T.C. Memo. 2011-105
UNITED STATES TAX COURT
WEEKEND WARRIOR TRAILERS, INC., ET AL.,1 Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 6984-08, 6997-08, Filed May 19, 2011.
15166-08.
Pietro E. Canestrelli and Stanley A. Harter, for
petitioners.
Heather K. McCluskey and Monica D. Gingras, for respondent.
1
Cases of the following petitioner are consolidated
herewith: Mark E. Warmoth, docket Nos. 6697-08 and 15166-08.
- 2 -
MEMORANDUM FINDINGS OF FACT AND OPINION
MARVEL, Judge: In separate notices of deficiency respondent
determined deficiencies in petitioners’ Federal income taxes and
accuracy-related penalties under section 6662(a)2 as follows:
Penalty
Docket Petitioner Year Deficiency Sec. 6661(a)
6984-08 Weekend Warrior
1
Trailers, Inc. 2002 $1,117,383 $446,953
6997-08 Mark E. Warmoth 2002 14,836 2,967
2003 1,252,944 250,589
15166-08 Mark E. Warmoth 2004 471,615 94,323
1
All monetary amounts have been rounded to the nearest
dollar. Respondent subsequently asserted an increased deficiency
in each docket. See infra pp. 33-36.
Petitioners contested the determinations by filing timely
petitions. The resulting cases have been consolidated.
2
Unless otherwise indicated, all section references are to
the Internal Revenue Code (Code), as amended and in effect for
the years in issue, and all Rule references are to the Tax Court
Rules of Practice and Procedure.
- 3 -
After concessions,3 the issues for decision with respect to
Weekend Warrior are: (1) Whether Weekend Warrior is entitled to
management fee deductions of $4,175,000, $4,800,000, and
$4,595,000 for 2002, 2003, and 2004, respectively, (2) whether
Weekend Warrior is entitled to depreciation deductions with
respect to the airplane and the Nordic boat (boat), (3) whether
Weekend Warrior is entitled to airplane expense deductions, (4)
whether Weekend Warrior has interest income under section 7872
from loans to Mark E. Warmoth (Mr. Warmoth) for each year at
issue, and (5) whether Weekend Warrior is liable for the
accuracy-related penalty under section 6662(a) for 2002.
3
Weekend Warrior Trailers, Inc. (Weekend Warrior), concedes
depreciation deductions with respect to the Malibu boat of
$5,885, $3,531, and $3,531 for 2002, 2003, and 2004,
respectively. At trial and on brief respondent asserted
adjustments to ending inventory for each year different from
those in the notices of deficiency. Respondent asserts these
adjustments equal $234,423, $222,115, and $539,786 for 2002,
2003, and 2004, respectively. Petitioners failed to address the
adjustments to ending inventory in the opening brief, and in the
reply brief petitioners state that they concede the adjustments
to Weekend Warrior’s ending inventory. At trial and on brief
respondent states that the forgone interest adjustment under sec.
7872 to Weekend Warrior’s 2002 return should be $39,896 rather
than $41,343 as he had determined in the notice of deficiency,
and we treat the $1,447 difference as respondent’s concession.
Lastly, at trial Revenue Agent Timothy Burke testified that the
adjustment to depreciation deduction with respect to the 1994
Beechcraft 58 Baron airplane (airplane) for 2003 should be $31
lower than what respondent had determined in the notice of
deficiency; we treat the difference as respondent’s concession.
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The issues for decision with respect to Mr. Warmoth are:
(1) Whether Mr. Warmoth is entitled to items of deduction that
flow through from Weekend Warrior in 2003 and 2004 in the light
of the issues listed above,4 (2) whether Mr. Warmoth received
unreported constructive dividend income from Weekend Warrior in
2002, and (3) whether Mr. Warmoth is liable for the accuracy-
related penalty under section 6662(a) for each year at issue.5
FINDINGS OF FACT
Some of the facts have been stipulated. The stipulation of
facts is incorporated herein by this reference. Mr. Warmoth
resided in California when he filed his petitions. Weekend
Warrior’s principal place of business was also in California when
it filed its petition.
I. Background
Mr. Warmoth started riding dirt bikes and off-road vehicles
when he was 9 years old. After graduating from high school, Mr.
Warmoth worked for a major recreational vehicle (RV) manufacturer
for 14 years.
A self-described “desert rat”, Mr. Warmoth vacationed in the
desert, where off-road enthusiasts travel to ride off-road
vehicles. To transport their off-road vehicles to the desert,
4
Our conclusions with respect to Weekend Warrior for 2003
and 2004 resolve this issue. See sec. 1366(a)(1).
5
Other adjustments to Mr. Warmoth’s 2002-04 tax returns are
computational.
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off-road enthusiasts build trailers. Having learned how to build
RVs during his employment with the RV manufacturer, Mr. Warmoth
developed a unique recreational travel trailer to serve this
niche market. The concept of the product was a trailer with a
drop-down back that could accommodate a motorcycle or an off-road
vehicle. In 1988 he started his own business of mass-producing
the trailers.
Originally, Mr. Warmoth’s business was “doing business as”
Warrior Manufacturing. On August 5, 1995, the business was
incorporated as Weekend Warrior.6 Between 1995 and 2002 Weekend
Warrior was a C corporation. Effective January 1, 2003, Weekend
Warrior elected S corporation status. From its incorporation
through December 31, 2009, Mr. Warmoth was the sole shareholder
of Weekend Warrior. From January 1, 2000, through December 31,
2005, Mr. Warmoth was Weekend Warrior’s chief executive officer
(CEO) and president.
Weekend Warrior designed, manufactured, and sold travel
trailers. It manufactured lightweight models at the main plant
located at 1320 Oleander Avenue, Perris, California, a leased
facility. Another facility, located in the same neighborhood,
manufactured heavy-duty wide-body expensive trailers, such as
fifth wheelers and full trailers.
6
In 2002-04 Warrior Manufacturing was a corporation wholly
owned by Weekend Warrior. It was a service warranty and parts
subsidiary and provided warranty work.
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Most of the manufacturing process took place outside; the
employees started work in the morning and finished by dark
because there were no lights outside. Mr. Warmoth spent 5 or 6
days per week at the factory and showed trailers to potential
customers approximately 40 weekends annually. Weekend Warrior
owned most of the equipment used in the manufacturing process.
Before the changes in structure described below, Weekend
Warrior’s main departments were sales, production, and
purchasing. Other departments, namely, engineering, service,
accounting, and operations, were on a lesser pay scale, as they
were perceived to be slightly less valuable. From December 31,
2001, through January 1, 2006, Weekend Warrior had three top
managers who reported directly to Mr. Warmoth: Corrie Stoap (Mr.
Stoap), who was in charge of purchasing and later held the
position of operations manager and vice president; Gary Denton
(Mr. Denton), a sales manager; and Kris Hansen (Mr. Hansen), a
production manager, who later became vice president of
production.
Weekend Warrior organized the manufacturing process in runs.
Each run produced similar models. On average, 80 percent of the
materials used in the production of trailers was the same.
Depending on the model, the run could last 1 or 2 weeks. If a
run was 25 trailers long, the purchasing department bought 25
refrigerators, 25 stoves, and 100 tires.
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To minimize the need for cash outlay and physical space,
Weekend Warrior used just-in-time purchasing. Materials were
delivered a few days before they were needed, although Weekend
Warrior purchased a 2-week supply of smaller, less expensive
items and reordered them when the supply ran low. The purchasing
manager at each plant was responsible for inventory on hand, its
turnover, and the amount of cash tied up in inventory. Suppliers
billed Weekend Warrior for materials and supplies.
Weekend Warrior sold its products through a dealer network.
It had ongoing relationships with various dealerships.
Generally, Weekend Warrior was paid 3 weeks after selling a
trailer to a dealer, which created a cashflow problem because
Weekend Warrior paid expenses for labor and material as it was
building a trailer. Warrior Manufacturing was responsible for
warranty work on sold trailers.
Mr. Warmoth was the “sole driving force behind the product.”
He performed design work. Around 2002 Mr. Warmoth received his
first patent; it was a patent for a part inside a trailer. Mr.
Warmoth subsequently received patents for sofa armrests and a
bed. Weekend Warrior held approximately six trademarks.7
At some point before 1995 Weekend Warrior implemented the
Weekend Warrior Bonus Plan (bonus plan) using as a template the
7
There was a trademark on the Weekend Warrior company name,
but it is not clear who owned it.
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bonus plan of the company for which Mr. Warmoth had worked before
starting Weekend Warrior. The bonus plan was not limited to the
top managers but rather was for key employees. Under the bonus
plan, one-third of Weekend Warrior’s profits became a key
employee pool. One-half of the key employee pool was split among
the top managers and Mr. Warmoth. One-half of the remaining
amount was split among eight assistant managers. The remainder
was split among managers at various levels.
Weekend Warrior had no incentive structure for rank-and-file
employees. Motivating them was a challenge. The funds remaining
after compensating key employees under the bonus plan were
insufficient to motivate rank-and-file employees.
By 1997 Weekend Warrior’s annual sales had reached $3
million. Around 1998 off-roading became a popular form of
recreation. Weekend Warrior’s gross sales started growing at the
annual rate of 50 percent and reached $40 million in 2002. For 2
or 3 years thereafter gross sales continued to grow at the annual
rate of 50 percent.
Weekend Warrior had no human resources department, so Mr.
Hansen handled employee matters. He calculated workforce needs
on the basis of production schedules, and he hired and fired
employees accordingly. To fill an open position, Mr. Hansen
placed an advertisement, although many applicants learned about
job openings at Weekend Warrior through “word of mouth”. Weekend
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Warrior advertised positions with special requirements and used
headhunters when searching for specific talent. The receptionist
answered phone calls and passed potential hires’ contact
information to Mr. Hansen. Mr. Hansen then invited the
applicants for interviews and made hiring decisions.8 Weekend
Warrior did not issue formal offer letters or enter into
employment contracts when hiring new employees. Terminating
employees was delegated to assistant managers and production
managers. Approximately 85 percent of employees worked for
Weekend Warrior’s manufacturing department. Although a number of
employees had been employed by Weekend Warrior for 15 years,
there was a high turnover rate for entry-level employees.
Weekend Warrior employed a controller, but an outside
accounting firm handled “all of the detail work”. After 2002 Ray
Espera (Mr. Espera) held the controller position. Mr. Espera and
Mr. Stoap were responsible for maintaining the books and records.
Weekend Warrior maintained a securities account at Comerica
Bank (Comerica) and three accounts with Foothill Independent Bank
(Foothill). Mr. Warmoth was the only individual with signature
authority over Weekend Warrior’s accounts.
8
Mr. Hansen’s testimony on this point appears inconsistent
with stipulation No. 179, according to which Mr. Warmoth made all
hiring decisions for Weekend Warrior. We found Mr. Hansen’s
testimony on the point convincing and make our findings of fact
regarding the foregoing on the basis of Mr. Hansen’s testimony.
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II. The 2002 Changes
A. Mr. Warmoth’s Group of Advisers
Before 2002 Weekend Warrior engaged the services of attorney
John Dana Mitchellweiler (Mr. Mitchellweiler), a partner at
Smith, Mitchellweiler in Riverside, California. Mr.
Mitchellweiler described himself as an outside general counsel to
Weekend Warrior. Mr. Mitchellweiler practiced law in the
business and estates areas. As of the date of trial Mr.
Mitchellweiler had practiced law for 15 years.
In August 2002 Mr. Mitchellweiler introduced Mr. Warmoth to
William R. Lindsey (Mr. Lindsey). Mr. Lindsey was a financial
adviser with 27 years of financial planning experience and was
formerly employed by New York Life. Mr. Lindsey holds a master’s
degree in financial services and certificates in business
succession and executive compensation and is an accredited estate
planner. Mr. Lindsey was a part of an “architectural team of
designers” for clients’ estate planning, investment, and life
insurance needs.
Mr. Warmoth hired Mr. Lindsey to prepare an overall plan for
him. Mr. Lindsey’s firm prepared an outline of Mr. Warmoth’s
goals that summarized Mr. Warmoth’s financial philosophy. The
goals included developing an investment strategy, achieving
financial independence, establishing an estate plan, and other
objectives.
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Mr. Warmoth also sought general advice as to how to handle the
company’s rapid growth.
