T.C. Memo. 2008-275
UNITED STATES TAX COURT
ALFRED J. OLSEN AND SUSAN K. SMITH, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 15665-06, 8038-07. Filed December 10, 2008.
Brad S. Ostroff and Martha Combellick Patrick, for
petitioners.
Anne W. Durning, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
KROUPA, Judge: Respondent determined a $19,168 deficiency
for 1999 and a $17,573 deficiency for 2000 in petitioners’
Federal income tax. The sole issue for decision is whether
2
petitioners are liable for self-employment tax under section
1402.1 We hold that they are liable.
FINDINGS OF FACT
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 Alfred J. Olsen
(petitioner husband) and Susan K. Smith (petitioner wife) are
both tax and estate planning attorneys. Petitioners have been
married since 1979 and have no children. They filed joint
Federal income tax returns for 1999 and 2000 (the years at
issue). Petitioners reside in Arizona.
Structure of Petitioners’ Business
Petitioners claim to be employees of Olsen-Smith, Ltd.
(Olsen-Smith), an Arizona general partnership, the partners of
which are three pass-through entities known as professional
limited liability companies (PLCs). Olsen-Smith was a
professional corporation until 1987 when it became a general
partnership. The three professional corporations were replaced
by the PLCs in 1992 for various reasons including tax
considerations. Olsen-Smith’s three equal direct partners during
the years at issue were Smith/Olsen PLC (Smith/Olsen), Smith &
Associates, PLC (Smith & Associates), and Rossie & Associates,
1
All section references are to the Internal Revenue Code for
the years at issue, and all Rule references are to the Tax Court
Rules of Practice and Procedure, unless otherwise indicated.
3
PLC (Rossie/Associates). Petitioners adopted this structure at
some point during the mid-1990s.
Smith/Olsen was an Arizona PLC that was managed by
petitioner husband and whose members were an irrevocable complex
trust named The 1992 WHO2 Trust (1-percent owner) and an
irrevocable grantor trust named The SKO-96 Trust (99-percent
owner). Petitioners treated petitioner husband as the grantor of
all property in The SKO-96 Trust for Federal income tax purposes
and listed him as the grantor on the Forms 1041, U.S. Income Tax
Return for Estates and Trusts for 1999 and 2000.3 Petitioner
husband is the beneficiary of both trusts, and petitioner wife is
the trustee for both trusts.
Smith & Associates was an Arizona PLC that was managed by
petitioner wife and whose members were an irrevocable complex
trust named The 1992 WLK Trust (1-percent owner) and an
irrevocable grantor trust named The MBK-96 Trust (99-percent
owner). Petitioners treated petitioner wife as the grantor of
all property in The MBK-96 Trust for Federal income tax purposes
and listed him as the grantor on the Forms 1041 for 1999 and
2
The trusts are named for the initials of various family
members.
3
Similarly, the Court found Alfred J. Olsen the grantor of
The SKO-96 Trust in Olsen-Smith, Ltd. v. Commissioner, T.C. Memo.
2005-174.
4
2000.4 Petitioner wife is the beneficiary of both trusts, and
petitioner husband is the trustee of both trusts.5
Petitioners designed The MBK-96 Trust and The SKO-96 Trust
to be “Megatrusts,” a trademark held by petitioners and others.
A megatrust is designed to benefit the beneficiaries while
attempting to minimize trust property claims, reduce or eliminate
all wealth transfer taxes, and help the beneficiaries reduce or
eliminate their own income tax and wealth transfer taxes.
Petitioners’ Income
Petitioners and James J. Rossie, Jr. (Mr. Rossie) worked for
and received salaries and fringe benefit compensation from Olsen-
Smith during the years at issue. Mr. Rossie was in charge of
personnel, including hiring and firing. Petitioner husband was
responsible for financials, and petitioner wife oversaw document
management. Mr. Rossie and petitioner wife earned salaries of
$36,000 a year and petitioner husband earned a salary of $12,000
a year during the years at issue.
Olsen-Smith had approximately 15 other employees, including
several legal assistants, but petitioners and Mr. Rossie were the
4
Similarly, the Court found Susan K. Smith the grantor of
The MBK-96 Trust in Olsen-Smith, Ltd. v. Commissioner, supra.
5
The other one-third interest in Olsen-Smith was held by
Rossie/Associates, an Arizona PLC with a single member, a grantor
trust named JJR-97 Trust, whose beneficiary was James J. Rossie,
Jr. (Mr. Rossie). Mr. Rossie practiced law with petitioners and
conceded that his third of partnership income is taxable to him
as earnings from self-employment.
