T.C. Summary Opinion 2011-58
UNITED STATES TAX COURT
RICHARD J. AND JACQUELINE ROCCHIO, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 7719-10S. Filed May 11, 2011.
Richard J. Rocchio, pro se.
William R. Brown, Jr., for respondent.
ARMEN, Special Trial Judge: This case was heard pursuant to
the provisions of section 7463 of the Internal Revenue Code in
effect when the petition was filed.1 Pursuant to section
7463(b), the decision to be entered is not reviewable by any
1
Unless otherwise indicated, all subsequent section
references are to the Internal Revenue Code in effect for the
year in issue, and all Rule references are to the Tax Court Rules
of Practice and Procedure.
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other court, and this opinion shall not be treated as precedent
for any other case.
Respondent determined a deficiency in petitioners’ 2007
Federal income tax of $7,033 and an accuracy-related penalty
under section 6662(a) of $1,407.
The issues for decision are:
(1) Whether petitioner-husband was a shareholder in an S
corporation during 2007 such that petitioner-husband is required
to report his pro rata share of the corporation’s income. We
hold that he was; and
(2) whether petitioners are liable for the accuracy-related
penalty under section 6662(a). We hold that they are not.
Background
Some of the facts have been stipulated, and they are so
found. We incorporate by reference the parties’ stipulation of
facts, supplemental stipulation of facts, and accompanying
exhibits. All references to petitioner in the singular are to
petitioner Richard J. Rocchio.
Petitioners resided in the State of Florida when the
petition was filed.
Petitioner’s mother and father each owned 50-percent
interests in Leas-Co Leasing, Inc. (Leas-Co), a New York
corporation. After the death of petitioner’s mother in 1993,
petitioner and each of his three siblings inherited 12.5-percent
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interests in Leas-Co. At all times, petitioner’s father owned
the remaining 50-percent interest in Leas-Co. In the years
following petitioner’s mother’s death, petitioner’s father ran
Leas-Co, petitioner was on the board of directors, and
petitioner’s siblings were all officers.
Sometime around 2000 petitioner’s father remarried.
Petitioner’s father’s new wife created family strife, and as a
result petitioner’s father became estranged from each of his
children. Petitioner’s father and his new wife began “living
their life in luxury”, and petitioner and his siblings received
“little to nothing” from the company.
On October 21, 2006, petitioner and his three siblings filed
for judicial dissolution of Leas-Co pursuant to N.Y. Bus. Corp.
Law section 1104-a (McKinney 2003). On January 9, 2007,
petitioner’s father elected to purchase the shares held by
petitioner and his siblings pursuant to N.Y. Bus. Corp. Law
section 1118 (McKinney 2003).
Petitioner and his siblings could not agree with their
father regarding the fair value of the corporation; thus,
litigation ensued that eventually resulted in a settlement.
Petitioner sold his shares in Leas-Co to his father on August 12,
2009.
Leas-Co’s 2007 Form 1120S, U.S. Income Tax Return for an S
Corporation, reported $316,635 of ordinary business income. A
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2007 Schedule K-1, Shareholder’s Share of Income, Deductions,
Credits, etc., reported petitioner’s share of the ordinary
business income as $39,579, consistent with petitioner’s 12.5-
percent interest in Leas-Co.
Petitioners did not include the $39,579 from the Schedule
K-1 on their 2007 Federal income tax return.
In the notice of deficiency respondent determined that
petitioners must include the $39,579 reported on the Schedule K-1
in gross income and that petitioners are liable for the accuracy-
related penalty under section 6662(a) for a substantial
understatement of income tax.
Discussion
A. Burden of Proof
Generally, the Commissioner’s determinations are presumed
correct, and the taxpayer bears the burden of proving that those
determinations are erroneous. Rule 142(a); Welch v. Helvering,
290 U.S. 111, 115 (1933).
Under section 7491(a)(1), the burden of proof may shift from
the taxpayer to the Commissioner if the taxpayer produces
credible evidence with respect to any factual issue relevant to
ascertaining the taxpayer’s liability. Petitioners have not
alleged that section 7491 applies, nor did they introduce a
sufficiency of evidence to invoke that section; therefore, the
burden of proof remains on petitioners.
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B. S Corporation Pro Rata Distributive Share
Generally, a shareholder of an S corporation must include in
gross income his or her pro rata share of the corporation’s
income, loss, deduction, or credit. Sec. 1366(a), (c); see also
sec. 61(a). Consequently, we must decide whether petitioner was
a shareholder of Leas-Co during 2007 such that he is required to
report his pro rata share of Leas-Co’s ordinary income.
In the application of Federal tax law, State law controls in
determining the nature of the taxpayer’s legal interest in
property. United States v. Natl. Bank of Commerce, 472 U.S. 713,
722 (1985); Aquilino v. United States, 363 U.S. 509, 513 (1960).
As a result we must look to New York State law to determine
petitioner’s interest in Leas-Co during 2007.