On the basis of Mr. Warmoth’s needs, Mr. Lindsey put
together a team of advisers--Mr. Lindsey and his pension
administration firm; Mr. Mitchellweiler; Greg Siegler, a
certified public accountant from the accounting firm Crabtree &
Associates; Steve Tweedlie, an auditor from Crabtree &
Associates; Ken Baily (Mr. Baily), a valuation analyst; Curt
McCombs from Comerica; and Roland Attenborough, an attorney from
Reish & Luftman.9 Mr. Lindsey coordinated the team members and
the document preparation. In the last quarter of 2002 the team
members met several times to discuss various options.
B. The New Structure and Various Compensation Plans
The team of advisers recommended the creation of Leading
Edge Designs, Inc. (Leading Edge). On November 11, 2002, the
articles of incorporation of Leading Edge were executed. On
November 14, 2002, Leading Edge was incorporated under the laws
of California. Effective November 14, 2002, Leading Edge elected
S corporation treatment. Mr. Mitchellweiler drafted
incorporation documents and provided tax advice regarding the
consequences of forming an S corporation.
9
Mr. Lindsey recommended the professionals to Mr. Warmoth,
and Mr. Warmoth decided who should be on the team.
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Mr. Warmoth received 10,000 shares of Leading Edge stock.
Mr. Warmoth was to pay $20,000 for the shares, but he failed to
execute a promissory note or pay the required amount. Mr.
Warmoth was the only member of the board of directors, and in
this capacity on November 14, 2002, he adopted bylaws. Through
December 31, 2005, Mr. Warmoth was the CEO and president of
Leading Edge. From incorporation through January 1, 2003, Mr.
Warmoth was also the secretary of Leading Edge. Starting January
2, 2003, Mr. Stoap became the secretary.
Effective December 15, 2002, Leading Edge established a
deferred compensation arrangement (deferred compensation plan)
“for a select group of management or highly-compensated
personnel”. According to the Accrued Severance Agreement
establishing the plan, the deferred compensation plan was an
unfunded arrangement and the board was to resolve annually which
employees were entitled to participate in it. The accrued
severance amounts allocated to an employee were deferred until
the employee’s involuntary termination, retirement, resignation,
disability or death, or in the event of emergency or necessity.
The contingent right to future payments could be forfeited (1) if
the employee were discharged for acts which in the opinion of the
board constitute embezzlement of corporate funds or (2) if the
employee entered into business or employment which the board
determined to be detrimentally competitive or substantially
- 13 -
injurious to Leading Edge. However, the board could order that
the right to the accrued payments was no longer subject to
forfeiture, and it could allow the payment of the vested amounts
“if it finds such action appropriate in the circumstances.” The
purpose of the deferred compensation plan was to allow Mr.
Warmoth to obtain a benefit out of Leading Edge other than wages.
Although Mr. Mitchellweiler and Mr. Warmoth discussed a
severance agreement for the top managers as an incentive
mechanism, as discussed below, see infra pp. 21, 24, for 2002 and
2003 Mr. Warmoth was the only person entitled to participate in
the deferred compensation plan. Under the deferred compensation
plan his compensation was $4 million and $4.1 million for 2002
and 2003, respectively.
On December 28, 2002, the Leading Edge board adopted the
Weekend Warrior Retirement Plan (retirement plan),10 effective
November 14, 2002.11 The retirement plan had two components.
The first was the employee stock ownership plan (ESOP), which was
a stock bonus plan under section 401(a) and an employee stock
ownership plan as defined in section 4975(e)(7). The second was
the section 401(k) profit-sharing plan under section 401(a) as
10
The copy of the retirement plan contained in the record is
missing pp. 24 through 60, 65 through 76, and 78 through 88.
11
The Weekend Warrior Retirement Plan and Trust Agreement
(trust agreement), however, recites that the effective date was
Dec. 1, 2002. The discrepancy in the effective dates does not
affect our resolution of the issues.
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well as a cash or deferred arrangement under section 401(k). The
retirement plan covered all employees of Leading Edge aged 21 and
older with at least 1 year of employment. All assets acquired
under the retirement plan were to be held in a trust in
accordance with the provisions of the trust agreement. The trust
agreement was signed on December 28, 2002, but was effective as
of December 1, 2002. Messrs. Warmoth and Stoap were the
trustees.
On December 18, 2002, Mr. Warmoth sold 9,990 shares of
Leading Edge stock to the retirement plan for $1.50 per share.12
Mr. Baily valued the stock for purposes of the sale. The
retirement plan executed a promissory note according to which it
would pay Mr. Warmoth $14,985 in four quarterly installments.
Mr. Mitchellweiler advised Mr. Warmoth that selling a part of the
Leading Edge shares to an ESOP was a necessary part of
establishing it. Mr. Warmoth understood that the employees of
Leading Edge would split the value of Leading Edge depending on
length of employment. Mr. Warmoth signed the stock purchase
agreement in his capacities as the trustee of the retirement
plan, president of Leading Edge, and the selling shareholder.13
12
The parties stipulated the described sale took place on
Dec. 19, 2002, but the stock purchase agreement is dated Dec. 18,
2002.
13
A copy of the Leading Edge Capitalization and Ownership
record incorrectly refers to the retirement plan as “Leading Edge
(continued...)
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On December 28, 2002, Weekend Warrior and Leading Edge
entered into a Management, Design, and Personnel Services
Agreement (management agreement). Mr. Mitchellweiler drafted the
management agreement. Mr. Warmoth signed the management
agreement on behalf of each party. The term of the management
agreement was from December 20, 2002, through December 31, 2003.
According to the recitals, Weekend Warrior sought to
centralize its general management functions such as accounting,
marketing, sales and purchasing, human resources, and product
research and development. Under the management agreement Leading
Edge was to provide three types of services to Weekend Warrior:
Design, personnel, and management services. The design services
included research and development of trailer and other product
design plans, patent and trademark acquisition, and industry
trend analysis. The essence of the personnel services
arrangement was that Leading Edge accepted the transfer of all
employees of Weekend Warrior14 and promised to lease those
employees to Weekend Warrior on terms to be agreed on.
13
(...continued)
Designs, Inc., ESOP”. It also incorrectly shows the number of
shares that the retirement plan purchased as 9,900 rather than
9,990. These inconsistencies in the record do not affect our
resolution of the issues.
14
The management agreement refers to schedule B containing
the list of Weekend Warrior employees transferred to Leading
Edge, but schedule B was left blank.
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The last type of services, management services, was
described in schedule A attached to the management agreement.
Management services included “all executive management services
required by Weekend Warrior in order to conduct its business
operations” and consisted of three components: Executive
personnel services, fiscal services, and purchasing. With
respect to the first component, Leading Edge agreed to recruit,
select, hire, and supervise all executive personnel. The
executive personnel would perform the executive management
services for Weekend Warrior. According to schedule A, all
executive personnel were to be Leading Edge’s employees, and
Leading Edge was to enter into employment agreements with them
and pay their salaries and benefits. The second component of the
management services was fiscal services, which included cash
management, accounting, bookkeeping, accounts payable, and
recordkeeping. The last component of the management services was
the purchasing function. Under the management agreement, Leading
Edge became responsible for negotiating the purchase of all
supplies, equipment, materials, goods, and services necessary for
Weekend Warrior’s operations. The cost of supplies, equipment,
and materials remained the responsibility of Weekend Warrior.
Under the management agreement, Weekend Warrior was to
compensate Leading Edge as follows. Weekend Warrior was to pay
Leading Edge an initial payment of $4,175,000. That amount was
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payable for: (1) Design services and management services in
December 2002, (2) bonus payments to leased employees, and (3) as
an inducement by Weekend Warrior for Leading Edge to enter into
the management agreement.
According to the management agreement, for management
services provided in 2003, Leading Edge’s compensation was an
amount equal to 8 percent of Leading Edge’s annual gross
receipts, with a $150,000 minimum monthly payment. For personnel
services Weekend Warrior was to pay Leading Edge an amount equal
to 5 percent of the gross payroll and liabilities of all
employees leased to Weekend Warrior.
C. Operations After the Changes
1. In General
Weekend Warrior’s gross sales continued to increase at the
rate of 50 percent annually. In 2003 and 2004 Weekend Warrior
acquired a 51-percent interest in a factory in Caldwell, Idaho,
and a factory in southern California. Each facility had a
specific function. The main plant in Perris, California,
continued to manufacture lightweight trailer models. The second
facility in Perris, California, continued to build more expensive
heavy-duty wide-body products. By 2005 Weekend Warrior operated
four factories and produced trailers with 25 different
floorplans.
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Mr. Warmoth remained Weekend Warrior’s CEO and received
wages from both Leading Edge and Weekend Warrior. Sometimes,
however, he deferred payment because he did not need the money.
Mr. Warmoth signed documents on behalf of Weekend Warrior because
various vendors and other entities required Weekend Warrior’s
representative to sign documents.
Messrs. Stoap, Denton, and Hansen continued to report to Mr.
Warmoth. Mr. Hansen became a vice president of Weekend
Warrior.15 As a vice president, he was responsible for
overseeing five assembly lines, writing schedules, and ensuring
that production deadlines were met. He was no longer involved in
the day-to-day operations and was responsible for overseeing
multiple plants, so he delegated responsibilities. He remained
responsible for writing schedules but was no longer involved in
employee matters, such as hiring and firing. Suppliers continued
to bill Weekend Warrior for materials and supplies.
Leading Edge was located at the same address as Weekend
Warrior’s main manufacturing plant and main office. It was
housed in a mobile home on a lot next-door. Leading Edge had the
same phone number as Weekend Warrior. Leading Edge did not
manufacture any products.
15
Mr. Hansen testified that he became vice president of
manufacturing. Other references in the record indicate that Mr.
Hansen became vice president of production.
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The human resources department was organized at Leading
Edge. Tucker May (Mr. May), who had a small staff, worked on
human resources issues, including workers’ compensation. Instead
of placing advertisements for open positions, Mr. Hansen
contacted Mr. May regarding Weekend Warrior’s workforce needs,
which grew with the acquisitions of the two additional factories.
Leading Edge advertised open positions, interviewed people, and
hired employees on the basis of Mr. Hansen’s requirements. Mr.
Warmoth made all hiring decisions for Leading Edge.
Leading Edge used Paychex as a third-party service provider.
Weekend Warrior also used Paychex in 2000-2003. Paychex
processed payroll checks and prepared management reports,
including employee earnings statements, payroll journals, month-
to-date department summaries, tax liabilities and deposits, and
worksheets to record the next month’s payroll. Both Weekend
Warrior and Leading Edge kept most payroll records at 1320
Oleander Avenue, Perris, California, but some records were kept
at the Paychex business locations. Weekend Warrior did not
provide health insurance benefits to its employees in 2000-2003.
Leading Edge did not provide health insurance benefits to its
employees in 2002-04.
Leading Edge maintained a portfolio account with Advest,
Inc. From August 2003 through December 2004 Leading Edge
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maintained a portfolio of stocks and received dividends.16
Leading Edge also maintained checking accounts with Foothill and
Comerica. Mr. Warmoth was the only individual with signature
authority on Leading Edge’s accounts.
2. 2002
From its incorporation on November 14, 2002, through
yearend, Mr. Warmoth was the only employee of Leading Edge. He
did not enter into a written employment agreement with Leading
Edge. In 2002 Leading Edge issued Weekend Warrior invoices for
management fees under the management agreement. The description
column of each invoice stated “Management Fee”. The amounts were
as follows:17
Date Amount
Sept. 30, 2002 $600,000
Oct. 31, 2002 680,000
Nov. 30, 2002 995,000
Dec. 31, 2002 700,000
Total 2,975,000
Weekend Warrior paid Leading Edge as follows:
Date Amount
Dec. 20, 2002 $600,000
Dec. 27, 2002 700,000
Dec. 30, 2002 680,000
Dec. 31, 2002 995,000
Total 2,975,000
16
The record does not contain Advest, Inc. account
statements for other periods.
17
These invoices are the only invoices issued by Leading
Edge to Weekend Warrior contained in the record.
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Weekend Warrior continued having cashflow problems. Leading
Edge made the following payments to Weekend Warrior:
Date Amount
Dec. 27, 2002 $600,000
Dec. 28, 2002 650,000
Dec. 30, 2002 660,000
Total 1,910,000
Weekend Warrior reported a note payable of $1,910,000, and
Leading Edge reported a note receivable from Weekend Warrior in
the same amount.