5
only lawyers at the firm. The legal assistants earned, on
average, more than $35,000 a year, substantially more than
petitioner husband.
Olsen-Smith’s Business Practices
Olsen-Smith generally contracted with clients and provided
legal services pursuant to engagement letters executed between
the clients and Olsen-Smith. Clients generally paid Olsen-Smith
for the services rendered by the firm but occasionally made
checks payable to the individual lawyers.
Olsen-Smith did not have written employment contracts with
any employees including petitioners. The PLCs practiced law
through their ownership of Olsen-Smith but had no clients or
employees of their own.
Distribution of Income and Payment of Tax
Olsen-Smith reported net income of $627,7366 in 1999 and
$437,332 in 2000, which was allocated to the PLCs in equal
shares. Smith/Olsen and Smith & Associates separately filed
Forms 1065, U.S. Partnership Return of Income,7 each reporting
approximately $202,000 of net ordinary income in 1999 and
$141,673 in 2000. The SKO-96 Trust reported taxable income from
6
It appears that the net income of $627,736, as reported on
the Form 1065, was adjusted on audit. Olsen-Smith, Ltd. v.
Commissioner, supra.
7
The Form 1065, U.S. Partnership Return of Income, became a
Form 1065, U.S. Return of Partnership Income, in 2000.
6
Smith/Olsen of $189,903 in 1999 and $140,256 in 2000. The 1992
WHO Trust reported income from Smith/Olsen of $12,502 in 1999 and
$1,417 in 2000. The MBK-96 Trust reported taxable income from
Smith & Associates of $190,888 in 1999 and $140,256 in 2000.
The 1992 WLK Trust reported taxable income from Smith &
Associates of $11,502 in 1999 and $1,417 in 2000.
The PLCs distributed the cash that they received from Olsen-
Smith to the trusts as soon as the money was received by the
PLCs. The trust agreements allowed the independent trustee to
distribute income or principal for the benefit of the
beneficiaries, including for their “benefit, care, comfort,
enjoyment or for any other purposes.” The trusts made immediate
distributions of all the money to petitioners as soon as they
received it from the PLCs.8
Respondent issued deficiency notices to petitioners in which
respondent adjusted petitioners’ taxable income to reflect self-
employment tax on the income distributed from the PLCs to the
trusts.9 Petitioners filed petitions for both years.
8
The trusts held other assets, including assets inherited
from petitioners’ parents and other partnership interests.
9
The Commissioner also audited Olsen-Smith, the PLCs, and
the trusts for 1999 and 2000. Petitioners are not strangers to
this Court. Petitioners, as individuals and representatives of
these entities, have filed petitions in this Court at least 20
other times.
7
OPINION
We are asked to decide whether petitioners are liable for
self-employment tax on funds that were distributed from their law
firm to their PLCs to their trusts and then to them. Respondent
argues that petitioners are liable for self-employment tax
because petitioners’ transactions with the trusts lack economic
substance.10 Petitioners argue that they are not liable for
self-employment tax because they carefully and meticulously
devised their structure for valid business purposes and the non-
salary income allocated to them as beneficiaries of the trusts is
not taxable under section 1402.
Burden of Proof
We first address the burden of proof. Petitioners generally
have the burden of proof. See Rule 142(a). Petitioners do not
dispute that they bear the burden of proof with respect to
respondent’s theory that their trusts lack economic substance.11
10
Respondent argues, alternatively, that petitioners are
liable for self-employment tax on the law firm earnings under the
assignment of income theory and under secs. 671 through 677. We
need not address these additional arguments because we have
determined that petitioners’ transactions with the trusts lacked
economic substance.
11
It is unnecessary to determine the burden of proof with
respect to respondent’s other two theories because we hold that
petitioners’ trusts lacked economic substance.
8
Economic Substance
We now address the economic substance theory. Taxpayers
have a legal right, by whatever means allowable under the law, to
structure their transactions to minimize their tax obligations.
See Gregory v. Helvering, 293 U.S. 465, 469 (1935). We will not
recognize for Federal income tax purposes, however, transactions
that have no significant purpose other than to avoid tax and do
not reflect economic reality. See Zmuda v. Commissioner, 79 T.C.
714, 719 (1982), affd. 731 F.2d 1417 (9th Cir. 1984). We look
through the form of a transaction when that form has not altered
any cognizable economic relationships, and we apply tax law
according to the substance of the transaction. Id. at 720;
Temple v. Commissioner, T.C. Memo. 2000-337, affd. 62 Fed. Appx.