On October 21, 2006, petitioner and his siblings filed for
judicial dissolution of Leas-Co pursuant to N.Y. Bus. Corp. Law
section 1104-a. That statute permits holders of shares
representing 20 percent or more of the votes of all outstanding
shares of an S corporation to file a petition for dissolution if
those in control of the corporation (1) have been guilty of
illegal, fraudulent, or oppressive actions toward the complaining
shareholders, or (2) are wasting the corporation’s assets. Id.
On January 9, 2007, petitioner’s father, as the remaining
shareholder, elected to purchase petitioner’s and his siblings’
outstanding shares pursuant to N.Y. Bus. Corp. Law section 1118.
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That statute provides for an irrevocable election and requires
valuation of the shares by the court if the shareholders cannot
agree on the fair value of such shares; further, the statute
provides that the valuation date is the date prior to the date on
which the petition for dissolution was filed. Id.
Petitioner contends that because he and his siblings filed
for judicial dissolution and his father elected to purchase his
shares, he was not liable for the Federal income tax on his pro
rata share of Leas-Co’s income in 2007. In support of his
position petitioner relies on a decision and order issued in In
re Gillman (Audio Den, Ltd.), N.Y.L.J., Nov. 25, 1988, at 27
(Sup. Ct. 1988), which states in part:
To permit the selling shareholder to participate
in post-election management would serve no purpose, for
his interest is frozen statutorily as of the day
preceding his application for the corporation’s
dissolution. What happens in the business thereafter
is of no moment vis a vis the value of his shares.
Indeed the last clause of [N.Y. Bus. Corp. Law] Section
1118 specifically excludes from the valuation process
“any element of value arising from * * * [the] filing
[for dissolution]”.
Petitioner contends that because his interest in Leas-Co was
frozen statutorily and he was no longer entitled to participate
in the management of Leas-Co, he is not liable for the Federal
income tax on his pro rata share of Leas-Co’s income for 2007.
Petitioner further contends that he is not liable for the Federal
income tax because he “never got the money for * * * [the
Schedule] K-1” in 2007.
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Respondent contends that petitioner remained a shareholder
of Leas-Co until his shares were sold in August 2009; therefore,
petitioner is liable for the Federal income tax on his pro rata
share of Leas-Co’s income for 2007.
Petitioner’s reliance upon In re Gillman (Audio Den, Ltd.),
supra, is misplaced. The court in that case acknowledged that
section 1118 of N.Y. Bus. Corp. Law, and the remainder of Article
11 of N.Y. Bus. Corp. Law, do not provide guidance regarding the
selling of a shareholder’s rights to profits and dividends during
“the hiatus which separates the filing of the dissolution
petition and payment for his shares.” Id.
In Commissioner v. Estate of Bosch, 387 U.S. 456, 465
(1967), the Supreme Court addressed the means for determining
State law in the context of a Federal tax case, stating:
the State’s highest court is the best authority on its
own law. If there be no decision by that court then
federal authorities must apply what they find to be the
state law after giving “proper regard” to relevant
rulings of other courts of the State. In this respect,
it may be said to be, in effect, sitting as a state
court. Bernhardt v. Polygraphic Co., 350 U.S. 198
(1956).
The parties have not cited any case from New York State’s
highest court deciding the narrow legal question presented
herein, and we are not aware of any such case.2 Under the
2
In most states the State supreme court is the highest
court; however, in New York the supreme court is a trial court.
The New York Court of Appeals is the State’s highest court.
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circumstances, we must do our best “to discern what such State’s
highest court would decide.” Estate of Young v. Commissioner,
110 T.C. 297, 302 (1998).
The New York Court of Appeals has held that even when a
corporation has been “dissolved, the shareholder’s interest does
not abruptly end.” Indep. Investor Protective League v. Time,
Inc., 406 N.E.2d 486, 488 (N.Y. 1980). Further, the New York
Supreme Court, Appellate Division, explained that a shareholder
in a corporation remains such “until payment is made for the fair
value of his shares”. In re Davis, 571 N.Y.S.2d 234, 236 (App.
Div. 1991).
In Stern v. Bambu Sales, Inc. (In re Spielfogel), 237 Bankr.
555, 559 (E.D.N.Y. 1999), the U.S. District Court for the Eastern
District of New York examined the issue of whether a shareholder
is entitled to a dividend after filing for dissolution (pursuant
to N.Y. Bus. Corp. Law section 1104-a) and a subsequent election
(pursuant to N.Y. Bus. Corp. Law section 1118) by the corporation
but before the purchase was complete. As in the instant case,
several years separated the filing for dissolution and the actual
purchase of the shareholder’s shares. Id. at 558. The court
held that despite the filing for judicial dissolution and the
election by the corporation to purchase the shares, the
shareholder’s interest “was not put to an ‘abrupt[] end,’ * * *
by virtue of the election, * * * [and he remained] entitled to
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the post-election dividend” before the sale of the shares was
accomplished. Id. at 560.