For 2002 Mr. Warmoth received wage income of $200,808 from
Weekend Warrior and $38,100 from Leading Edge. Leading Edge did
not issue any Forms W-2, Wage and Tax Statement, for 2002, nor
did it report any Form W-2 wages during 2002. Leading Edge also
did not make any quarterly employment tax deposits during 2002.
On December 30, 2002, Mr. Warmoth, as the sole director of
Leading Edge, executed a resolution stating that he was the only
employee entitled to participate in the deferred compensation
plan for 2002 and that his compensation thereunder was $4
million.
3. 2003
At some point during 2003 Weekend Warrior employees were
transferred to Leading Edge, and Leading Edge started leasing
those employees to Weekend Warrior.18 Leading Edge did not issue
18
No documents are available regarding the employee
(continued...)
- 22 -
a formal letter of employment or enter into employment contracts
when hiring new employees.
Employees began receiving their paychecks from Leading Edge.
Many employees normally cashed their paychecks at liquor stores,
and those employees encountered problems because the stores did
not know what Leading Edge was. The transfer of Weekend
Warrior’s employees to Leading Edge and the interruption in the
employees’ length of employment also became a problem for
employees who were buying houses.
During 2003 Weekend Warrior made the following payments by
check to Leading Edge for management and design services:
Date Amount
Aug. 15, 2003 $100,000
August 2003 200,000
Aug. 21, 2003 100,000
Aug. 31, 2003 400,000
Oct. 3, 2003 100,000
Oct. 6, 2003 150,000
Oct. 7, 2003 100,000
1
Total 1,150,000
1
In stipulation No. 207 the parties incorrectly totaled
these payments.
During 2003 Weekend Warrior accrued a management fee
liability of $2,276,081. As of December 31, 2003, Weekend
Warrior reported an accrued management fee of $3,476,081 due to
Leading Edge.
18
(...continued)
transfer. Other than the management agreement, no documents are
available regarding employee leasing either.
- 23 -
During 2003 Leading Edge made the following payments to
Weekend Warrior:
Date Amount
Jan. 2, 2003 $980,000
July 1, 2003 400,000
Sept. 12, 2003 100,000
Total 1,480,000
During 2003 Mr. Warmoth received $66,500 from Weekend
Warrior and $316,700 from Leading Edge.19 Mr. Hansen received
wages of $41,066 from Weekend Warrior and of $404,340 from
Leading Edge. Mr. Stoap received $175,634 in wages from Leading
Edge only. Mr. Denton received $187,441 in wages from Leading
Edge only. Leading Edge paid combined wages of $1,084,115 to Mr.
Warmoth and the three top managers, whereas Weekend Warrior paid
them $107,566 in combined wages. Both Leading Edge and Weekend
Warrior issued Forms W-2 to most employees.
Leading Edge did not file a Form 941, Employer’s Quarterly
Federal Tax Return, for the quarter ended March 31, 2003.
Weekend Warrior did not file Forms 941 for the quarters ended
September and December 2003.20 Leading Edge filed Forms 941 for
those quarters. Weekend Warrior claimed a worker compensation
deduction of $213,543 for 2003.
19
The record contains copies of checks totaling $244,528
that Leading Edge issued to Mr. Warmoth in 2003.
20
The parties’ stipulations Nos. 212 and 215 are
contradictory as to whether Weekend Warrior filed a Form 941 for
the quarter ended Mar. 31, 2003.
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As of the plan year ended December 31, 2003, the retirement
plan had 181 participants and/or beneficiaries.
On December 30, 2003, Mr. Warmoth, as the sole director,
executed a resolution stating that he was the only employee
entitled to participate in the deferred compensation plan and
that his compensation thereunder for 2003 was $4.1 million.
4. 2004
By letter dated February 23, 2004, the Internal Revenue
Service determined that the retirement plan and related trust
were designed in accordance with the applicable sections of the
Code.
Weekend Warrior made the following transfers by phone from
its Comerica account to Leading Edge’s Comerica account:
Date Amount
May 13, 2004 $174,467
May 20, 2004 160,000
May 24, 2004 349,634
Total 684,101
During 2004 Mr. Warmoth received wages of $125,000 from
Leading Edge but did not receive any wages from Weekend Warrior.
Leading Edge paid the top managers wages as follows: (1) Mr.
Denton, $225,920, (2) Mr. Hansen, $36,115, and (3) Mr. Stoap,
- 25 -
$183,761. Leading Edge thus paid the top managers and Mr.
Warmoth $570,796 in wages.21
Weekend Warrior did not file Forms 941 for any quarters in
2004. Leading Edge issued Forms W-2 for 2004 and filed Forms 941
for every quarter of 2004.
Weekend Warrior continued to experience working capital
shortfalls, and it borrowed money from Leading Edge and Mr.
Warmoth. Between April 1 and December 31, 2004, Weekend Warrior
signed several promissory notes. On April 1, 2004, Weekend
Warrior signed two notes promising to pay Leading Edge $1,075,000
and $2,971,882. On December 31, 2004, Weekend Warrior executed
additional promissory notes for $3,169,987, $430,934, and
$3,653,062 reflecting loans from Leading Edge.
Upon Mr. Lindsey’s advice, on June 1, 2004, Leading Edge
acquired all of its shares from the retirement plan. According
to the stock repurchase agreement dated June 1, 2004, Leading
Edge purchased 9,990 shares of common stock held by the
retirement plan for $150,000. Mr. Warmoth again became Leading
Edge’s sole shareholder. Mr. Mitchellweiler’s firm prepared the
documents related to the sale. Mr. Baily valued the shares at
21
The record contains no information as to wages Weekend
Warrior paid any individuals for 2004, other than that Mr.
Warmoth received no wages from Weekend Warrior.
- 26 -
$189,500.22 The reason for the 2004 sale was a change in rules
under section 409(p) that made the structure unattractive.
As of the plan year ended December 31, 2004, the retirement
plan had 226 participants and/or beneficiaries.
5. After 2004
The parties stipulated that Leading Edge was inactive after
December 31, 2004.23 The retirement plan was terminated and was
converted into a profit-sharing plan which stayed in effect until
Mr. Warmoth started experiencing financial difficulties. Since
2006 and as of the date of trial, the retirement plan had been in
the process of winding down and distributing assets to its
beneficiaries. Weekend Warrior ceased operations in July 2008
because of cashflow problems.24
22
Mr. Baily’s appraisal is dated July 21, 2004. Mr. Baily
valued Leading Edge on the basis of historic earnings. Mr. Baily
subtracted $4 million and $4.1 million for 2002 and 2003,
respectively, from Leading Edge’s operating profits to account
for Mr. Warmoth’s compensation under the deferred compensation
plan.
23
Contrary to the parties’ stipulation, the record contains
Leading Edge’s 2005 and 2006 Forms 1120S, U.S. Income Tax Return
for an S Corporation, showing gross sales of $29,866,317 and
$39,420,742, respectively.
24
At some point Mr. Warmoth “lost control” of accounting.
In October 2007, to Mr. Warmoth’s surprise, Weekend Warrior lost
money for the first time. In Mr. Warmoth’s words, “the books
were being bent so we could borrow more money from a bank and pay
bonuses every step of the way.” In addition, warranties that
Weekend Warrior authorized its dealers to extend and that should
have been shown as payables were not reflected in Weekend
Warrior’s accounting records. On a date that does not appear in
(continued...)
- 27 -
III. The Airplane and Boat
A. The Airplane
During 2002 Weekend Warrior purchased an airplane. The
Purchase Order/Aircraft Purchase Agreement shows Mr. Warmoth as
the buyer. The U.S. Department of Transportation, Federal
Aviation Administration, Certificate of Aircraft Registration,
however, shows Weekend Warrior’s name but lists its address as
8635 Moovalya Dr., Parker, Arizona.
The airplane was based out of Parker, Arizona. Between
December 31, 2001, and January 1, 2005, Weekend Warrior had no
manufacturing operations in Arizona, but from July 30, 1999,
through December 1, 2003, Mr. Warmoth owned property there.
Accounting and pilot flight logs do not list any business
purpose for flights on the airplane. During 2002-04 Weekend
Warrior did not maintain a contemporaneous mileage log describing
the purposes of any flights.
B. The Boat
In January 2001 Mr. Warmoth and Weekend Warrior purchased a
boat. The Marine Purchases Agreement provides that “Mark Warmoth
24
(...continued)
the record, the bank stopped lending money to Weekend Warrior.
Weekend Warrior ceased operations in July 2008 after it filed the
petition, but it did not file a bankruptcy petition. Comerica
“took” all valuable assets of Weekend Warrior and Leading Edge,
including the names “Weekend Warrior Trailers” and “Leading Edge
Design” and Mr. Warmoth’s patents. The record is not clear on
whether Comerica owns Weekend Warrior stock.
- 28 -
(Weekend Warrior)” was the purchaser and lists Mr. Warmoth’s
address in California. It was a river boat to be used on the
Colorado River. Mr. Warmoth owned a house on the river where he
entertained almost every weekend in both summer and winter.
Weekend Warrior did not maintain a contemporaneous log regarding
the business use of the boat.
IV. Weekend Warrior’s Loans to Mr. Warmoth
On its Schedules L, Balance Sheets Per Books, which are a
part of the Forms 1120, U.S. Corporation Income Tax Return, and
Forms 1120S, Weekend Warrior reported loans to shareholders as
follows:
Year Loan amount
2002 $1,205,325
2003 2,019,153
2004 3,421,458
During the years at issue Mr. Warmoth was Weekend Warrior’s only
shareholder.
V. Procedural History
Weekend Warrior timely filed its 2002 Form 1120 pursuant to
an extension. Weekend Warrior filed its 2003 Form 1120S25 and
timely filed its 2004 Form 1120S pursuant to an extension.
Weekend Warrior claimed deductions for management and
employee leasing fees paid to Leading Edge as follows:
25
It is not clear whether Weekend Warrior filed its 2003
Form 1120S timely.
- 29 -
Year Management fee Employee leasing fee
2002 $4,175,000 -0-
2003 4,800,000 $13,067,430
1
2004 4,595,000 14,055,577
1
On the 2004 Form 1120S, Weekend Warrior reported a
$1,626,198 deduction for designer costs and a $2,968,802
deduction for marketing services.
During the years at issue Weekend Warrior claimed
depreciation deductions with respect to the airplane as follows:
Year Special depreciation Depreciation Total depreciation
2002 $160,000 $74,667 $234,667
2003 -0- 170,667 170,667
2004 -0- 170,667 170,667
Weekend Warrior also claimed other airplane-related expenses.
Weekend Warrior claimed depreciation with respect to the
boat as follows:
Year Depreciation
2002 $30,661
2003 21,897
2004 21,897
Leading Edge filed its 2002-04 Forms 1120S.26 Leading Edge
included in its income management and employee leasing fees as
follows:
26
Leading Edge filed its 2002 and 2003 Forms 1120S timely,
but it is not clear whether the 2004 Form 1120S was filed timely.
- 30 -
Year Management fee Employee leasing fee
2002 $4,175,000 -0-
2003 4,800,000 $13,067,430
1 1
2004 2,000,000 17,371,877
1
The parties stipulated that “The Gross Receipts claimed by
Leading Edge Design’s [sic] include management fee income in the
amount of $4,595,000 and employee leasing income in the amount of
$14,055,577 for the taxable year 2004.” However, on its 2004
Form 1120S Leading Edge reported income amounts as shown in the
table above. The categories of income as stipulated by the
parties total $18,650,577, whereas the 2004 Form 1120S shows they
total $19,371,877. We disregard this stipulation as inconsistent
with the record. See Cal-Maine Foods, Inc. v. Commissioner, 93
T.C. 181, 195 (1989).
Leading Edge also reported gross income consisting of $5,704
of miscellaneous income for 2003 and $2,205 of other income and
$176,495 of investment income for 2004.
Mr. Warmoth filed his 2002-04 Forms 1040, U.S. Individual
Income Tax Return.27 On his Forms 1040 Mr. Warmoth reported (1)
passive income of $4,134 from Leading Edge for 2002; (2)
nonpassive income of $4,014 from Leading Edge and a nonpassive
loss of $22,281 from Weekend Warrior for 2003; and (3) a
nonpassive loss of $167,006 from Leading Edge and nonpassive
income of $400,168 from Weekend Warrior for 2004.
