T.C. Summary Opinion 2008-94
UNITED STATES TAX COURT
REGINALD JARRETT, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
THOMAS JARRETT AND JUDA L. JARRETT, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 4873-06S, 4874-06S. Filed July 31, 2008.
Reginald Jarrett and Thomas Jarrett, pro sese.
Jeanne Gramling, for respondent.
SWIFT, Judge: These consolidated cases were heard
pursuant to the provisions of section 7463 of the Internal
Revenue Code in effect when the petitions were filed. Pursuant
to section 7463(b), the decisions to be entered are not
reviewable by any other court, and this opinion shall not be
treated as precedent for any other case. Respondent determined
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deficiencies in and additions to petitioners’ 1999 Federal
income taxes as follows:
Addition to Tax Penalty
Petitioners Deficiency Sec. 6651(a)(1) Sec. 6662(a)
Reginald Jarrett $1,251 $62 $250
Thomas and Juda 914 -- 182
Jarrett
Unless otherwise indicated, all subsequent section
references are to the Internal Revenue Code in effect for 1999,
and all Rule references are to the Tax Court Rules of Practice
and Procedure.
In these consolidated cases the primary issue for decision
is whether petitioner Thomas Jarrett (Thomas) and petitioner
Reginald Jarrett (Reginald) underreported their respective 1999
self-employment tax liabilities.
Background
Some of the facts have been stipulated and are so found.
At the time the petitions were filed petitioners resided
in Raleigh, North Carolina.
Thomas and petitioner Juda Jarrett (Juda) were married,
and Reginald is their adult son.
Thomas
Between 1975 and early 1998 Thomas operated a tax return
preparation business as a sole proprietorship under the name of
TJ’s Enterprises.
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On March 3, 1998, a North Carolina corporation named
Trecom, Inc. (Trecom), was formed by Thomas as an
S corporation. Thomas and Reginald were each 50-percent
shareholders in Trecom.1 Thomas and Juda served as Trecom’s
officers. Nominally, Trecom was incorporated to provide a
corporate form for Thomas’s tax return preparation business.
After the incorporation of Trecom in 1998 and during 1999,
however, Thomas did not make significant changes to the
operation of his tax return preparation business. In payment
for tax return preparation services, clients continued to make
checks out to Thomas personally or to TJ’s Enterprises, not to
Trecom. Thomas treated funds received for tax return
preparation services as his own. Few, if any, of Thomas’s
clients apparently knew of Trecom’s existence.
In 1999 Thomas maintained two bank accounts–-one in his
own name and one in the name of TJ’s Enterprises. In 1999 no
bank account was maintained in the name of Trecom.
In 1999 Thomas received certain payments from individual
clients of his tax preparation business totaling approximately
$7,000.
Some of the payments Thomas received for tax return
preparation services were deposited in TJ’s Enterprises’ bank
1
The record indicates that Juda may have owned some of
the shares of stock in Trecom that we treat as owned by Thomas.
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account. Other payments were not deposited in a bank account
and were spent by Thomas for personal purposes.
It does not appear that Thomas had an employment agreement
with Trecom, that Trecom exercised direction and control over
Thomas in his execution of the tax return preparation business,
or that in 1999 Trecom paid Thomas a salary. The record does
not indicate that Trecom had any clients or business activity
whatsoever.
The evidence does not establish that Trecom performed any
tax return preparation services or any other services of any
kind for Thomas, for Reginald, or for anyone else.
Thomas prepared and timely filed with Juda a 1999 joint
Federal income tax return. Thomas attached a Schedule C,
Profit or Loss From Business, for TJ’s Enterprises reflecting
$17,444 in total gross income (which included the $7,000 Thomas
received for tax return preparation services), $16,420 in
expenses (including $7,000 in expenses Thomas allegedly paid to
Trecom for professional services allegedly rendered by Trecom
to TJ’s Enterprises), and taxable income of $1,024, on which
Thomas calculated and reported a total 1999 self-employment tax
liability of just $145.
Thomas also attached a Schedule E, Supplemental Income and
Loss, and reported as passthrough income from Trecom the $7,000
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that Thomas had reported on his Schedule C as paid to Trecom
for professional services.
Reginald
During 1999 Reginald operated a cabinet installation
business as a sole proprietorship.
Reginald was not an employee of Trecom and performed no
services for Trecom, and Trecom did not pay Reginald a salary.
