theatres v. Commissioner, T.C. Memo. 1995-610.
We agree with respondent that petitioners lacked reasonable
cause for, and failed to act in good faith with respect to, their
substantial understatements of income tax for 2001 and 2002.
Petitioners made very little effort to assess their proper tax
liability, and they failed to heed the advice of their longtime
return preparer, Mr. Borges. Petitioners ignored Mr. Borges’
advice, and Mr. Huff amended the returns instead. We find that
Mr. Borges’ refusal to amend the returns should have raised a red
flag for petitioners, but petitioners disregarded that warning.
Petitioners offer no explanation for their reliance upon Mr.
Rosenstein and Mr. Huff in spite of their longtime preparer Mr.
Borges’ refusal to amend their returns. Petitioners also failed
to establish that Mr. Huff and Mr. Rosenstein were competent
professionals with sufficient expertise to justify their
reliance. Mr. Rosenstein never testified. Mr. Huff did. Mr.
Huff does not appear to have a background in tax, and he offered
no legal authority to explain why he amended the returns other
than that Mr. Rosenstein directed him to do so.
Petitioner is a successful businessman who, as a partner of
GCMS, operated a multimillion-dollar business. It is reasonable
to assume that such a person would investigate the basis for
amending his returns when his longtime accountant advised against
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the position taken in those returns. Petitioners’ decision to
amend their returns appears to have been motivated not by the
demands of the law but by their desire for tax refunds.
Conclusion
We find that petitioners’ efforts to assess their correct
tax liabilities were unreasonable and not in good faith.
Petitioners could not in good faith rely upon Mr. Huff’s and Mr.
Rosenstein’s advice when they disregarded their longtime
preparer’s concerns and then provided no explanation of their
decision to follow controversial advice other than that they
wanted the refunds.
We have considered all the remaining arguments that the
parties made and, to the extent not addressed, we find them to be
irrelevant, moot, or without merit. Accordingly, we sustain
respondent’s determinations for each of the years at issue
regarding the accuracy-related penalty under section 6662.
To reflect the foregoing,
Decision will be entered for
respondent.