On December 28, 2007, respondent issued a notice of
deficiency to Weekend Warrior for 2002 and a notice of deficiency
to Mr. Warmoth for 2002 and 2003. On April 21, 2008, respondent
27
It is not clear whether the 2002 Form 1040 was timely
filed. The 2003 and 2004 Forms 1040 were filed timely pursuant
to extensions.
- 31 -
issued a notice of deficiency to Mr. Warmoth for 2004. The
notices of deficiency issued to Mr. Warmoth included adjustments
consistent with adjustments to the corporate returns from the
examination of Weekend Warrior’s Forms 1120S for 2003 and 2004
and the examination of Leading Edge’s Forms 1120S for 2002-04.
With respect to Weekend Warrior’s tax year 2002, respondent
determined that $4,131,433 of the management fee deduction should
be disallowed. Respondent calculated the adjustment to the
management fee deduction using the section 482 principles.
Respondent also adjusted forgone interest and ending inventory
and disallowed depreciation and other deductions. With respect
to the partial management fee deduction disallowance, respondent
stated:
The deduction had been adjusted to the amount verified.
This item is not an allowable deduction.
Because there is no business purpose for this
transaction your deduction is denied.
See Economist’s Report Attached.
Alternatively, Leading Edge Design, Inc. should be
disregarded for Federal income tax purposes as Leading
Edge Design, Inc. lacked both economic substance and
economic purpose and was formed for the primary
purpose of obtaining tax benefits.
Transactions entered into between Leading Edge Design,
Inc. and Weekend Warrior Trailers, Inc. should be
disregarded for Federal income tax purposes. These
transactions lacked economic substance and economic
purpose and were entered into for primary purpose
of obtaining tax benefits.
- 32 -
Respondent also determined that a section 6662(a) penalty
applied. Specifically, respondent determined that section
6662(h) applied to the entire underpayment and calculated the
amount of the penalty on the entire underpayment using the 40-
percent rate.28
With respect to Mr. Warmoth’s 2002 return, respondent
adjusted income reported on Schedule E, Income or Loss From
Partnerships and S Corporations, from Leading Edge by negative
$4,132. Respondent also determined that in 2002 Mr. Warmoth
received a $41,343 dividend. Respondent determined that a 20-
percent penalty under section 6662(a) applied.
With respect to Mr. Warmoth’s 2003 and 2004 returns,
respondent made the following adjustments to Mr. Warmoth’s
Schedules E:29
28
At the same time, however, the attachment to the notice of
deficiency titled “200212-Adjustments Subject to Accuracy-Related
Penalty-IRC 6662” indicates that only the underpayment resulting
from the adjustment to the management fee deduction is
attributable to a gross valuation misstatement. According to
this attachment, the underpayment resulting from the remaining
adjustments is attributable to negligence or disregard of rules
or regulations. We address respondent’s inconsistent penalty
determination infra pp. 70-71.
29
Respondent did not enumerate the adjustments to Weekend
Warrior’s return in the notices of deficiency issued to Mr.
Warmoth but simply stated: “We adjusted your return in
accordance with the examination results of the S corporation
return (Form 1120S) of which you are a shareholder.”
- 33 -
Per return Per exam Adjustment
2003
Leading Edge $4,014 $954 ($3,060)
Weekend Warrior 417,171 3,941,354 3,524,183
2004
Leading Edge $167,006 ($390,004) ($222,998)
Weekend Warrior 400,168 1,968,331 1,568,163
In the Forms 886-A, Explanation of Items, attached to Mr.
Warmoth’s notices of deficiency, respondent then stated that (1)
“Leading Edge Design, Inc. should be disregarded for Federal
income tax purposes as Leading Edge Design, Inc. lacked both
economic substance and economic purpose and was formed for the
primary purpose of obtaining tax benefits”, and (2) “Transactions
entered into between Leading Edge Design, Inc. and Weekend
Warrior Trailers, Inc. should be disregarded for Federal Income
tax” purposes because they lacked economic substance and economic
purpose and were entered into for the primary purpose of
obtaining tax benefits. Respondent calculated the adjustments to
the management fee deductions for each year using the principles
of section 482. Respondent also determined that Mr. Warmoth’s
underpayments were attributable to negligence or disregard of
rules or regulations, substantial understatement of income tax,
or substantial valuation misstatement and that a 20-percent
accuracy-related penalty under section 6662(a) applied.
After the cases were calendared for trial, we continued the
cases. After the cases were calendared for trial again,
- 34 -
respondent filed motions for leave to file an amendment to answer
in each docket, which we granted. In the amendment to answer in
docket No. 6984-08 respondent asserted an increased deficiency
and the section 6662(a) penalty with respect to Weekend Warrior’s
2002 return as follows:
Notice of Amendment to
deficiency answer
Deficiency $1,117,383 $1,132,230
Sec. 6662(a) penalty 446,953 452,892
The increase in the deficiency results from respondent’s
determination to disallow the management fee deduction in full.30
Accordingly, respondent’s adjustments, as amended, to Weekend
Warrior’s Form 1120 for 2002 are as follows:
Adjustment Amount
Depreciation $256,279
Repairs and maintenance--aircraft 40,199
Other--insurance aircraft 21,500
Other deductions--aircraft fees 614
Other deductions--pilot 5,657
Management fees 4,175,100
Balance sheet--forgone interest 41,343
Cost of goods sold--ending inventory 240,029
Total 4,780,721
In the amendment to answer respondent again calculated the
section 6662(a) penalty using the 40-percent rate.
30
Because in the notice of deficiency respondent had
disallowed $4,131,433 of the management fee deduction, the
additional disallowance of that deduction is $43,667 rather than
$43,567, as respondent states in the amendment to answer.
- 35 -
In the amendments to answers in dockets Nos. 6997-08 and
15166-08 respondent asserted increased deficiencies and accuracy-
related penalties with respect to Mr. Warmoth’s 2003 and 2004
returns as follows:
Notice Amendment to
of deficiency answer
2003
Deficiency $1,252,944 $1,862,245
Sec. 6662(a) penalty 250,589 372,449
2004
Deficiency 471,615 1,932,273
Sec. 6662(a) penalty 94,323 386,455
For both years the increased deficiencies result from
respondent’s determination to totally disallow the management fee
deductions claimed on Weekend Warrior’s 2003 and 2004 Forms
1120S.31
In the amendments to answers respondent asserted that
Leading Edge should be disregarded for Federal income tax
purposes because it lacked a legitimate business purpose and
31
In the amendment to answer in docket No. 6997-08
respondent explained that in the notice of deficiency issued to
Mr. Warmoth for 2003 he disallowed $3,059,142 of the design and
marketing services fee and failed to disallow the remaining
$1,740,858. In the amendment to answer in docket No. 15166-08,
respondent explained that in the notice of deficiency issued to
Mr. Warmoth for 2004 he disallowed $490,946 of the design costs
and marketing services fee deduction on Weekend Warrior’s 2004
Form 1120S and failed to disallow the remaining $4,104,054.
Because Weekend Warrior was an S corporation in 2003 and 2004,
the adjustments affected Mr. Warmoth’s returns. See secs.
1363(a), 1366.
- 36 -
economic substance and was formed for the sole purpose of
obtaining tax benefits. Respondent also stated in the
alternative that any agreements or transactions between Leading
Edge and Weekend Warrior should be disregarded for Federal income
tax purposes because they lacked a legitimate business purpose
and economic substance and were entered into for the primary
purpose of obtaining tax benefits. Respondent also stated in the
alternative that (1) the payments from Weekend Warrior to Leading
Edge “were [not] paid or incurred in the ordinary and necessary
course of business” under section 162, and (2) a redistribution
or reallocation under section 482 is necessary to prevent the
evasion of taxes or to clearly reflect income.
In the Forms 4549-B, Income Tax Examination Changes,
attached to the amendments to answers in docket Nos.
6997-08 and 15166-08, respondent explained all adjustments to
Weekend Warrior’s 2003 and 2004 Forms 1120S as follows:
Adjustment 2003 2004
Depreciation $127,859 $127,829
Repairs and maintenance--aircraft 27,600 27,600
Other--insurance aircraft 15,000 15,000
Other deductions--aircraft fees 429 429
Other deductions--pilot 3,947 3,947
Management fees 4,800,000 4,595,000
Balance sheet--forgone interest 69,256 117,356
Cost of goods sold--ending inventory 220,950 785,056
Total adjustments 5,265,041 5,672,217
- 37 -
OPINION
I. Burden of Proof in General
Generally, the Commissioner’s determinations in the notice
of deficiency are presumed correct, and the taxpayer bears the
burden of proving that they are incorrect. See Rule 142(a);
Welch v. Helvering, 290 U.S. 111, 115 (1933). Rule 142(a)
provides: “The burden of proof shall be upon the petitioner,
except as otherwise provided by statute or determined by the
Court; and except that, in respect of any new matter, increases
in deficiency, and affirmative defenses, pleaded in the answer,
it shall be upon the respondent.” In Shea v. Commissioner, 112
T.C. 183, 197 (1999), we stated:
where a notice of deficiency fails to describe the
basis on which the Commissioner relies to support a
deficiency determination and that basis requires the
presentation of evidence that is different than that
which would be necessary to resolve the determinations
that were described in the notice of deficiency, the
Commissioner will bear the burden of proof regarding
the new basis. * * *
The allocation of the burden of proof in these cases is not
a simple matter. Bearing in mind the general principles stated
above, we shall describe the burden of proof allocation as it
pertains to specific adjustments in each relevant section below.
Petitioners do not contend that section 7491(a) shifts the burden
of proof to respondent, nor does the record establish that
petitioners satisfy the section 7491(a)(2) requirements.
Accordingly, section 7491(a) does not affect our conclusions.
- 38 -
II. The Management Fee Deductions
A. Statutory Background
Generally, an S corporation is defined as a small business
corporation for which an election under section 1362(a) is in
effect for such year. Sec. 1361(a)(1). An S corporation is not
subject to Federal income taxes. Sec. 1363(a); see also Taproot
Admin. Servs., Inc. v. Commissioner, 133 T.C. 202, 204 (2009).
Like a partnership, an S corporation is a conduit through which
income flows to its shareholders, resulting in only one level of
taxation. See Taproot Admin. Servs., Inc. v. Commissioner, supra
at 204 (quoting Gitlitz v. Commissioner, 531 U.S. 206, 209
(2001)). The passthrough taxation system applicable to S
corporations includes detailed eligibility rules at both the
corporate and shareholder levels. See, e.g., sec. 1361(b)-(d).
Some of the eligibility rules are incorporated into the
definition of small business corporation. See sec. 1361(b)(1).
In 1996 Congress expanded the definition of a small business
corporation to allow certain tax-exempt organizations to own S
corporation stock. See Small Business Job Protection Act of
1996, Pub. L. 104-188, sec. 1316(a), 110 Stat. 1785; see also
Taproot Admin. Servs., Inc. v. Commissioner, supra at 205.
Section 1361(c)(6) now permits qualified pension, profit-sharing,
and stock bonus plans (within the meaning of section 401(a)) and
exempt organizations (within the meaning of section 501(a) and
- 39 -
(c)(3)) to hold S corporation stock. See also Taproot Admin.
Servs., Inc. v. Commissioner, supra at 205 n.5. In expanding the
list of eligible shareholders in this manner, Congress intended
to encourage employee ownership of closely held businesses and to
facilitate the establishment of ESOPs by S corporations. S.
Rept. 104-281, at 60-61 (1996); see also S. Prt. 107-30, at 123
(2001). As a consequence of ESOPs’ holding shares in S
corporations, S corporation profits may generally escape current
taxation.32
In some circumstances, however, the expanded eligible
shareholder rules resulted in inappropriate tax deferral.33 To
32
In 1997 Congress enacted other provisions affecting
taxation of S corporations. See, e.g., Taxpayer Relief Act of
1997, Pub. L. 105-34, sec. 1523(a), 111 Stat. 1070-1071 (amending
sec. 512(e) to repeal the application of the unrelated business
income tax to ESOPs for years beginning after Dec. 31, 1997).
33
In United States v. Stover, 731 F. Supp. 2d 887, 891, 895
(W.D. Mo. 2010) (an action under sec. 7408), the court described
the transaction in which
a business owner [formed] a separate business
denominated as a management company. The “operating
company”--the initial, pre-existing business--retains
the new company to perform “management services.” Fees
paid to the management company are expenses that reduce
the operating company’s taxable income. * * *
* * * * * * *
In this structure, the management company was an S
corporation. The management company then formed an
ESOP, which owned the management company’s stock. The
same person or persons who owned the operating and
managing companies were also the only beneficiaries of
(continued...)