Thomas timely prepared Reginald’s 1999 Federal income tax
return, and on May 12, 2000, Reginald filed his 1999 Federal
income tax return late. The attached Schedule C for Reginald’s
cabinet installation business reported $20,149 in total gross
income, $19,363 in expenses, and $786 in taxable income, on
which Reginald calculated and reported a total self-employment
tax liability of just $111. Included among the $19,363 in
claimed business expense deductions of Reginald’s cabinet
installation business was $7,200 in expenses allegedly paid by
Reginald to Trecom for professional services Trecom allegedly
provided to Reginald. Reginald also attached a Schedule E, and
reported as passthrough income from Trecom the $7,200 that
Reginald had reported on his Schedule C as paid to Trecom for
professional services.
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Trecom
Thomas also prepared and filed Trecom’s 1999 Form 1120S,
U.S. Income Tax Return for an S Corporation, on which Trecom
reported $14,200 of income (consisting solely of the above
$7,000 and $7,200 Thomas and Reginald allegedly paid to
Trecom). Attached to Trecom’s 1999 Form 1120S were two
Schedules K-1, Shareholder’s Share of Income, Credits,
Deductions, etc., reflecting the $14,200 purportedly earned by
Trecom and passed through to Thomas and to Reginald as
shareholders of Trecom ($7,000 to Thomas and $7,200 to
Reginald).
For 1999 Trecom did not file a Form 940, Employer’s Annual
Federal Unemployment (FUTA) Tax Return, or any Forms 941,
Employer’s Quarterly Federal Tax Return.
In summary, through the above Federal income tax reporting
for 1999, Thomas and Reginald claimed deductions from their
gross income ($7,000 and $7,200 respectively) that eliminated
the identical earned income amounts and then reported the same
amounts as unearned passthrough income from Trecom. Obviously,
such reporting did not affect taxable income or Thomas’s and
Reginald’s reported 1999 Federal income tax liability, but it
did convert reported earned income (on which self-employment
taxes would be due) into reported unearned income (on which no
self-employment taxes would be due).
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IRS Audits
On audit of Thomas’s return for 1999, respondent
disallowed the $7,000 in Schedule C expenses claimed for
payments allegedly made to Trecom, and respondent removed from
Thomas’s income the $7,000 Thomas reported as passthrough
income from Trecom. On the basis of respondent’s adjustments,
respondent then increased Thomas’s self-employment tax
liability from $145 to $1,134 and allowed Thomas a deduction
for one-half of the recalculated self-employment tax.
On audit of Reginald’s return for 1999, respondent allowed
$11,285 and disallowed $8,078 of the total $19,363 in expenses
Reginald claimed on his 1999 tax return. The disallowed
expenses included the entire $7,200 that Reginald claimed he
had paid to Trecom as well as $611 of car and truck expenses
and $500 of storage expenses. Respondent removed from
Reginald’s income the $7,200 that Reginald reported as
passthrough income from Trecom. Respondent then increased
Reginald’s 1999 self-employment tax liability from $111 to
$1,252, and respondent allowed Reginald a deduction for one-
half of the recalculated self-employment tax.
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Discussion
Self-Employment Tax
Under section 1401 self-employment income of individuals
is subject to self-employment tax. Self-employment income
consists of earnings derived from the self-employment of
an individual less allowable business expense deductions.
Sec. 1402(a) and (b). Income received in a trade or business
operated as a sole proprietorship generally constitutes self-
employment income and is subject to self-employment taxes.
Sec. 1.1402(c)-1, Income Tax Regs.
Income received in a trade or business conducted as an
S corporation and passed through to its shareholders, however,
generally is not considered to be self-employment income and is
not subject to self-employment taxes. Ding v. Commissioner,
T.C. Memo. 1997-435, affd. 200 F.3d 587 (9th Cir. 1999); Rev.
Rul. 59-221, 1959-1 C.B. 225.
Respondent has treated income that Thomas and Reginald
received in their respective sole proprietorships as their
individual income and imposed thereon self-employment taxes.
Respondent disallowed expense deductions for the alleged
$14,200 in payments to Trecom and disregarded the $14,200 in
reported passthrough income from Trecom.
The limited record before us establishes that in 1999
Thomas and Reginald operated their businesses as sole
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proprietors. The income in question is to be treated as earned
not by Trecom but by Thomas and Reginald individually and is
subject to self-employment taxes.
The record establishes that the alleged $14,200 in
payments on the one hand between Thomas and Reginald to Trecom
and on the other hand from Trecom to Thomas and Reginald lacked
economic substance and should be disregarded.
Transactions that lack economic substance (other than tax
benefits) are not recognized for Federal tax purposes. Nicole
Rose Corp. v. Commissioner, 117 T.C. 328, 336 (2001), affd. 52
Fed. Appx. 545 (2d Cir. 2002), published at 320 F.3d 282 (2d
Cir. 2003); Winn-Dixie Stores, Inc. v. Commissioner, 113 T.C.