605 (6th Cir. 2003). This rule applies regardless of whether the
transaction creates an entity with a separate existence under
State law. Zmuda v. Commissioner, supra at 720; Temple v.
Commissioner, supra.
We traditionally consider four factors in deciding whether a
trust lacks economic substance. These four factors include: (1)
Whether the taxpayer’s relationship, as grantor, to property
purportedly transferred into trust differed materially before and
after the trust’s formation; (2) whether the trust had a bona
fide independent trustee; (3) whether an economic interest in the
trust passed to trust beneficiaries other than the grantor; and
9
(4) whether the taxpayer honored restrictions imposed by the
trust or by the law of trusts. Markosian v. Commissioner, 73
T.C. 1235, 1243-1245 (1980); Castro v. Commissioner, T.C. Memo.
2001-115; Hanson v. Commissioner, T.C. Memo. 1981-675, affd. per
curiam 696 F.2d 1232 (9th Cir. 1983).
We begin by examining the first factor. Petitioners’
relationship to the trust property did not change after the
trusts were created. Petitioners apparently transferred their
PLC interests to the trusts in the mid-1990s. Petitioners
presented no evidence to suggest that this altered their
relationship with the PLCs or Olsen-Smith. They continued to
manage the firm, work for the firm, and operate their business
under the same name, in the same location, and in the same
capacity as before the transfer. The trusts engaged in no trade
or business, and petitioners, as trustees, had complete control
over the income-producing properties of the trusts.
Petitioners’ relationship to the income did not change
either. Petitioners and Mr. Rossie received distributions of all
income earned by the law firm. Each petitioner still took home
one-third of the net profits of the firm. Though petitioners
testified that assets did not remain in the partnership but were
moved to the trusts to protect them from creditors, the record
does not support their arguments that the trusts were used to
protect the income from creditors. Petitioners distributed to
10
themselves all the income that their trusts received from Olsen-
Smith. This suggests that petitioners were not motivated by a
true desire to protect the income from creditors but rather by a
desire for tax avoidance. We find that this factor weighs
against petitioners.
As to the second factor, petitioners claimed that they had
independent trustees even though each was the other’s trustee.
Petitioners distributed all the earnings from the PLCs to each
other as a matter of course. This suggests that they exercised
complete control over the trusts, and petitioners presented no
evidence to convince us otherwise. We find that this factor also
weighs against petitioners because their reciprocal arrangements
in the two trusts insured that they would act in harmony with one
another.
As to the third factor, no economic interest in the trusts
ever passed to any beneficiary other than petitioners. They were
the only beneficiaries, and they had no children or other
descendants to name as beneficiaries. We find that this factor
also weighs against petitioners.
As to the final factor, petitioners argue that they honored
all the restrictions imposed by the trusts and by the law of
trusts. Petitioners presented no evidence to corroborate this.
The evidence does suggest that petitioners used the property as
they desired without restriction and that there were no
11
restrictions on what they did. Their reciprocal arrangements
with each other’s trusts further suggest that they would not have
faced any such restrictions. We find that this factor also
weighs against petitioners.
For these reasons, we find that the trusts lacked economic
substance and we conclude that they are not recognizable for
Federal tax purposes.
Self-Employment Tax
Section 1401 imposes a tax on the self-employment
income of every individual. See Baker v. Commissioner, T.C.
Memo. 2001-283. Self-employment income is defined as the net
earnings from self-employment derived by an individual
during any taxable year. Sec. 1402(b). “[N]et earnings
from self-employment” include gross income derived by an
individual from any trade or business carried on by that
individual minus the deductions that are attributable to the
trade or business. See sec. 1402(a).
Petitioners have offered no reason other than that their
trusts were the owners of their PLC interests and proper
receptacles for their earnings from the law firm to explain why
the net income from their law firm is not self-employment income
to them. We have concluded that petitioners’ transactions
resulting in distributions to and from the trusts lacked economic
substance. It follows that petitioners’ share of the net income
12
of the law firm represents petitioners’ net earnings from self-
employment. The income represents petitioners’ distributive
share of profits of a business conducted by a partnership of
which they are, indirectly or directly, members. Petitioners are
liable for self-employment tax on that income for the years at
issue. Accordingly, we sustain respondent’s determinations in
the deficiency notices.
To reflect the foregoing,
Decisions will be entered
for respondent.