- 40 -
address concerns about ownership structures involving S
corporations and ESOPs, in 2001 Congress added section 409(p).
See Economic Growth and Tax Relief Reconciliation Act of 2001,
Pub. L. 107-16, sec. 656(a), 115 Stat. 131. For ESOPs created
after March 14, 2001, section 409(p) was effective for plan years
ending after March 14, 2001. See id. sec. 656(d), 115 Stat. 135.
Section 409(p) is intended to limit the tax benefits of ESOPs
maintained by S corporations to situations where the ESOP
provides meaningful benefits to rank-and-file employees. See S.
Prt. 107-30, supra at 123-124. The legislative history explains:
the Committee has become aware that the present-law
rules allow inappropriate deferral and possibly tax
avoidance in some cases.
The Committee continues to believe that S corporations
should be able to encourage employee ownership through
an ESOP. The Committee does not believe, however, that
ESOPs should be used by S corporation owners to obtain
inappropriate tax deferral or avoidance.
Specifically, the Committee believes that the tax
deferral opportunities provided by an S corporation
ESOP should be limited to those situations in which
there is broad-based employee coverage under the ESOP
33
(...continued)
the ESOP. The management fees paid by the operating
company obtained an indefinite deferral: the income to
the management company was not taxed because it made an
election under subchapter S, and an ESOP’s income is
not subject to taxation. Thus, the operating company
gains a deduction in the amount of the management fees,
and those fees are not taxed until money is distributed
from the ESOP. [Fn. ref. omitted.]
- 41 -
and the ESOP benefits rank-and-file employees as well
as highly compensated employees and historical owners.
Id.
Under section 409(p)(1), an ESOP holding employer securities
consisting of stock in an S corporation must provide that no
portion of the assets of the plan attributable to (or allocable
in lieu of) such employer securities may, during a nonallocation
year, accrue (or be allocated directly or indirectly) for the
benefit of any disqualified person. If a plan fails to meet
these requirements, it is treated as having distributed to any
disqualified person the amount allocated to the account of such
person. See sec. 409(p)(2). A nonallocation year occurs when
disqualified persons own at least 50 percent of the number of
shares of stock in the S corporation. Sec. 409(p)(3). Whether
an owner is a disqualified person depends on a person’s deemed-
owned shares of S corporation stock held by an ESOP. Under
section 409(p)(4), a person is a disqualified person if that
person is either (1) a member of a deemed 20-percent shareholder
group, or (2) a deemed 10-percent shareholder.
B. Deductions at Issue and Respondent’s Arguments
Respondent is not challenging the employee leasing fee
deductions that Weekend Warrior reported. Rather, he disallowed
the deductions for management fees, which Weekend Warrior
reported under the categories “Management Fees” for 2002, “Design
and Marketing Services” for 2003, and “Designer Costs” and
- 42 -
“Marketing Services” for 2004. Because under the management
agreement Weekend Warrior paid Leading Edge for design,
management, and personnel services, we understand that respondent
challenged only the deductions claimed for payments under the
design and management portions of the agreement.
As for the grounds for the disallowance, in the opening
brief respondent repeats his position in the amendments to
answers, which is described above. See supra pp. 33-36. In his
reply brief respondent also argues that the sale of Leading Edge
stock to the retirement plan lacked a business purpose.
Respondent contends that establishing the retirement plan as an
incentive for the employees was not the true purpose of the
structure. Respondent points to the short lifespan of the
retirement plan and the fact that as soon as the changes to
section 409 made the ESOP arrangement less appealing from a tax
standpoint, the retirement plan’s shares were redeemed and Mr.
Warmoth became Leading Edge’s sole shareholder.
As a general rule, the Court will not consider issues first
asserted on brief. See Sundstrand Corp. & Subs. v. Commissioner,
96 T.C. 226, 346-349 (1991). When issues are presented in the
reply brief only, there is an even stronger reason to disregard
them. See Estate of Sparling v. Commissioner, 60 T.C. 330, 350
(1973), revd. on another issue 552 F.2d 1340 (9th Cir. 1977).
- 43 -
Accordingly, we shall not consider whether the sale of Leading
Edge stock to the retirement plan lacked a business purpose.
C. Burden of Proof Issues
Generally, deductions are a matter of legislative grace, and
the taxpayer must show that he or she is entitled to any
deduction claimed. Rule 142(a); Deputy v. du Pont, 308 U.S. 488,
493 (1940). In the amendments to answers respondent asserted
increased deficiencies for 2002 with respect to Weekend Warrior
and for 2003 and 2004 with respect to Mr. Warmoth. As described
above, the increased deficiencies are attributable solely to full
rather than partial disallowance of the management fee
deductions. Under Rule 142(a) respondent bears the burden of
proof in respect to the increases in deficiency as follows: (1)
$43,567 of the management fee deduction Weekend Warrior claimed
for 2002; and (2) $1,740,858 and $4,104,054 of the design and
marketing services deductions Weekend Warrior claimed for 2003
and 2004, respectively.
Petitioners do not contend that section 162 constitutes a
new matter that affects the burden of proof allocation, see Shea
v. Commissioner, 112 T.C. at 197, and we conclude it is not. The
notice of deficiency issued to Weekend Warrior for 2002 is
broadly worded (“This item is not an allowable deduction.”). In
the amendment to answer respondent cited section 162, which is
not inconsistent with the language in the notice of deficiency,
- 44 -
and accordingly, the assertion of section 162 does not constitute
a new matter. See Abatti v. Commissioner, 644 F.2d 1385 (9th
Cir. 1981), revg. T.C. Memo. 1978-392; Achiro v. Commissioner, 77
T.C. 881, 890 (1981). For 2003 and 2004 (as well as 2002) the
section 162 argument requires evidence that is generally
consistent with the grounds for disallowance proffered in the
notices of deficiency, such as economic substance and sham
entity. Accordingly, the section 162 argument does not
constitute a new matter.34 See Shea v. Commissioner, supra at
197; Achiro v. Commissioner, supra at 890.
D. Deductibility of the Management Fees
We now address the deductibility of the management fees.
1. Sham Entity
Relying on Moline Props., Inc. v. Commissioner, 319 U.S. 436
(1943), respondent contends that Leading Edge should be
disregarded for Federal income tax purposes because it lacked a
legitimate business purpose and economic substance and was formed
for the sole purpose of obtaining tax benefits. Respondent
argues that Mr. Warmoth was motivated by a desire to reduce
Weekend Warrior’s taxable income and that the incorporation of
Leading Edge was merely an accounting arrangement to funnel
income away from Weekend Warrior. Respondent contends that the
34
We do not address whether the sec. 482 argument
constituted a new matter with respect to any year because we do
not resolve the management fee issue on the grounds of sec. 482.
- 45 -
structure allowed Weekend Warrior to claim management fee
deductions without incurring real costs because Leading Edge then
lent money to Weekend Warrior. Respondent also argues that
Leading Edge did not carry on business activity after it was
formed because it had only one client, that Mr. Warmoth’s design
work did not change, that the invoices for management services do
not describe what work was done or who performed it, and that
Leading Edge performed no functions that Weekend Warrior had not
performed before Leading Edge’s creation.
Generally, “a taxpayer may adopt any form he desires for the
conduct of his business and * * * the chosen form cannot be
ignored merely because it results in a tax saving.” Bass v.
Commissioner, 50 T.C. 595, 600 (1968); see also Aldon Homes, Inc.
v. Commissioner, 33 T.C. 582, 596-597 (1959). However, to be
respected, the form the taxpayer chooses must be a viable
business entity. In Moline Props., Inc. v. Commissioner, supra
at 438-439, the Supreme Court observed:
Whether the purpose be to gain an advantage under the
law of the state of incorporation or to avoid or to
comply with the demands of creditors or to serve the
creator’s personal or undisclosed convenience, so long
as that purpose is the equivalent of business activity
or is followed by the carrying on of business by the
corporation, the corporation remains a separate taxable
entity. [Fn. refs. omitted.]
See also Bass v. Commissioner, supra at 600-601; Aldon Homes,
Inc. v. Commissioner, supra at 596-597.
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Petitioners proffer several potentially legitimate business
reasons for incorporating Leading Edge. Petitioners suggest that
they were motivated by the desire to establish an incentive plan
for rank-and-file employees. Several witnesses testified that
the purpose of the plan was to provide equity ownership as a
performance incentive for employees and to encourage employees to
remain with the company. However, viewing the ESOP through the
lens of the deferred compensation plan that benefited solely Mr.
Warmoth casts doubt that the benefits to rank-and-file employees
were more than minimal. This reason also appears questionable in
the light of Mr. Warmoth’s testimony that in 2004 Leading Edge
repurchased the shares because “the Government had changed the
law and it was not a good deal anymore.”
Petitioners also claim the rapid business growth was a
reason for incorporating Leading Edge. The record shows that
Weekend Warrior was experiencing significant sales growth at the
time the ESOP was established, with gross sales increasing from
$18.7 million in 2000 to $24.3 million in 2001. Mr.
Mitchellweiler testified that it was projected Weekend Warrior
would have divisions and subsidiaries and that it became apparent
that centralizing management would create efficiencies. Under
the plan Leading Edge would take all employees and lease them to
various related entities that would be formed in the future. The
employees would be able to contract with multiple entities from a
- 47 -
single source. According to Mr. Warmoth, the reorganization
would allow Leading Edge to handle some of the responsibilities
that Mr. Warmoth had previously handled. It was accomplished by
moving certain operations from Weekend Warrior to Leading Edge;
Weekend Warrior would remain the manufacturing entity.
The record contains no credible evidence, however, that any
additional divisions were organized in years after 2001, despite
sales of $43.7 million, $67.9 million, and $85.9 million in 2002,
2003, and 2004, respectively. There is no credible evidence in
the record that the new structure allowed Weekend Warrior to
achieve cost savings or efficiencies or that it resulted in any
meaningful changes in business operations.
Petitioners suggest that isolating manufacturing liability
and protecting value were additional reasons for incorporating
Leading Edge. Mr. Warmoth was concerned about product liability
in particular given that at some point before 2002, Weekend
Warrior had become involved in a personal injury lawsuit.35 A
wheel came off a trailer, went onto incoming traffic, and injured
a person. Mr. Warmoth’s team of advisers believed that shifting
value away from Weekend Warrior was desirable from a product
liability standpoint. Yet no credible evidence in the record
corroborates petitioners’ proffered theory. Petitioners do not
35
The plaintiffs also sued Mr. Warmoth, the chassis company,
the dealer, the tire company, the rim company, and the axle
company.
- 48 -
claim they considered additional liability insurance or evaluated
whether the corporate shield of Leading Edge would have practical
significance in case of a lawsuit. Cf. Aldon Homes, Inc. v.
Commissioner, supra at 597-598.
Even if a corporation was not formed for a valid business
purpose, it nevertheless must be respected for tax purposes if it
actually engaged in business activity. See Moline Props., Inc.
v. Commissioner, 319 U.S. at 438-439; Bass v. Commissioner, supra
at 602. The prongs of the test under Moline Props. are
alternative prongs. See Moline Props., Inc. v. Commissioner,
supra at 438-439; Bass v. Commissioner, supra at 602; see also
Rogers v. Commissioner, T.C. Memo. 1975-289 (“Moline establishes
a two-pronged test, the first part of which is business purpose,
and the second, business activity. * * * Business purpose or
business activity are alternative requirements.”). Accordingly,
the issue turns on whether Leading Edge engaged in business
activity. Whether a corporation is carrying on sufficient
business activity to require its recognition as a separate entity
is a question of fact. Bass v. Commissioner, supra at 602
(status of a corporation respected when testimony established
that “the corporation was managed as a viable concern, and not as
simply a lifeless facade.”)
On this record we decline to hold that Leading Edge was a
“lifeless facade”. See id. Leading Edge provided personnel
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services to Weekend Warrior. It maintained an investment account
and bank accounts. It paid its employees by check, adopted a
retirement plan, which respondent does not timely argue was a
sham, kept books and records, and engaged Mr. Baily to appraise
its stock. Leading Edge invested excess funds and at least from
August 2003 through December 2004 purchased and sold stocks and
received dividends. Corporate formalities were followed.
