Swanson v. Comm'r

T.C. Memo. 2008-265

UNITED STATES TAX COURT

DAVID W. AND CONNIE L. SWANSON, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

FSH SERVICES, R. RICHARD EVANS, TRUSTEE, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 550-00, 551-00. Filed December 1, 2008.

Joe Alfred Izen, Jr., for petitioners.

Erin K. Salel and Jolene Itakura, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

COHEN, Judge: In these consolidated cases, respondent

determined the following deficiencies, additions to tax, and

penalties with respect to petitioners’ Federal income taxes:
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David W. and Connie L. Swanson (Docket No. 550-00)

Addition to Tax Penalty
Year Deficiency Sec. 6651(a)(1) Sec. 6662(a)

1993 $144,841 -- $28,968
1994 278,548 -- 55,710
1995 414,030 $41,403 82,963

FSH Services, R. Richard Evans, Trustee (Docket No. 551-00)

Addition to Tax Penalty
Year Deficiency Sec. 6651(a)(1) Sec. 6662(a)

1993 $186,002 $46,501 --
1994 311,953 77,988 --
1995 434,977 -- $86,995

Unless otherwise indicated, all section references are to the

Internal Revenue Code in effect for the years in issue, and all

Rule references are to the Tax Court Rules of Practice of

Procedure.

Respondent concedes that if FSH Services is disregarded for

Federal tax purposes, it should not be subject to deficiencies,

additions to tax, or penalties. After trial, respondent

submitted the following revised computations of the amounts at

issue, attributing the income in issue to David W. and Connie L.

Swanson (collectively, the Swansons) and taking into account

respondent’s concessions as to deductions:

Addition to Tax Penalty
Year Deficiency Sec. 6651(a)(1) Sec. 6662(a)

1993 $17,068 -- $3,413.60
1994 95,913 -- 19,182.60
1995 191,486 -0- 38,297.20
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After concessions, the issues for decision are: (1) Whether

the burden of proof has shifted to respondent under section 7491;

(2) whether FSH Services is disregarded for Federal tax purposes

and its income for the years in issue is attributed to the

Swansons; (3) whether the periods of limitations on assessment

expired before the deficiency notices were sent; (4) whether the

Swansons are liable for self-employment tax on income from FSH

Services; (5) whether the Swansons are entitled to deductions in

excess of those allowed by respondent; (6) whether the Swansons

are liable for the accuracy-related penalty under section

6662(a); and (7) whether the Swansons are liable for a penalty

under section 6673.

The terms “trust”, “trustee”, “settlor”, and other related

terms are used in this opinion for convenience and are not

intended to be conclusive as to the characterization of FSH

Services for Federal tax purposes.

FINDINGS OF FACT

Some of the facts have been stipulated, and the stipulated

facts are incorporated in our findings by this reference. The

Swansons resided in California and FSH Services had a mailing

address in California at the time their petitions were filed.

David W. Swanson (Mr. Swanson) and Connie L. Swanson (Mrs.

Swanson) are married and have five children. The Swansons are

well educated, each having a bachelor of science degree in
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mechanical engineering from California Polytechnic State

University, San Luis Obispo. From 1983 to 1991, Mr. Swanson

worked for Hewlett-Packard Co. (Hewlett-Packard), first as an

engineer and then as an engineer manager. Wanting to start his

own engineering consulting business (the business), Mr. Swanson

began investigating which form of business entity would best suit

his needs.

In the summer of 1991, Mr. Swanson met with R. Richard Evans

(Evans) to discuss the possibility of running the Swansons’

forthcoming business through an “unincorporated organization in

trust form”. The Swansons decided to establish their business in

this trust form, and on August 8, 1991, Cache Properties

Unlimited (Cache), as named settlor, created FSH Services for

this purpose.

One hundred shares called “capital units” represented the

beneficial interest in FSH Services and were memorialized on a

document called the trust certificate. In exchange for all 100

capital units, Cache purportedly transferred a corpus to the

board of trustees, which at that time consisted only of Marcia

Doerr (Doerr). According to the trust instrument, referred to as

the Declaration of Trust and Indenture (indenture), FSH Service’s

corpus consisted of:
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Personal Property

Received $100
Received $200
Paid Out $200

The record is not clear as to many details of the

transaction, including who received the $200 “paid out”. It

appears that Cache contributed the $100 “received”, and Doerr

transferred all 100 capital units to Cache at this time. The

Swansons contributed the $200 “received”, also in exchange for

the 100 capital units, even though the trust certificate

designated all 100 capital units to Cache. No other money or

property was put into the trust at its creation.