Because petitioner’s interest in Leas-Co did not “abruptly
end” upon the filing for judicial dissolution and subsequent
election by petitioner’s father to purchase shares, petitioner
remained a shareholder in Leas-Co until the sale of his shares
was complete in August 2009. See id. at 559; Indep. Investor
Protective League v. Time, Inc., supra at 488; In re Davis, supra
at 236.
Petitioner maintains that even if he were a shareholder in
2007, he is not liable for the Federal income tax on the income
of Leas-Co for 2007 because he “never got the money for
* * * [the Schedule] K-1” in 2007.
Contrary to petitioner’s contention, section 1.1366-1(a)(1),
Income Tax Regs., provides that “An S corporation must report,
and a shareholder is required to take into account in the
shareholder’s return, the shareholder’s pro rata share, whether
or not distributed, of the S corporation’s items of income”.
(Emphasis added.) Because petitioner was a shareholder in Leas-
Co until August 2009 and regardless of whether the income from
Leas-Co was distributed in 2007, petitioner must report his pro
rata share of Leas-Co’s income on his Federal income tax return.
See sec. 1366(a), (c); sec. 1.1366-1(a)(1), Income Tax Regs.
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Accordingly, we hold that petitioner is required to report
his pro rata share of Leas-Co’s 2007 income on his joint Federal
income tax return for that year.
C. Section 6662(a) Substantial Understatement of Tax
Respondent determined in the notice of deficiency that
petitioners are liable for the accuracy-related penalty under
section 6662(a) for a substantial understatement of income tax
for 2007.
Section 6662(a) and (b)(2) imposes a penalty equal to 20
percent of any underpayment of tax that is due to a substantial
understatement of income tax. See sec. 6662(a), (b)(2). An
individual substantially understates his or her income tax when
the reported tax is understated by the greater of 10 percent of
the tax required to be shown on the return or $5,000. Sec.
6662(d)(1)(A).
The accuracy-related penalty does not apply to any portion
of an underpayment, however, if it is shown that there was
reasonable cause for the taxpayer’s position and that the
taxpayer acted in good faith with respect to that portion. Sec.
6664(c)(1); sec. 1.6664-4(a), Income Tax Regs. The determination
of whether a taxpayer acted with reasonable cause and in good
faith is made on a case-by-case basis, taking into account all
the pertinent facts and circumstances. Sec. 1.6664-4(b)(1),
Income Tax Regs. The most important factor is the extent of the
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taxpayer’s effort to assess his proper tax liability for such
year. Id. Circumstances that may indicate reasonable cause and
good faith include an honest misunderstanding of fact or law that
is reasonable in light of the experience, knowledge, and
education of the taxpayer. Sec. 1.6664-4(b), Income Tax Regs.;
see Higbee v. Commissioner, 116 T.C. 438, 449 (2001) (citing Remy
v. Commissioner, T.C. Memo. 1997-72). The determination of
whether a taxpayer acted with reasonable cause and in good faith
with respect to an underpayment that is related to an item
reflected on the return of a passthrough entity is made on the
basis of all pertinent facts and circumstances, including the
taxpayer’s own actions, as well as the actions of the passthrough
entity. Sec. 1.6664-4(e), Income Tax Regs.
Section 7491(c) places on the Commissioner the burden of
production with respect to a taxpayer’s liability for any
penalty. Respondent satisfied his burden of production because
the record shows that petitioners substantially understated their
income tax for 2007 by $7,033, which amount exceeds the greater
of 10 percent of the tax required to be shown on the return or
$5,000. See sec. 6662(d)(1)(A); Higbee v. Commissioner, supra at
446. Accordingly, petitioners bear the burden of proving that
the accuracy-related penalty should not be imposed with respect
to any portion of the underpayment for which they acted with
reasonable cause and in good faith. See sec. 6664(c)(1); Higbee
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v. Commissioner, supra at 446. The mere fact that we held
against petitioners with respect to petitioner’s status as a
shareholder of Leas-Co 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).
In view of the complexities surrounding the taxation of S
corporations and their shareholders, as well as the challenges of
devining New York State law, we find that petitioner did have
reasonable cause to believe that he was not a shareholder of
Leas-Co in 2007 and did act in good faith with respect to the
underpayment.
Accordingly, we hold that petitioners are not liable for the
accuracy-related penalty under section 6662(a).
Conclusion
We have considered all of the arguments made by the parties,
and, to the extent that we have not specifically addressed them,
we conclude that they do not support a result contrary to that
reached herein.
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Finally, we observe, without commenting on the validity of
such, that petitioner may have a remedy pursuant to New York
State law with respect to the undistributed earnings of Leas-Co
reported on the Schedule K-1 for 2007.
To reflect the foregoing,
Decision will be entered
for respondent as to the
deficiency in tax and for
petitioners as to the
accuracy-related penalty.