254, 278 (1999), affd. 254 F.3d 1313 (11th Cir. 2001). The
Commissioner may ignore the parties’ characterization of
transactions that lack economic substance, and the Commissioner
may instead tax the transactions according to their true
nature. Rice’s Toyota World, Inc. v. Commissioner, 752 F.2d
89, 95 (4th Cir. 1985), affg. in part and revg. in part on
other grounds 81 T.C. 184 (1983).
Clearly, the alleged offsetting $14,200 in payments
between Thomas and Reginald and Trecom had no business purpose
and produced only reported self-employment tax avoidance for
Thomas and Reginald. As respondent determined, Thomas and
Reginald may not deduct the claimed $7,000 and $7,200 payments
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allegedly made to Trecom as business expenses, and the $7,000
and the $7,200 in alleged passthrough income from Trecom to
Thomas and to Reginald is not includable in petitioners’ income
as S corporation passthrough income. The $7,000 and $7,200 are
includable in Thomas’s and Reginald’s respective gross business
income and are subject to self-employment taxes.2
Reginald’s Other Expenses
With regard to deductions disallowed by the Commissioner
in a notice of deficiency, generally taxpayers bear the burden
to prove that the deductions are allowable. Rule 142(a)(1);
Turner v. Commissioner, 126 T.C. 299, 310 (2006). Petitioners
have not argued that the burden of proof has shifted to
respondent. See sec. 7491(a).
No information was provided regarding the disallowed
storage expenses. A reconstructed mileage log Thomas provided
for Reginald at trial does not support the $611 car and truck
expense deduction respondent disallowed. See secs. 162,
274(d).
2
For a case involving a fact pattern similar to that
involved herein and holding that income allegedly passed
through from an S corporation was to be treated as wage income
and subject to employment taxes, see Arnold v. Commissioner,
T.C. Memo. 2007-168. See also Spicer Accounting, Inc. v.
United States, 918 F.2d 90, 92-93 (9th Cir. 1990);
Joly v. Commissioner, T.C. Memo. 1998-361, affd. without
published opinion 211 F.3d 1269 (6th Cir. 2000).
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Petitioners have not met their burden of proof relating to
storage and car and truck expenses. We sustain respondent’s
disallowance of these items.
Section 6662(a) Penalty
Under section 6662(a) a 20-percent penalty is imposed on
the amounts of taxes shown due on Federal income tax returns
attributable to negligence or disregard of Federal income tax
rules or to substantial understatements of income taxes. Sec.
6662(a) and (b)(1) and (2).
For purposes of section 6662(a) negligence includes
failure to make a reasonable attempt to comply with the tax
laws. Sec. 6662(c); Nicole Rose Corp. v. Commissioner, supra
at 341.
Under section 6664(c)(1) a taxpayer who had reasonable
cause for and in good faith took a position that created an
underpayment may be excepted from imposition of a section
6662(a) penalty. Gee v. Commissioner, 127 T.C. 1, 5-6 (2006).
Respondent has met his burden of production under section
7491(c) relating to imposition of the section 6662(a)
penalties, and petitioners bear the burden to show why they
should be excepted from the penalties. See Higbee v.
Commissioner, 116 T.C. 438, 446-447 (2001). Petitioners have
not met their burden.
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We sustain respondent’s section 6662(a) penalties as to
petitioners.
Section 6651(a)(1) Additions to Tax
Under section 6651(a)(1) an addition to tax is imposed on
the amount of tax shown due on late-filed Federal income tax
returns in the amount of 5 percent for each month or part of a
month that the return is late with a maximum addition to tax of
25 percent of the amount of tax shown due. The addition to tax
under section 6651(a)(1) will not be imposed, however, if the
taxpayer demonstrates that the late filing was for reasonable
cause and not due to the taxpayer’s willful neglect. Sec.
6651(a)(1); McGowan v. Commissioner, T.C. Memo. 2008-125.
Reginald admits that his 1999 Federal income tax return
was filed late. Reginald does not argue that he had reasonable
cause to file his return late or that his late filing was not
due to willful neglect. Reginald only argues that because a de
minimis amount of tax was shown due on his 1999 Federal income
tax return, he should not have to pay the section 6651(a)(1)
addition to tax. There is no de minimis statutory or
regulatory exception from the imposition of the section
6651(a)(1) penalty, and Reginald is liable therefor.
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To reflect the foregoing,
Decisions will be entered
for respondent.