Leading Edge filed Federal income tax and employment tax returns.
We conclude Leading Edge carried on sufficient business activity
to be recognized for Federal income tax purposes. See id. at
602.
2. Section 162
Respondent argues that the management fees are not
deductible under section 162. He concedes the expenses were
ordinary but contends the payments to Leading Edge were not
necessary or reasonable. We agree.
Generally, section 162 permits the taxpayer to deduct all
the ordinary and necessary expenses paid or incurred during the
taxable year in carrying on any trade or business. An expense is
necessary if it is helpful or appropriate to the taxpayer’s
business. Welch v. Helvering, 290 U.S. at 113. To be necessary,
the expense does not need to be absolutely essential. See id.
For an expense to be considered ordinary and necessary, it must
be reasonable in amount. United States v. Haskel Engg. & Supply
- 50 -
Co., 380 F.2d 786, 788-789 (9th Cir. 1967) (citing Commissioner
v. Lincoln Electric Co., 176 F.2d 815, 817 (6th Cir. 1949), revg.
a Memorandum Opinion of this Court). Only the portion of the
expense that is reasonable qualifies for a deduction under
section 162(a). United States v. Haskel Engg. & Supply Co.,
supra at 788-789.
Respondent is not challenging the deductibility of the
employee leasing fees Weekend Warrior paid, so we focus our
analysis only on the services that Leading Edge purportedly
provided under the management and design portions of the
management agreement. Whether the fees were reasonable and
necessary depends on what services Leading Edge actually
performed (as opposed to what the management agreement provided
it would perform). The record, however, is sparse as to the
details of the parties’ actual relationship. Leading Edge issued
no invoices to Weekend Warrior for 2003 and 2004. Of the four
invoices that Leading Edge issued for 2002, two predate the
incorporation of Leading Edge, raising questions regarding the
genuineness of the other two invoices as well. The invoices
contain only a general description “Management Fee”.
The record is also sparse regarding the identity of the
persons who allegedly supplied services on behalf of Leading Edge
under the management agreement. On the basis of the record as a
whole, we find that besides Mr. Warmoth, the top managers Messrs.
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Hansen, Stoap, and Denton could have provided some services that
might fall under the management agreement umbrella. Mr. Hansen
testified at trial, but his testimony did not explain how his
duties were divided between his employment with Weekend Warrior
and his work on Leading Edge’s behalf under the management
agreement. The record is devoid of any credible evidence
regarding other top managers’ jobs after 2002. In 2003 Messrs.
Stoap and Denton received wages from Leading Edge only, leading
to an inference that they performed all their work under the
management agreement. With no credible evidence as to Messrs.
Stoap’s and Denton’s jobs or the actual services they performed,
however, we are unable to find that they provided any services
under the management agreement.
The record with respect to Mr. Warmoth’s services and
responsibilities is a bit more substantial. Mr. Warmoth
testified that his duties were split between the companies after
Leading Edge was organized. He testified also that after the
creation of Leading Edge his job consisted of obtaining reports
from the companies and managing vice presidents rather than being
involved in details. However, the record contains no details as
to what exactly Mr. Warmoth did under the management agreement.
When asked about the purpose of the management agreement, Mr.
Warmoth testified: “It’s where we drew the line on what the
responsibilities were from the manufacturing side of the company
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and the management or the Leading Edge Designs side of the
company. * * * It was--it was more a by-law than an agreement.
It said, Here’s what we’re gonna do for this fee and separated
the companies then.” Counsel then asked Mr. Warmoth what he did
through Leading Edge and under the management agreement. Mr.
Warmoth answered:
A: I don’t know specifically. I probably can--I
know it had to do with managing the employees and
managing the integral parts of the companies * * * So
we separated the operation into Leading Edge Designs
and the manufacturing facility so at that point I was
still doing the most important thing, which was the
design of the trailers, the concept of the whole
company, and the flavor of the whole company through
some marketing but mostly managing the vice presidents
at that point to make sure that they’re watching over
the multiple factories that we had started to acquire.
Q: And you did that at that point through Leading
Edge Design?
A: Correct.
Mr. Warmoth then testified that Leading Edge handled the labor,
the material control, the quality control, the shipment of the
units, and the morale of the employees. The labor issues aside
(because leasing fees are not at issue), Mr. Warmoth’s testimony
was not corroborated by other credible evidence regarding any
changes in operations, such as material control, quality control,
or product shipment.
Mr. Warmoth’s general and vague testimony and the lack of
credible evidence regarding specifics of the companies’
operations are products of a fuzzy dividing line, if any, between
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Leading Edge and Weekend Warrior. Because the record is vague as
to what specific services Leading Edge performed for Weekend
Warrior under the management agreement and who exactly performed
those services, we cannot conclude that the fees for those
undefined and unquantified services were necessary or reasonable.
Petitioners submitted to the Court an expert report dated
February 27, 2008, prepared by Mr. Baily, whom petitioner called
as an expert witness at trial. In his report Mr. Baily concludes
that fees under the management agreement as of December 20, 2002,
were reasonable. We did not find Mr. Baily’s report helpful
because Mr. Baily prepared it as of December 20, 2002, at the
outset of the relationship between Leading Edge and Weekend
Warrior. According to the letter from Mr. Baily to Mr. Warmoth
accompanying the report, the effective date of the analysis was
December 20, 2002, and “The value determined herein is based upon
information that was reasonably available as of that date and
does not incorporate events that occurred or information that
became available subsequent” to December 20, 2002. As discussed
above, the record does not allow us to conclude that Leading Edge
performed the services envisioned by the management agreement.
Accordingly, any valuation of the fees that does not take into
account the actual relationship of the parties is speculative at
best for the purpose of determining whether the management fee
- 54 -
deductions Weekend Warrior claimed on the 2002-04 returns were
reasonable.
Neither party carried its respective burden of proof on the
issue of the deductibility of the management fees. Given the
allocation of the burden of proof discussed above, we sustain
respondent’s adjustments to the management fee deductions in the
amounts determined in the notices of deficiency. Because
respondent did not carry his burden of proof regarding the
additional deficiencies attributable to the total disallowance of
the management fee deductions, we also hold that petitioners are
not liable for the additional deficiencies asserted in the
amendments to answers.
III. Depreciation Deductions
A. Burden of Proof Issues
With respect to the burden of proof for other adjustments,
such as depreciation and airplane expenses, the general principle
that deductions are a matter of legislative grace and the
taxpayer bears the burden of proof, applies. See New Colonial
Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). Petitioners do
not contend that the burden of proof with respect to these
adjustments shifts to respondent.
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B. Deductions Under Sections 167 and 168(a)
1. In General
Generally, section 167(a) allows a deduction for a
reasonable allowance for the exhaustion, wear and tear, and
obsolescence of property used in a trade or business or held for
the production of income. Pursuant to section 168(a), taxpayers
determine such deduction by using the applicable depreciation
method, applicable convention, and the applicable recovery
period. Section 274(a)(1)(A) generally disallows deductions,
otherwise allowable under the Code, involving entertainment,
amusement, or recreational activities, unless the taxpayer
establishes that the item was directly related to or associated
with the active conduct of the taxpayer’s trade or business.
Section 274(a)(1)(B) generally disallows deductions incurred with
respect to a facility used in connection with such entertainment
activities. Section 274 does not define the term “facility”, but
according to the legislative history, the term includes any item
of real or personal property which is owned, rented, or used by a
taxpayer in conjunction or connection with an entertainment
facility, such as airplanes and yachts. See H. Conf. Rept. 95-
1800, at 249 (1978), 1978-3 C.B. (Vol. 1) 521, 583; S. Rept. 95-
1263, at 174-175 (1978), 1978-3 C.B. (Vol. 1) 315, 472-473.
Section 274(d) requires the taxpayer to substantiate by
adequate records or by sufficient evidence corroborating the
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taxpayer’s own statement any item with respect to an activity
which is of a type generally considered to constitute
entertainment, amusement or recreation, or with respect to a
facility used in connection with entertainment activity. Section
274(d)(4) also disallows any deduction otherwise allowable under,
inter alia, sections 167 and 168 with respect to any “listed
property” unless the taxpayer satisfies the substantiation
requirements of that section. “Listed property” is defined in
section 280F(d)(4) to include any property used as a means of
transportation. Sec. 280F(d)(4)(A)(ii). Section 1.280F-6(b),
Income Tax Regs., includes boats and airplanes as a means of
transportation.
To substantiate a deduction under section 274, a taxpayer
must maintain adequate records or present sufficient evidence
corroborating the taxpayer’s statement as to the following
elements: (1) The amount of the expense, (2) the time and place
of the travel, recreation, or use of the property, (3) the
business purpose of the expense, and (4) the business
relationship to the taxpayer of persons entertained or using the
facility or property. Sec. 274(d); sec. 1.274-5T(a), (c)(1),
Temporary Income Tax Regs., 50 Fed. Reg. 46006, 46016 (Nov. 6,
1985). To meet the adequate records requirements of section
274(d), a taxpayer must maintain an account book, a log, or other
documentary evidence which, in combination, is sufficient to
- 57 -
establish each element of an expenditure or use. Sec. 1.274-
5T(c)(2), Temporary Income Tax Regs., 50 Fed. Reg. 46017 (Nov. 6,
1985). To constitute an adequate record that substantiates
business or investment use of listed property, the taxpayer’s
record must contain sufficient information as to each element of
every business or investment use. Sec. 1.274-5T(c)(2)(ii)(C)(1),
Temporary Income Tax Regs., 50 Fed. Reg. 46018 (Nov. 6, 1985).
If the taxpayer fails to comply with the adequate records
requirements with respect to an element of the expenditure or
use, the taxpayer must establish that element by his own
statement containing specific information in detail as to each
element, including business use, and by other corroborative
evidence sufficient to establish the element. See sec. 1.274-
5T(c)(3)(i), Temporary Income Tax Regs., 50 Fed. Reg. 46020 (Nov.
6, 1985). As explained below, petitioners failed to substantiate
the business use of the airplane and boat in excess of that
allowed by respondent.
2. The Airplane
Respondent determined that Weekend Warrior used the airplane
for business 14 percent in 2002 and 40 percent in 2003 and 2004.
Respondent thus partially disallowed depreciation deductions with
respect to the airplane on the ground that Weekend Warrior failed
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to establish business use of the airplane and failed to meet the
strict substantiation requirements.36 We agree.
The record contains accounting flight logs for 2002 and
pilot flight logs for each year at issue, but these logs do not
list any business purposes for the flights. The parties
stipulated that during 2002-04 Mr. Warmoth did not maintain a
contemporaneous mileage log that described the purposes of the
flights.37 Accordingly, Weekend Warrior fails to satisfy the
adequate records requirements of section 274(d) with respect to
the airplane.
Petitioners introduced into evidence a list of the people
who allegedly flew on the airplane and their alleged business
relationships, which Mr. Warmoth created from memory in 2007.
Mr. Warmoth’s list shows names of individuals and the number of
times each individual was flown on the airplane but fails to list
or explain the business purpose for each airplane use. Mr.
Warmoth testified that the airplane was used for entertaining
dealers, customers, and employees, and “it was part of our
36
Petitioners suggest in their reply brief that respondent
conceded depreciation deductions with respect to the airplane.
Respondent does address lack of substantiation for the claimed
depreciation deductions in his reply brief, and therefore we
address it.
37
Mr. Warmoth testified that Mr. Espera was responsible for
documenting flights for tax purposes. After every trip Mr.
Espera met with Mr. Warmoth and the pilot to obtain information
on the destination and the people involved. The records,
however, could not be found.
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lifestyle”. Mr. Warmoth also testified that Weekend Warrior
organized “jamborees”, such as river rafting trips for 60 to 70
people. According to Mr. Warmoth, the airplane was a tool for
organizing such rafting outings more efficiently.
Such general testimony is insufficient to meet the strict
substantiation requirements of section 274(d). We conclude that
Weekend Warrior failed to substantiate the business use of the
airplane by other sufficient evidence and is not entitled to
depreciation deductions with respect to the airplane beyond those
respondent already allowed.