Shortly thereafter, the Swansons further funded the trust

with approximately $3,400 to “get it going”. On October 9, 1991,

Doerr transferred 97 capital units to the Swansons and 3 capital

units to three of the Swansons’ children from the 100 capital

units held by Cache. There is no record that Cache received

remuneration for transferring its capital units.

Also on October 9, 1991, Doerr appointed the officers of FSH

Services, as follows: Mr. Swanson, general manager; Mrs.

Swanson, treasurer; Vernon Tritchka (Tritchka), assistant manager

and secretary; and Gary McLeod (McLeod), protector. The

indenture provided that no officer could be removed “without

thirty days written notice given prior to such removal”. The

indenture also provided that McLeod, as protector, is the
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“internal guardian of the fiduciary obligation of the Trustees

toward the Capital Unit Holder(s)” and that he has the power to

access all the records of the trust.

At the same time, Doerr appointed Evans cotrustee of FSH

Services, and he served in that capacity for the years in issue.

While still serving as treasurer, Mrs. Swanson replaced Tritchka

as assistant manager on September 30, 1992. On February 20,

1994, Evans replaced Doerr as executive trustee, and he appointed

Susan O’Brien (O’Brien) cotrustee. With respect to appointment

of trustees, the indenture provided the following:

Should there remain no Board to appoint a
Successor Trustee, the Protector shall appoint one
Trustee, or else the Capital Unit Holders may apply to
a court of competent jurisdiction to appoint one
Trustee; who shall then have power to appoint other
Trustees.

The indenture and additional trust provisions contained

within the minutes granted all the officers and trustees

authority to manage operations of the trust and have signature

authority of its bank accounts. The indenture also provided that

full health coverage and educational expenses of the officers and

certificate holders could be paid for by the trust.

The business initially operated out of a converted bedroom

at the Swansons’ residence. In 1993, the Swansons built a

freestanding workshop on their property that FSH Services used

for the business and Mr. Swanson used for his own commercial

enterprise. FSH Services paid rent for its use of the residence
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and workshop and also paid one-quarter of the Swansons’ utility

bills.

FSH Services treated the Swansons as independent contractors

and not as its employees. Personal expenses of the Swansons were

nonetheless paid by FHS Services, including family meals, medical

and dental expenses, braces for at least one child’s teeth, and

their children’s school tuition. These personal expenses were

claimed as deductible expenses of FSH Services.

Mrs. Swanson did the bookkeeping and kept the records for

FSH Services. For the years in issue FSH Services had six bank

accounts, including an “income” account and an “operations”

account, and all the accounts used the Swansons’ home address as

their mailing address. Mrs. Swanson earned $100 a year in her

capacity as bookkeeper, treasurer, and assistant manager of FSH

Services.

Mr. Swanson quit his job with Hewlett-Packard in early 1992

to concentrate on the business full time. As the general manager

of FSH Services, Mr. Swanson found customers, made proposals, and

reviewed contracts. He also found and hired other engineers for

FSH Services, whom he managed and assigned work. On many

contracts he worked as an engineer as well. Mr. Swanson’s

reputation as an engineer/manager and his expertise, contacts,

and goodwill attracted the clients of FSH Services. For the

years in issue, Mr. Swanson secured contracts with large
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companies such as Hewlett-Packard, Gradco USA, Inc., and Proxima

Corp. Mr. Swanson earned $500 a year in his capacity as general

manager of FSH Services.

During the years in issue, Mr. Swanson also worked outside

of FSH Services in his personal engineering business. Mr.

Swanson decided which engineering jobs he worked through FSH

Services and which jobs he personally performed. In the same

workshop shared by FSH Services, Mr. Swanson invented products

that he patented to himself. He received substantial licensing

fees through his patents during this time.

After the business was up and running, Evans purportedly

introduced Mr. Swanson to an Englishman named Bernard Putz

(Putz). Putz claimed to represent an offshore trust in Gibraltar

called the Loire Trust; he allegedly offered to capitalize FSH

Services up to $200,000 if the Swansons would transfer their

capital units to the Loire Trust. On November 16, 1992, the

Swansons transferred one of their capital units to another of

their children (for a total of 4 capital units in their

children’s names) and their remaining 96 units to the Loire Trust

in exchange for an oral promise from Putz of a loan. The loan

never occurred, and the Swansons never attempted to get their 96

units back from Putz or the Loire Trust.

The O’Brien Group, a tax services business owned and

operated by O’Brien, prepared FSH Services’ tax returns for the
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years in issue. FSH Services was listed as a simple trust on its

Forms 1041, U.S. Income Tax Return for Estates and Trusts, for

1992, 1993, and 1995, and the “Type of entity” box was left

unchecked for 1994. As of June 1997, Internal Revenue Service

(IRS) records did not show these tax returns as having been filed

by FSH Services.