3. The Boat
Respondent disallowed in full depreciation deductions with
respect to the boat. The parties stipulated that Weekend Warrior
did not maintain a contemporaneous log regarding the boat’s
business use. Mr. Warmoth testified that the boat was a river
boat for the Colorado River where Mr. Warmoth had an
entertainment house, and he entertained there almost every
weekend in both summer and winter. According to Mr. Warmoth, it
was used, like the airplane, for entertaining dealers, customers,
and employees. The marine purchase agreement, however, provides
that “Mark Warmoth (Weekend Warrior)” was the purchaser and lists
Mr. Warmoth’s address in California.
Mr. Warmoth’s general testimony falls short of that required
to satisfy the strict substantiation requirements of section
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274(d). We conclude that the record does not satisfy the
adequate records requirement of section 274(d) and is
insufficient to allow us to conclude that the boat was used for
business purposes.
Petitioner contends, however, that the record shows that the
boat was used at least 50 percent for business purposes and that
the incidental use exception of section 1.274-2(e)(4)(iii)(a),
Income Tax Regs., applies. We disagree. The record does not
allow us to conclude that the boat was used at least 50 percent
for business purposes, and we conclude that the exception does
not apply. We also note that the boat qualifies as listed
property, for which no deduction is allowed unless the taxpayer
meets strict substantiation requirements with respect to the
property. Weekend Warrior failed to substantiate the business
use of the boat by adequate records or sufficient evidence.
Accordingly, Weekend Warrior may not deduct expenses relating to
the boat.
C. Deduction Under Section 168(k) for 2002
For 2002 Weekend Warrior claimed a special depreciation
deduction of $160,000 under section 168(k) with respect to the
airplane. Respondent contends that Weekend Warrior was not
eligible for a special depreciation deduction under section
168(k).
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As discussed above, Weekend Warrior is not entitled to the
disputed depreciation deduction because it did not satisfy the
substantiation requirements of section 274(d). However, even if
Weekend Warrior had met the section 274(d) requirements, it would
not be entitled to the special depreciation deduction under
section 168(k).
Congress enacted section 168(k) as part of the Job Creation
and Worker Assistance Act of 2002, Pub. L. 107-147, sec. 101(a),
116 Stat. 22, to allow an additional first-year depreciation
deduction. The additional depreciation deduction is equal to 30
percent of the adjusted basis of qualified property. See id.
Qualified property is defined as property that meets all of the
following requirements: (1) The property is modified accelerated
recovery system property with an applicable recovery period of 20
years or less (unless an exception not relevant is applied); (2)
the original use of the property commenced with the taxpayer
after September 10, 2001; (3) the taxpayer acquired the property
within a certain period; and (4) the taxpayer placed the property
in service before specified dates. Id.
The “original use” requirement is at issue here.
Petitioners contend that the airplane was original property to
Weekend Warrior in 2002 because it was the first use to which the
airplane was put by Weekend Warrior. We disagree. For the
purposes of section 168(k), original use means the first use to
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which the property is put. See S. Rept. 107-49, at 5 n.7 (2001),
2002-3 C.B. 180, 186; H. Rept. 107-251, at 20 n.2 (2001), 2002-3
C.B. 44, 63; see also January Transp., Inc. v. Commissioner, T.C.
Memo. 2008-268. The record contains documents related to the
purchase of the 1994 airplane. The documents establish that
Weekend Warrior purchased a used rather than a new airplane. For
example, the airplane is described as “beautiful condition”, “2-
owner”, “no damage history”. Moreover, petitioners do not deny
in their reply brief that Weekend Warrior acquired a used
airplane. Accordingly, Weekend Warrior is not entitled to the
section 168(k) special depreciation deduction with respect to the
airplane for 2002.
IV. Airplane Expenses
For each year at issue Weekend Warrior deducted expenses
related to repairs and maintenance of the airplane, insurance
costs, aircraft fees, and pilot expenses. Respondent argues that
these expenses are not deductible on the ground of lack of
substantiation. We agree.
Section 162 allows taxpayers to deduct “ordinary and
necessary” business expenses provided they establish that each
expense claimed was paid or incurred in carrying on a trade or
business. Section 274(d)(4) disallows any deduction otherwise
allowable under, inter alia, section 162, with respect to any
“listed property” unless the taxpayer satisfies the
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substantiation requirements of that section. As discussed above,
the airplane is listed property. See sec. 280F(d)(4)(A)(ii);
sec. 1.280F-6(a)(1), Income Tax Regs.
Weekend Warrior did not provide any receipts or other
credible evidence to substantiate the amount of the expenses. As
discussed above, other than Mr. Warmoth’s general testimony
regarding the business use of the airplane for entertaining,
which was simply not adequate to satisfy the detailed section 274
substantiation requirements, Weekend Warrior presented no
evidence regarding its business use. Accordingly, Weekend
Warrior is not entitled to deduct the airplane expenses.
V. Forgone Interest and Constructive Dividend
Respondent determined that Weekend Warrior had forgone
interest income of $41,343, $69,256, and $117,356 for 2002, 2003,
and 2004, respectively, under section 7872. Respondent relies on
Weekend Warrior’s Schedules L to support his determination. The
Schedules L show that Weekend Warrior reported loans to a
shareholder of $1,205,325, $2,019,153, and $3,421,458 for 2002,
2003, and 2004, respectively. Because of the mechanics of
section 7872 discussed below, the forgone interest determination
also resulted in a determination that for 2002 Mr. Warmoth, as
Weekend Warrior’s sole shareholder, received a $41,343
constructive dividend.
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At trial and on brief respondent claimed that (1) for 2002
Weekend Warrior’s forgone interest equals $39,896 rather than
$41,34338 as determined in the notice of deficiency; (2) for 2003
Weekend Warrior’s forgone interest equals $71,680 rather than
$69,256 as determined in the notice of deficiency; and (3) for
2004 Weekend Warrior’s forgone interest equals $122,138 rather
than $117,356 as determined in the notice of deficiency.39
Generally, section 7872 recharacterizes a below-market loan
as an arm’s-length transaction in which the lender makes a loan
to the borrower in exchange for a note requiring the payment of
interest at a statutory rate. As a result, the parties are
treated as if the lender made a transfer of funds to the borrower
and the borrower used these funds to pay interest to the lender.
The transfer to the borrower is treated as a gift, dividend,
contribution of capital, payment of compensation, or other
payment depending on the substance of the transaction. Section
7872 applies to a transaction that is a loan subject to a below-
market interest rate and is described in one of several
enumerated categories. Sec. 7872(c)(1), (e)(1), (f)(8). One of
38
We treat respondent’s position with respect to 2002 as a
concession. See supra note 3.
39
As stated above, the notices of deficiency issued to Mr.
Warmoth for 2003 and 2004 provided only the totals of adjustments
to Weekend Warrior’s returns. Petitioner correctly notes that
such notices of deficiency are “unhelpful”.
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the categories is a loan between a corporation and any of its
shareholders. Sec. 7872(c)(1)(C).
To determine whether the below-market loan took place, we
consider whether the loan was a demand or term loan and whether
it was subject to a below-market interest rate. See sec.
7872(e)(1); KTA-Tator, Inc. v. Commissioner, 108 T.C. 100, 103
(1997). A demand loan includes “any loan which is payable in
full at any time on the demand of the lender.” Sec. 7872(f)(5).
A term loan is “any loan which is not a demand loan.” Sec.
7872(f)(6). The determination of whether a loan is a demand loan
or a term loan is a factual one. See KTA-Tator, Inc. v.
Commissioner, supra at 104. Loans between closely held
corporations and their controlling shareholders are subject to
special scrutiny. Id.
We first address the question of the burden of proof. The
determinations of forgone interest and constructive dividend are
determinations of unreported income. The Court of Appeals for
the Ninth Circuit, to which an appeal would lie absent a
stipulation to the contrary, see sec. 7482(b)(1)(A), has held
that for the presumption of correctness to attach to the notice
of deficiency in unreported income cases, the Commissioner must
establish “some evidentiary foundation” connecting the taxpayer
with the income-producing activity, see Weimerskirch v.
Commissioner, 596 F.2d 358, 361-362 (9th Cir. 1979), revg. 67
- 66 -
T.C. 672 (1977), or demonstrating that the taxpayer actually
received unreported income, Edwards v. Commissioner, 680 F.2d
1268, 1270-1271 (9th Cir. 1982). If the Commissioner introduces
some evidence that the taxpayer received unreported income, the
burden shifts to the taxpayer, who must establish by a
preponderance of the evidence that the deficiency was arbitrary
or erroneous. See Hardy v. Commissioner, 181 F.3d 1002, 1004
(9th Cir. 1999), affg. T.C. Memo. 1997-97.
With respect to the interest income determination for
Weekend Warrior’s 2002-04 returns, respondent introduced evidence
of an income-producing activity. In particular, respondent
introduced evidence that Weekend Warrior reported loans to
shareholders as assets on Schedules L. Accordingly, the
presumption of correctness attached to respondent’s
determinations, and petitioners bear the burden of proof with
respect to unreported interest income on a below-market rate loan
(1) for 2002 of $39,896 as per the amendment to answer for that
year, and (2) for 2003 and 2004 as determined in the notices of
deficiency and clarified in the amendments to answers for those
years. The $2,424 and $4,781 increases in the adjustments to
forgone interest for 2003 and 2004, respectively, that respondent
asserted at trial produce increases in deficiencies, and
respondent bears the burden of proof with respect to these
increases. See Rule 142(a).
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With respect to the constructive dividend determination,
respondent introduced evidence that Mr. Warmoth had an income-
producing activity in that he was a shareholder of Weekend
Warrior. Accordingly, the burden of proof shifted to petitioners
to prove that respondent’s adjustments with respect to unreported
constructive dividend income in the notice of deficiency issued
to Mr. Warmoth for 2002 were incorrect. Consequently,
petitioners bear the burden of proof and the burden of production
with respect to the adjustment to dividend income for 2002.
Petitioners do not deny the existence of the loans and argue
only that the loans were not below market rate. However, for
2002 and 2003 petitioners presented no evidence to refute
respondent’s determination that the shareholder loans were below-
market-rate loans. Accordingly, we sustain respondent’s
determination that Weekend Warrior has forgone interest income of
$39,896 and $71,680 for 2002 and 2003, respectively.
The foregoing conclusion results in the corollary conclusion
that in 2002 Mr. Warmoth had constructive dividend income of
$39,896.40 Petitioners do not rely on any facts or legal
principles to contest respondent’s constructive dividend
determination, and petitioners argue only that respondent failed
to prove by any fact or document in the record that Mr. Warmoth
40
Because of the mechanics of sec. 7872, the amount of the
constructive dividend differs from respondent’s determination of
$41,342 in the notice of deficiency.
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had received a constructive dividend. Petitioners forget that
they bear the burden of proof with respect to the constructive
dividend adjustment. See Rule 142(a). Petitioners failed to
carry it.
However, we do not agree with respondent that the 2004
Schedule L shows the correct amount of loans to Mr. Warmoth for
2004. Petitioners introduced into evidence, albeit without
pointing to the relevant postings, Weekend Warrior’s general
ledgers for 2004. We understand that on the 2004 Schedule L
Weekend Warrior reported the shareholder loans on the basis of
the total of the ending balances of accounts titled “Officer
Receivable” ($2,311,458) and “Account Receivable--Warmoth”
($1,110,000) for 2004. Under these accounts, however, Weekend
Warrior recorded loans and advances to various individuals and
companies, in addition to Mr. Warmoth. For example, the account
“Account Receivable--Warmoth” shows journal postings of loans to
National RV Holdings, Inc., LEDI Services, Inc., and others.
Only one posting of a $500,000 loan in that account was to Mr.
Warmoth. The $500,000 loan is further corroborated by Promissory
Note #3 dated October 31, 2004. The $500,000 loan carried an
annual interest rate of 5 percent, and we therefore disregard
that loan in our section 7872 analysis. The journal account
titled “Officer Receivable” shows postings of only two loans to
Mr. Warmoth that total $16,250 for the period January 1 through
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June 30, 2004, and $7,300 for the period July 1 through December
31, 2004.
However, the record also contains a copy of a check dated
December 30, 2004, drawn on Mr. Warmoth’s account for $1,249,149.
The memorandum line on the check reads “loan * * * 6138”.
According to a handwritten note below the copy of the check, the
check was for loan repayment. We conclude that the loan amount
was $1,249,149, rather than what respondent determined.