Schedules K-1, Beneficiary’s Share of Income, Deductions,

Credits, etc., attached to the tax returns showed FSH Services as

having made beneficiary income distributions to the Loire Trust

as follows: $51,789 in 1993; $225,813 in 1994; and $369,221 in

1995. However, there is no record that FSH Services ever made

any distributions to the Loire Trust. FSH Services reported no

other beneficial distributions, and the Swansons waived their

children’s rights to trust income for the years in issue.

On their Forms 1040, U.S. Individual Income Tax Return, the

Swansons reported the following:

Year Gross Income Taxable Income Total Tax

1993 $87,471 $59,330 $20,917
1994 86,393 57,014 20,666
1995 94,258 61,364 21,178

The Swansons wrote the phrase “coactus feici” (sic) in the jurat

box of their tax returns for the years in issue. The O’Brien

Group prepared the Swansons’ 1995 tax return.

The IRS audited petitioners’ returns for the years in issue.

The IRS recomputed FSH Services’ gross receipts using a bank
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deposit analysis. The IRS determined that FSH Services’ net

taxable deposits were $415,365.83 for 1993, $726,956.22 for 1994,

and $983,721.96 for 1995. After concessions, these amounts were

reduced to $53,359.44, $256,049.54, and $481,466.84 for 1993,

1994, and 1995, respectively. For reasons set forth below, and

in relation to petitioners’ statute of limitations argument,

these reduced amounts represent amounts properly includable on

but omitted from the Swansons’ returns.

Revenue Agent Higgins (Higgins) conducted audit interviews

with Mr. Swanson and his agent, O’Brien. When asked questions

regarding FSH Services, Mr. Swanson refused to explain the

Swansons’ close connections with the trust other than his

position as general manager. In a followup interview, Mr.

Swanson and O’Brien refused to talk with Higgins and demanded

that he be replaced on the grounds that Mr. Swanson had filed a

lawsuit against him. Revenue Agent Lee (Lee) replaced Higgins

and conducted a third interview. Mr. Swanson and O’Brien refused

to answer many of Lee’s questions, and they made insulting

comments to and about Lee.

Higgins also conducted an interview with Evans (accompanied

by O’Brien as his agent) regarding FSH Services. Evans refused

to answer many questions at the interview, asserting his Fifth

Amendment right against self-incrimination.
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The IRS sent a notice of deficiency to the Swansons on

October 12, 1999. Deficiencies were determined for the years in

issue on conclusions that: 1) The Swansons improperly assigned

their income to FSH Services; or, alternatively, 2) FSH Services

is a sham trust with no economic substance and is disregarded for

Federal tax purposes; or, alternatively, 3) FSH Services is

determined to be a grantor trust under sections 671-677, and its

income is taxable to the Swansons. The adjustments reflected in

the notice included unreported gross receipts derived from the

bank deposit analyses and disallowance of itemized deductions.

By a separate notice of deficiency sent to FSH Services, the

IRS determined deficiencies for the years in issue primarily

because of unreported gross receipts. Other adjustments for 1995

included modifications to expenses claimed on Schedule C, Profit

or Loss From Business, and disallowance of the income

distribution deduction.

After the years in issue, the Swansons discovered checks

disappearing and unexplained amounts being withdrawn from the FSH

Services’ bank accounts. Evans refused to respond to questions

regarding these matters. Mr. Swanson brought a copy machine to

Evans’s home and copied the FSH Services records that were stored

there. Upon investigation, the Swansons found that Evans had

written several checks that were unaccounted for in the

bookkeeping. The Swansons objected to Evans’s behavior and,
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along with O’Brien, requested that Evans resign as trustee.

Because Evans did not agree to resign, they demanded that he

surrender FSH Services’ checkbooks, which he did. The Swansons

later transferred the business out of FSH Services and into a new

entity, Maxim Automation Products, L.L.C. (Maxim), which acquired

all subsequent contracts. FSH Services provided capital for the

new venture and became a partner in Maxim.

On October 5, 2006, the U.S. District Court for the Southern

District of California found O’Brien guilty of 1 count of

conspiracy to defraud the United States, 6 counts of tax evasion,

6 counts of tax evasion--aiding and abetting, and 28 counts of

aiding and assisting the filing of false income tax returns. The

court sentenced her to over 10 years in prison.

On October 6, 2006, the District Court found Evans guilty of

1 count of conspiracy to defraud the United States, 6 counts of

tax evasion--aiding and abetting, and 12 counts of aiding and

assisting the filing of false income tax returns. The court

sentenced him to over 6 years in prison. Joe Alfred Izen, Jr.

(Izen), petitioners’ counsel in these cases, represented Evans in

his trial. Petitioners were aware of and consented to Izen’s

representation of Evans in spite of potential conflicts of

interest between petitioners and Evans.
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Because of these criminal convictions, Evans and O’Brien no

longer served as trustees. The Swansons chose a friend, Mark

Corcoran (Corcoran), as the new trustee of FSH Services.

OPINION

Petitioners argue that FSH Services is a valid entity

independent of the Swansons and that all transactions involving

FSH Services should be respected for Federal tax purposes.

Respondent argues that the Swansons should be taxed on income of

FSH Services and adduces three alternative theories as to why:

1) FSH Services is a sham trust that has no economic substance;

2) the assignment of income doctrine applies; or 3) the grantor

trust provisions apply. We agree with respondent on the first

theory.

Burden of Proof

Petitioners bear the burden of proof in these cases, and it

has not shifted under section 7491(a). See Rule 142(a); Welch v.

Helvering, 290 U.S. 111, 115 (1933). Petitioners did not

cooperate during IRS examinations but obstructed them by refusing

to produce certain documents or to answer questions. See sec.

7491(a)(2)(B). Petitioners were confrontational and insulting to

the revenue agents.

Moreover, even though their testimony and exhibits are

voluminous, petitioners did not present credible evidence that

FSH Services had economic substance. See sec. 7491(a)(1). The
 - 14 -

evidence that they did produce was undermined by their

implausible claims. Their testimony about events and their

explanations of improper deductions were not credible. (For

example, Mrs. Swanson, during her testimony, attempted to justify

the FSH Services deduction of the costs of family meals and a

trip by petitioners to Hawaii as “management expenses”.) We are

not required to accept testimony that is improbable or vague.

See Geiger v. Commissioner, 440 F.2d 688, 689-690 (9th Cir.

1971), affg. T.C. Memo. 1969-159; Sanderlin v. Commissioner, T.C.

Memo. 2008-209.

The Swansons’ testimony was improbable. They claim that the

trust they established, with the effect of their reporting

minimal tax liability on substantial profits of the business, was

not tax motivated. Petitioners contend that they created their

business within the trust for “asset protection” purposes. Yet

the Swansons, according to their testimony, inexplicably gave

away their 96 capital units of FSH Services for nothing more than

a stranger’s promise of a loan. Petitioners present no evidence

of this transaction or of the unknown, off-shore Loire Trust. It

is not plausible or credible that the Swansons, gravely concerned

about protecting assets, would have given away their legal and

beneficial interests in the business that was their livelihood.

The Swansons closely interacted with Evans and O’Brien but

deny that they ever discussed tax avoidance. Evans, however, has
 - 15 -

long been involved with the abusive trusts, and both he and

O’Brien promoted tax evasion schemes to their clients. See

Buckmaster v. Commissioner, T.C. Memo. 1997-236; see also United

States v. Evans, No. 03CR1110-L (S.D. Cal. Oct. 6, 2006) (finding

Evans guilty of tax evasion aiding and abetting, among other

crimes); United States v. O’Brien, No. 03CR1110-L (S.D. Cal. Oct.

5, 2006) (finding O’Brien guilty of tax evasion aiding and

abetting, among other crimes), affd. sub nom. United States v.

Cook, 261 Fed. Appx. 52 (9th Cir. 2007). We do not believe that

Evans did not promote tax avoidance as a primary objective when

proposing his trust schemes to the Swansons.

The Swansons also directly demonstrated tax-protester

actions, including writing “coactus feici” in the jurat boxes of

their tax returns for the years in issue. Mrs. Swanson

understood that coactus feci meant “something like [signing the

return] but under protest, or not protest but reserving my rights

kind of thing”. Mr. Swanson’s hostile actions against the

examining agents were consistent with protester attitudes. Their

associates playing roles in these cases maintained similar

positions in other cases. See Corcoran v. Commissioner, T.C.

Memo. 2002-18 (Corcoran, a trained accountant, brought standard

tax-protester arguments before the Court, which imposed a section

6673(a) penalty for his insistence in pursuing frivolous

contentions), affd. 54 Fed. Appx. 254 (9th Cir. 2002); Caralan
 - 16 -

Trust v. Commissioner, T.C. Memo. 2001-241 (Doerr was the trustee

of trusts used by taxpayers to avoid tax and shift income and, as

a result, the Court determined a penalty of $12,500 was warranted

for frivolous claims and positions). Given their antitax

position, implausible claims, and dearth of credible evidence, we

do not accept petitioners’ assertion that they established the

trust for nontax business reasons. They have not satisfied the

prerequisite to shifting the burden of proof under section

7491(a)(2).