Petitioners argue that whatever loans Mr. Warmoth took
carried market interest rates. Petitioners point to no credible
evidence in the record showing that Mr. Warmoth actually paid
interest or that Weekend Warrior accrued and/or recorded interest
on the receivable. It is unclear which journal postings record
Mr. Warmoth’s payments of interest. Petitioners similarly failed
to explain any of Mr. Warmoth’s bank statements that could show
loan interest payments.41 We therefore sustain respondent’s
41
Petitioners introduced into evidence voluminous financial
documents yet failed to identify the relevant pages in those
documents that petitioners wanted the Court to consider. These
documents included: The 149-page Weekend Warrior General Ledger
for the period Jan. 1 through June 30, 2004; the 313-page Weekend
Warrior General Ledger for the period July 1 through Dec. 31,
2004; 78 pages of Weekend Warrior’s bank statements for the
Comerica account for the periods May 1 through June 30, 2004, and
Aug. 1 through Dec. 31, 2004; 275 pages of bank statements for
Weekend Warrior’s Foothill account ending in No. 6138 for the
period from Jan. 31, 2003, through Dec. 31, 2004; 24 pages of
Weekend Warrior’s statements for Foothill account ending in 1527
for the period Mar. 31, 2000, through Dec. 31, 2004; 144 pages of
Weekend Warrior’s statements for Foothill account ending in 1519
(continued...)
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determination that the loan, in the amount stated above, was a
below-market loan.
VI. Section 6662(a) Penalties
In the notices of deficiency issued to Mr. Warmoth
respondent determined that Mr. Warmoth’s underpayment was
attributable to (1) negligence or disregard of rules or
regulations under section 6662(b)(1); (2) substantial
understatement of income tax under section 6662(b)(2); or (3)
substantial valuation misstatement under section 6662(a), (b)(3),
and (h).
With respect to Weekend Warrior’s underpayment for 2002, on
brief respondent changed his position regarding the applicable
component of the section 6662(a) penalty. In the notice of
deficiency issued to Weekend Warrior respondent calculated the
amount of the penalty using the 40-percent rate that generally
applies to gross valuation misstatements. See sec. 6662(a), (h).
The form titled “Accuracy-Related Penalties Under IRC 6662” that
respondent attached to Weekend Warrior’s notice of deficiency
explains these calculations citing section 6662(h) and using the
40-percent rate with respect to the total amount of deficiency.
Yet another attachment to the notice of deficiency titled
41
(...continued)
for the period Jan. 1, 2003, through Dec. 31, 2004; and 79 pages
of Mr. Warmoth’s statements for his Wells Fargo Bank account for
the period from Apr. 22, 2002, through Feb. 23, 2005.
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“200212--Adjustments Subject to Accuracy-Related Penalty--IRC
6662” indicates that only the underpayment resulting from the
adjustment to the management fee deduction is attributable to the
40-percent gross valuation misstatement penalty, and the
remaining underpayment is attributable to negligence or disregard
of rules or regulations. Respondent’s amendment to answer
contains similar inconsistencies, but respondent again calculates
the amount of the penalty using the 40-percent rate of the gross
valuation misstatement penalty for the whole underpayment.
On brief, however, respondent does not argue that the gross
or substantial valuation misstatement penalty under section
6662(a), (b)(3), and (h) applies. Instead, respondent asserts
that Weekend Warrior’s underpayment is attributable to negligence
or disregard of rules or regulations or substantial
understatement of income tax under section 6662(a) and (b)(1) and
(2). We construe respondent’s position on brief as an
abandonment of his prior position regarding the 40-percent
accuracy-related penalty. We therefore must decide whether the
underpayments of both petitioners are attributable to (1)
negligence or disregard of rules or regulations under section
6662(a) and (b)(1) or (2) substantial understatement of income
tax under section 6662(a) and (b)(2).
Generally, section 6662(a) and (b)(1) authorizes the
Commissioner to impose a 20-percent penalty on the portion of an
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underpayment of income tax attributable to negligence or
disregard of rules or regulations. The term “negligence”
includes any failure to make a reasonable attempt to comply with
the provisions of the internal revenue laws, and the term
“disregard” includes any careless, reckless, or intentional
disregard. Sec. 6662(c); sec. 1.6662-3(b)(1) and (2), Income Tax
Regs. Disregard of rules or regulations is careless if “the
taxpayer does not exercise reasonable diligence to determine the
correctness of a return position” and is reckless if “the
taxpayer makes little or no effort to determine whether a rule or
regulation exists, under circumstances which demonstrate a
substantial deviation from the standard of conduct that a
reasonable person would observe.” Sec. 1.6662-3(b)(2), Income
Tax Regs.; see also Neely v. Commissioner, 85 T.C. 934, 947
(1985).
Section 6662(a) and (b)(2) also authorizes the Commissioner
to impose a 20-percent penalty if there is a substantial
understatement of income tax. An “understatement” means the
excess of the amount of the tax required to be shown on the
return over the amount of the tax imposed which is shown on the
return, reduced by any rebate. Sec. 6662(d)(2)(A). An
understatement is substantial in the case of a corporation other
than an S corporation when it exceeds the greater of 10 percent
of the tax required to be shown on the return or $10,000. Sec.
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6662(d)(1)(A) and (B). An understatement is substantial in the
case of an individual if the amount of the understatement for the
taxable year exceeds the greater of 10 percent of the tax
required to be shown on the return or $5,000. Sec.
6662(d)(1)(A).
The Commissioner bears the burden of production with respect
to the taxpayer’s liability for the section 6662(a) penalty and
must produce sufficient evidence indicating that it is
appropriate to impose the penalty. See sec. 7491(c). Once the
Commissioner meets his burden of production, the taxpayer must
come forward with persuasive evidence that the Commissioner’s
determination is incorrect or that the taxpayer had reasonable
cause or substantial authority for the position. See Higbee v.
Commissioner, 116 T.C. 438, 447 (2001).
Respondent met his burden of production with respect to
negligence as to both petitioners. He introduced evidence that
the management fee deductions did not satisfy the standard for
deductions under section 162, that Weekend Warrior had forgone
interest, that Mr. Warmoth had constructive dividend income, and
that various other adjustments were appropriate. Respondent also
introduced evidence that the corporate structure created in 2002
resulted in improper unsupportable deductions.
Respondent also met his burden of production regarding the
substantial understatement component of the penalty with respect
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to Weekend Warrior. Weekend Warrior reported no tax due for
2002, and its understatement exceeds both 10 percent of the tax
amount required to be shown on the return and $10,000.
With respect to Mr. Warmoth, respondent met his burden of
production regarding the substantial understatement component of
the penalty for 2003 and 2004. For 2003 and 2004 Mr. Warmoth
reported $256,319 and $136,274 of tax due, respectively. In the
notices of deficiency respondent determined Mr. Warmoth had
deficiencies of $1,252,944 and $471,615 for 2003 and 2004,
respectively. Respondent therefore met his burden of production
under section 7491(c) for 2003 and 2004. However, respondent did
not meet his burden of production regarding the substantial
understatement component of the penalty for 2002. Mr. Warmoth
reported total tax of $158,779, and in the notice of deficiency
respondent determined a deficiency of $14,836. Mr. Warmoth’s
understatement does not exceed the greater of 10 percent of the
amount required to be shown on the return or $5,000.
By reason of the above, petitioners had the burden of
producing sufficient evidence to prove that respondent’s penalty
determinations, except the determination that Mr. Warmoth is
liable for the accuracy-related penalty for 2002 on the basis of
a substantial understatement of income tax, are incorrect. See
Higbee v. Commissioner, supra at 446-447. Petitioners did not do
so.
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Petitioners presented no argument or credible evidence on
the substantial understatement component, nor do petitioners
argue that they were not negligent. Instead, petitioners contend
that they should not be liable for the accuracy-related penalties
on the ground of the reasonable cause and good-faith defense
under section 6664(c)(1). Petitioners contend that they sought
professional tax advice in connection with the structuring of the
businesses and the preparation of the Federal income tax returns.
Petitioners state that they had a team of competent professional
advisers on whom they relied heavily and in good faith.
Generally, section 6664(c)(1) provides an exception to the
section 6662(a) accuracy-related penalty with respect to any
portion of an underpayment if the taxpayer shows that there was
reasonable cause for such portion and that the taxpayer acted in
good faith with respect to such portion. The determination of
reasonable cause and good faith is made on a case-by-case basis,
taking into account all pertinent facts and circumstances. Sec.
1.6664-4(b)(1), Income Tax Regs. The most important factor is
the extent of the taxpayer’s effort to assess the proper tax
liability. Id. For the reasonable cause exception to apply, the
taxpayer must prove that it exercised ordinary business care and
prudence as to the disputed item. See Neonatology Associates,
P.A. v. Commissioner, 115 T.C. 43, 98 (2000), affd. 299 F.3d 221
(3d Cir. 2002). The taxpayer bears the burden of proving that it
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meets the requirements for relief under the section 6664(c)(1)
reasonable cause exception. See Higbee v. Commissioner, supra at
446-447. We determine reasonable cause and good faith on a case-
by-case basis, taking into account all pertinent facts and
circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs. The most
important factor is the extent of the taxpayer’s effort to assess
his proper tax liability. Id.
Reliance upon the advice of a tax professional may establish
reasonable cause and good faith. See United States v. Boyle, 469
U.S. 241, 250 (1985). Reliance on a tax professional is not an
“absolute defense” but merely “a factor to be considered.”
Freytag v. Commissioner, 89 T.C. 849, 888 (1987), affd. 904 F.2d
1011 (5th Cir. 1990), affd. 501 U.S. 868 (1991). Whether
reasonable cause exists when a taxpayer has relied on a tax
professional to prepare a return must be determined on the basis
of all of the facts and circumstances. See Neonatology
Associates, P.A. v. Commissioner, supra at 98. The taxpayer
claiming reliance on a tax professional must prove by a
preponderance of evidence each of the following: “(1) The
adviser was a competent professional who had sufficient expertise
to justify reliance, (2) the taxpayer provided necessary and
accurate information to the adviser, and (3) the taxpayer
actually relied in good faith on the adviser’s judgment.” Id. at
99. Reliance on a return preparer is not reasonable where even a
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cursory review of the return would reveal inaccurate entries.
See, e.g., Pratt v. Commissioner, T.C. Memo. 2002-279.
The record is replete with broad references that the team of
advisers provided “general” tax advice and “general” information
about, for example, S corporation taxation. For example, Mr.
Warmoth testified that Mr. Mitchellweiler, Crabtree & Associates,
and Mr. Lindsey advised Mr. Warmoth that the transactions
separately and as a whole complied with Federal income tax laws.
Mr. Mitchellweiler provided tax advice as to the consequences of
forming an S corporation, although not specifically with respect
to tax compliance issues. Crabtree & Associates advised that the
transaction complied with the applicable Federal income tax law.
Mr. Lindsey also provided general tax advice regarding the
transaction. No opinion letter, however, was prepared with
regard to the transaction between Weekend Warrior and Leading
Edge, ostensibly because the team believed the transaction was
not aggressive.
The record establishes that Crabtree & Associates prepared
the returns for each petitioner for 2002 and 2003 and that
Curzon, Cumbey & Kunkel, PLLC, prepared petitioners’ 2004
returns. The testimony about what general advice was provided to
petitioners does not establish that petitioners meet the elements
for relief from the penalties. The record contains no credible
evidence regarding the return preparation process or the
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background of the tax professionals who prepared the returns that
would justify reliance on them. In addition, we base our
conclusion regarding the management fees on the lack of credible
evidence in the record establishing that the fees were reasonable
or necessary.
With respect to the airplane and boat depreciation and
airplane-related deductions, the parties stipulated that Weekend
Warrior did not maintain travel logs. Weekend Warrior therefore
did not provide all relevant information to the tax adviser for
reporting those expenses.
Petitioners have failed to carry their burden of proving
that there was reasonable cause for, and that they acted in good
faith with respect to, any portion of the underpayment in tax for
each year at issue. We sustain respondent’s determinations of
the accuracy-related penalties.
We have considered the remaining arguments made by the
parties, and to the extent not discussed above, we conclude those
arguments are irrelevant, moot, or without merit.
To reflect the foregoing,
Decisions will be entered
under Rule 155.
Weekend Warrior Trailers, Inc. v. Comm'r
Court: United States Tax Court
Date filed: 2011-05-19
Citations: 2011 T.C. Memo. 105, 101 T.C.M. 1506, 2011 Tax Ct. Memo LEXIS 103
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