Disregard of FSH Services

Tax motivation alone is not a ground to disregard FSH

Services for Federal tax purposes. A taxpayer has the right to

elect a business form to minimize or altogether avoid the

incidence of taxation by any means that the law permits. See

Gregory v. Helvering, 293 U.S. 465, 469 (1935). This right,

however, does not grant the taxpayer leeway to structure a paper

entity to avoid tax when that entity is without economic

substance. Zmuda v. Commissioner, 79 T.C. 714, 719 (1982), affd.

731 F.2d 1417 (9th Cir. 1984). Nor is the Government required to

simply accept a taxpayer’s election of business form where that

form is a sham. Higgins v. Smith, 308 U.S. 473, 477 (1940).

Instead, the Government should disregard the sham, as any other

result would allow the schemes of the taxpayer to supersede the

law. Id.
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Application of these principles requires us to look beneath

the surface of a purported trust and examine its economic

reality. See Profl. Servs. v. Commissioner, 79 T.C. 888, 924

(1982). If a trust has no economic substance apart from tax

considerations, the trust is not recognized for Federal tax

purposes. Markosian v. Commissioner, 73 T.C. 1235, 1244-1245

(1980). We consider the following factors to determine whether

FSH Services lacks economic substance: (1) Whether the Swansons’

relationship as settlors to the property differed materially

before and after the trust’s creation; (2) whether the trust had

trustees who could act independently of the Swansons; (3) whether

any economic interest passed to other trust beneficiaries; and

(4) whether the Swansons respected the restrictions placed on the

operation of FSH Services as set forth by the indenture or the

law of trusts. Id. at 1243-1244; accord Sparkman v.

Commissioner, 509 F.3d 1149, 1155 (9th Cir. 2007), affg. T.C.

Memo. 2005-136.

With respect to the first factor, we look beyond the named

settlor to the economic reality of the purported trust in order

to determine the true settlor. See Zmuda v. Commissioner, supra

at 720. Cache, the named settlor, appeared out of nowhere and

transferred $100 to create FSH Services. Once it had served this

purpose, Cache conveniently disappeared from the record. This

exact scenario occurred in another case involving Evans where we
 - 18 -

determined Cache to be a “straw man”. Buckmaster v.

Commissioner, supra. Here, too, Cache was a nominal settlor.

Petitioners contend that the Swansons never transferred any

property to FSH Services and therefore cannot be its settlors.

The economic reality of the creation of FSH Services, however, is

that only the Swansons funded the trust in any meaningful way,

first with an initial $200, then more funds amounting to $3,400.

These amounts, along with the use of the Swansons’ residence, are

the only physical assets that started FSH Services and the

business within. Petitioners state that FSH Services “started

with nothing”, but they ignore these assets with which the

Swansons initially funded FSH Services.

Petitioners also disregard the intangible assets that the

Swansons supplied to FSH Services. The trust had no potential

value without the services of the Swansons, especially Mr.

Swanson’s skills and resources. The combination of $3,600 in

capital and the Swansons’ talents was the principal asset and

income producer for FSH Services. As the only persons to put

anything of value into the trust, the Swansons are the true

settlors of FSH Services.

We now look to whether the Swansons’ relationship to trust

property differed materially before and after creation of FSH

Services. Petitioners argue that the business was formed within,

and not transferred to, the trust. Thus, they claim, the
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Swansons could not have had a relationship with the business

before the trust because the business did not exist at that

point. The business of FSH Services, however, was nothing more

than Mr. Swanson’s array of income-producing skills. These

service skills cannot be transferred solely to the trust, and

they remain as inherent to Mr. Swanson after the creation of the

trust as they were before. Moreover, the Swansons’ access to

their residence, their tools, and their initial funds did not

materially change because of the trust. The line between trust

property and personal property was often blurred as the Swansons

used trust funds to pay for clearly personal expenses of

themselves and their children. The Swansons’ relationship to the

property did not differ in any material aspect before and after

the creation of the trust.

The second factor is whether FSH Services had trustees who

could act independently of the Swansons. This factor would

include the power to prevent the Swansons from acting against the

interests of the beneficiaries. See Markosian v. Commissioner,

supra at 1244. The failure of a trustee to have any meaningful

role in the operation of the trust has been repeatedly cited by

this Court as evidence that the entity lacks economic substance.

See Zmuda v. Commissioner, supra at 720-721; Para Techs. Trust v.

Commissioner, T.C. Memo. 1994-366, affd. without published

opinion sub nom. Anderson v. Commissioner, 106 F.3d 406 (9th Cir.
 - 20 -

1997). Petitioners interpret this factor as satisfied because

the trustees, especially Evans, were actively involved in the

business. Petitioners argue that Evans signed multiple business

letters and minutes of FSH Services. The name on the documents,

however, is not persuasive evidence of Evans’s independent

control.

Evans paid what he was told by the Swansons to pay and

signed what he was told to sign. Mr. Swanson, not Evans, decided

what contracts would be accepted and which ones he would perform

as an individual and which would be attributed to FSH Services.

When the Swansons disagreed with Evans’s use of an FSH Services

bank account, apparently to his own benefit and not that of the

trust, they forced Evans to surrender the trust’s checkbook. The

Swansons transferred the main asset of FSH Services, the

business, to Maxim along with all new engineering contracts and

the accompanying income. No trustee had the power to prevent

this from happening, and FSH Services funded the Swansons’ new

business. The Swansons could not be removed from their positions

as management officers without prior notice, while the trustees

were not entitled to such notice. The evidence establishes that

the Swansons held perpetual control of FSH Services and that FSH

Services lacked independent trustees. See United States v.

Scott, 37 F.3d 1564, 1571 (10th Cir. 1994).
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As to the third factor, petitioners failed to prove that an

economic interest ever passed to any beneficiary of FSH Services.

For the years in issue, the purported beneficiaries were the

Loire Trust (96 units) and the Swanson children (4 units). FSH

Services, as a simple trust, was required to distribute all of

its current income for the taxable year to the beneficiaries.

See sec. 1.651(a)-1, Income Tax Regs. FSH Services’ Forms 1041

and Schedules K for the years in issue reflect substantial income

distributions to the Loire Trust. However, none of these

distributions can be substantiated from the evidence. To the

contrary, the income of FSH Services remained under the control

of petitioners. There is no persuasive corroboration that the

Loire Trust exists as an entity.

With respect to the children, the Swansons provided letters

to Evans that waived their children’s beneficial distributions

for the years in issue. While the children did receive benefits

paid from the trust such as school tuition, medical insurance,

braces, and other personal expenses, they did not receive them in

their capacity as beneficiaries of FSH Services. The payments

for the benefit of the children were disguised as deductible

expenses of the trust. Mrs. Swanson admitted during her

testimony that FSH Services paid and deducted as expenses tuition

for the children and all medical costs for the family.
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Moreover, the trust certificate shows that Cache was

initially assigned the 100 capital units of FSH Services. Two

months later, Cache transferred its 100 units to the Swansons and

their children. The Swansons transferred their units a little

over a year later to the Loire Trust. These transfers took place

with no evidence that the previous “beneficiaries” ever received

any consideration for their capital units. This paper shuffling

further shows the lack of economic reality of these arrangements.

See Sparkman v. Commissioner, T.C. Memo. 2005-136. We conclude

that no economic interest passed to any of the alleged

beneficiaries of FSH Services.

In considering the fourth factor, we look to whether the

Swansons were bound by any restrictions imposed by the indenture

of FSH Services or the law of trusts. The record shows that the

Swansons disregarded the purported separateness of the trust.

Several properties were used interchangeably between the Swansons

and the trust including the Swansons’ residence, the workshop,

and tools. The Swansons had and used access to trust bank

accounts and used trust income to pay their personal expenses.

The trust indenture states that a successor trustee can be

appointed by another trustee, the protector, or a court through

the request of the capital unit holders. The Swansons, who held

none of those titles, disregarded the indenture and chose their

friend Corcoran as successor trustee.
 - 23 -

The Swansons allegedly pursued Evans over missing funds of

FSH Services, supposedly on behalf of their children’s 4-capital-

unit interest and through a self-proclaimed fiduciary duty. The

indenture grants the “protector” McLeod the fiduciary

responsibility to proceed against the trustees on behalf of the

beneficiaries. It also grants the protector the right to access

trust records. Again, the Swansons ignored the trust instrument

and acted as the owners of trust assets. The Swansons’ actions

were inconsistent with the restrictions set forth in the

indenture or the laws of trust.

The four factors for testing the economic reality of FSH

Services weigh heavily against petitioners. In accordance with

Markosian v. Commissioner, 73 T.C. 1235 (1980), we conclude that

FSH Services is a sham trust lacking economic substance for

Federal tax purposes. Having found the trust structure of FSH

Services to be a sham, we hold that the income in issue is

taxable wholly to the Swansons. Because we reach this holding

under a sham trust theory, we need not consider respondent’s

alternative arguments applying grantor trust provisions or the

assignment of income doctrine.

Petitioners alternatively argue that if FSH Services is not

recognized for Federal tax purposes, then Evans should be liable

for the amounts at issue under a theory of attribution of income.
 - 24 -

Petitioners contend that Evans, and not the Swansons, received,

maintained, and enjoyed the income in issue.

A well-established principle of tax law is that income is

taxed to the person who earns it. Lucas v. Earl, 281 U.S. 111,

114-115 (1930). This taxing of income cannot “be escaped by

anticipatory arrangements and contracts however skil[l]fully

devised to prevent the salary when paid from vesting even for a

second in the man who earned it.” Id. at 115. The determination

of the proper taxpayer depends upon which person or entity in

fact controls the earning of the income rather than who

ultimately receives the income. See Vnuk v. Commissioner, 621

F.2d 1318, 1320 (8th Cir. 1980), affg. T.C. Memo. 1979-164.

The Swansons used their expertise, labor, goodwill, and

money to start up and maintain the business that earned income

through FSH Services for the years in issue. Mr. Swanson made

all the business decisions free from demands or direction by

anyone else. He decided who FSH Services would work with, how

many jobs to take, how much to charge, and even which jobs would

be done through the auspices of FSH Services and which jobs he

would take on personally. He sought customers, hired and managed

contractors, made proposals, and reviewed contracts. The

Swansons controlled who received the money earned by their

services, be it FSH Services, Maxim, or the Swansons themselves

through Mr. Swanson’s own work.
 - 25 -

That the Swansons placed Evans in a figurehead position with

signature authority over their accounts does not alter their

control over the earnings of the income in issue anymore than

does their giving away all their beneficial interests to the

Loire Trust. That Evans, well after the years in issue, may have

diverted funds does not alter the Swansons’ control over the

earnings of that income during the years in issue. The Swansons

ultimately directed when, where, and with whom their earnings

would be placed. Consequently, the Swansons, and not Evans, are

liable for the amounts at issue as the income they earned through

their services can be attributed only to them.

Period of Limitations

Without ever having pleaded the issue, petitioners, almost

as an afterthought in their briefs, argue that the deficiencies

are barred by the 3-year statute of limitations under section

6501. We need not consider an issue not properly raised. See

Rule 39; Mecom v. Commissioner, 101 T.C. 374, 382 (1993), affd.

without published opinion 40 F.3d 385 (5th Cir. 1994). The

answer here, however, is clear: section 6501(e)(1)(A) provides

that tax may be assessed within 6 years after a return is filed

where, as here, a taxpayer omits from gross income “an amount

properly includible therein which is in excess of 25 percent of

the amount of gross income stated in the return”. Because the
 - 26 -

Swansons omitted income in the amounts set forth in our findings,

section 6501(e) applies.

Self-Employment Tax

Petitioners contend that the Swansons are not liable for

self-employment taxes solely because the income in issue is not

attributable to them. Because we hold that the Swansons earned

the income, they are liable for the self-employment tax imposed

by section 1401 and entitled to the related deduction under

section 164(f).

Deductions

Petitioners argue that the Swansons are entitled to Schedule

C deductions in excess of those allowed by respondent for the

years in issue. Taxpayers bear the burden of proving that they

are entitled to any deductions claimed. New Colonial Ice Co. v.

Helvering, 292 U.S. 435 (1934); Rockwell v. Commissioner, 512

F.2d 882, 886 (9th Cir. 1975), affg. T.C. Memo. 1972-133.

Taxpayers are required to maintain records that are sufficient to

enable the IRS to determine their correct tax liability. See

sec. 6001; sec. 1.6001-1(a), Income Tax Regs. Taxpayers must

substantiate both the amount and the purpose of the claimed

deductions. Higbee v. Commissioner, 116 T.C. 438, 440 (2001).

Taxpayers must also show that the IRS’s determinations as to

deductions are in error. Rule 142(a); Welch v. Helvering, 290

U.S. at 115.
 - 27 -

In their reply brief, petitioners specify items and amounts

that they still claim are deductible. Petitioners, however, do

not cite evidence that substantiates these deductions or shows

any error in the IRS’s determinations. For example, petitioners

claim $2,773 should be allowed as a deduction for “FSH Services

Continuing Education” in 1994. The first $2,320 of this

“business expense” was for “Beneficiary Education”, which

apparently was the tuition payments for the private education of

the Swansons’ children. The remaining $453 was for “Officer

Education”, which apparently was a subscription to an undisclosed

newsletter and law books. No effort is made to explain how this

tuition reimbursement, an untitled newsletter, and tersely

described “law books” relate to the ordinary and necessary

expenses of the Swansons’ business. See sec. 162(a). Moreover,

the documents petitioners submitted, i.e., self-generated or

generic receipts, scrawled notes, and a copy of the front of one

check, are unreliable.

The record establishes only that petitioners are trying to

claim personal expenses as business deductions. See sec. 262(a).

It does not support any allowances not already conceded by

respondent.

Accuracy-Related Penalties

Respondent determined that the Swansons are liable for

section 6662(a) accuracy-related penalties for all years in
 - 28 -

issue. Section 6662(a) imposes a 20-percent accuracy-related

penalty on the portion of an underpayment of tax attributable to

any one of various factors, including any substantial

understatement of income tax. See sec. 6662(b)(2). A

substantial understatement exists if the amount of the

understatement exceeds the greater of 10 percent of the tax

required to be shown on the return or $5,000. Sec.

6662(d)(1)(A).

Under section 7491(c), the Commissioner bears the burden of

production with regard to penalties and must come forward with

sufficient evidence indicating that it is appropriate to impose

penalties. Higbee v. Commissioner, supra at 446. However, once

the Commissioner has met the burden of production, the burden of

proof remains with the taxpayer, including the burden of proving

that the penalties are inappropriate because of reasonable cause

or substantial authority. Id. at 446-447. Respondent’s burden

of production is met by proof that the Swansons substantially

understated their income tax because they failed to properly

report the income they earned.

Section 6662(a) penalties are inapplicable to the extent the

taxpayers had reasonable cause and acted in good faith. Sec.

6664(c)(1). Petitioners argue that they are not liable for this

penalty because they did not understate their Federal income tax.

This is so, petitioners contend, because FSH Services was a
 - 29 -

taxable entity separate from them and not a sham. We have,

however, already held that FSH Services was a sham. Given the

evidence presented, we conclude that petitioners neither had

reasonable cause for their underpayments nor acted in good faith.

We sustain respondent’s determination on this issue.

Section 6673

Section 6673(a)(1) prescribes a penalty not in excess of

$25,000 when a taxpayer: (1) Institutes or maintains a

proceeding primarily for delay, (2) pursues a position in this

Court that is frivolous or groundless, or (3) unreasonably fails

to pursue available administrative remedies. Petitioners contend

that they brought these cases in good faith and were able

drastically to reduce the determined deficiencies.

The Swansons’ tax liabilities are reduced from the amounts

determined in the notices of deficiency, but this aspect alone

does not avoid a section 6673 penalty. The reduction was not

based on any evidence produced or arguments made by petitioners,

and respondent’s concessions would have probably occurred during

the administrative process if petitioners had cooperated rather

than obstructed the examination. See sec. 6673(a)(1)(C); Suri v.

Commissioner, T.C. Memo. 2004-71, affd. 96 AFTR 2d 2005-6526 (2d

Cir. 2005); Caralan Trust v. Commissioner, T.C. Memo. 2001-241;

Griest v. Commissioner, T.C. Memo. 1995-165; see also Ruocco v.

Commissioner, T.C. Memo. 2002-91, affd. 346 F.3d 223 (1st Cir.
 - 30 -

2003). The arguments petitioners assert regarding the economic

reality of their trust have been universally rejected by this and

other courts. See MatrixInfoSys Trust v. Commissioner, T.C.

Memo. 2001-133, affd. sub nom. Hromiko v. Commissioner, 56 Fed.

Appx. 359 (9th Cir. 2003).

Petitioners claim that the Court at the conclusion of the

trial recognized the uniqueness of their trust, but the Court’s

statement was that no such trust ever succeeded in avoiding tax

on earnings of a business and allowing individuals to deduct

obviously personal expenses. Petitioners were warned that their

arguments lacked merit and had been the basis for sanctions in

prior cases. E.g., Sandvall v. Commissioner, T.C. Memo. 1989-

189, affd. 898 F.2d 455 (5th Cir. 1990). Petitioners continued

to press forward with these cases. They created a voluminous

paper record, but it lacked substance and defied reality. Their

claims were implausible and groundless, and their cases are not

distinguishable from scores of others. Penalties had previously

been imposed on their chosen associates and others in similar

circumstances. See Johnson v. Commissioner, 289 F.3d 452, 456-

457 (7th Cir. 2002), affg. 116 T.C. 111 (2001); Corcoran v.

Commissioner, T.C. Memo. 2002-18; Caralan Trust v. Commissioner,

supra. On the record in these cases, a penalty of $12,500 is

appropriately imposed on the Swansons.
 - 31 -

We have considered the other arguments of the parties, and

they either are without merit or need not be addressed in view of

our resolution of the issues.

To reflect the foregoing,

Decision will be entered

under Rule 155 in docket No.

550-00, and an appropriate order

will be issued in docket No.

551-00.